In recent years, the idea of a Central Bank Digital Currency (CBDC) has gained increasing attention from economists, financial regulators, and policymakers around the world. In 2020, only 35 countries were considering the idea of CBDC.
However, at the dawn of 2023, that number had skyrocketed to 114 making about 95% of the global GDP. Apparently, the emergence of cryptocurrencies and blockchain technology has sparked interest in the potential benefits of a digital currency issued by a central bank. And governments are keen to not be left behind in the development of digital currencies. But what exactly is a CBDC, and why is it important?
In this article, we will explore the concept of central bank digital currencies, how it differs from traditional currencies, and the potential benefits and risks associated with its implementation.
What is a CBDC Currency? (Central Bank Digital Currency)
A Central Bank Digital Currency is a digital form of currency or digital money issued by a central bank, which is a government institution responsible for managing a country's monetary policy. It is a digital representation of a country's fiat currency that can be used as a medium of exchange, a store of value, and a unit of account.
Unlike traditional fiat currencies, which is physical money, a CBDC is a digital asset that can be transferred through electronic means, such as smartphones, computers, or other digital devices. It is designed to be a secure and efficient form of payment that can be used by anyone, anywhere, at any time.
Types of Central Bank Digital Currencies
Central bank digital currencies can be classified into two types, namely retail CBDC and wholesale CBDC. A retail CBDC is a digital currency that can be used by individuals and businesses to make payments and transactions, just like traditional money. They are intended to be used as a form of electronic payment for retail transactions, just like physical cash or digital payment methods such as credit cards or mobile payments.
The exact features of retail CBDCs may vary depending on the specific design and implementation chosen by each central bank. Some possible features may include instant settlement, increased transaction privacy, and reduced costs compared to traditional payment methods. However, there are also potential risks and challenges associated with the development and adoption of retail CBDCs, such as the need to ensure security and prevent fraud, as well as potential impacts on monetary policy and financial stability.
A wholesale central bank digital currency, on the other hand, is used for interbank transactions and settlement between financial institutions. Like the Project Icebreaker which is being built for testing interlinking and interoperability between several retail CBDCs. It was launched by the Bank of Israel, Central Bank of Norway, Sveriges Riksbank, and BIS Innovation Hub Nordic Centre in September 2022. The study, which was supposed to last until the end of 2022, examines a framework for allowing cross-border retail CBDC payments. A report is anticipated in 2023.
Countries Currently Exploring Central Bank Digital Currencies?
Several countries are currently exploring the concept of CBDC, including:
- China: China has been at the forefront of CBDC development, with the launch of its digital yuan by its central bank in 2020. The digital yuan currently has a reach of 260 million and is expected to be rolled out more widely in 2023.
- Sweden: Sweden is also in process of developing a CBDC, with the launch of its e-krona project. The project is currently in its testing phase, and the country's central bank is expected to make a decision on its implementation in the coming years.
- The United States: The United States Federal Reserve launched its research and experimentation initiative in 2020. It started a project called Project Cedar shifting the country from research phase into development although it is unclear when a CBDC might be launched in the US.
- The European Union: The European Central Bank is also exploring the concept of a CBDC, with the launch of its digital euro project. The project is currently in its exploratory phase, and a decision on its implementation is expected in the coming years.
It is also worthy of note that by December 2022 all G7 countries had moved into the development phase of a CBDC while 18 of G20 countries are in an advanced stage of their development of their CBDC according to an Atlantic Council publication.
How Does a Central Bank Digital Currency Work?
The underlying technology behind a CBDC is a distributed ledger, which is a digital database that records all transactions in a secure and transparent manner. This technology is also used in cryptocurrencies such as Bitcoin and Ethereum.
A CBDC is issued by a central bank and is backed by the full faith and credit of the government. It can be converted into fiat currency at a one-to-one ratio, which means that one unit of the CBDC is equal to one unit of the fiat currency.
The central bank will be responsible for the issuance, management, and regulation of the CBDC. Furthermore, users will be required to create a digital wallet to store and use the CBDC, and transactions will be recorded on the distributed ledger.
What are the Potential Benefits of a Central Bank Digital Currency?
There are several potential benefits of a CBDC, including:
Traditional payment methods including cash, cheques, and bank transfers can be made faster and less expensively by using a CBDC. Also, it can increase transaction and settlement speed, which will make it easier for customers and clients to transact and make payments.
In every country, there are people who don't have access to financial services because of low or no education or even distance. A CBDC can provide access to financial services to this set of people who are currently unbanked or underbanked. It can also help to reduce the cost and barriers to entry for financial services, making them more accessible to people with limited access to traditional banking services.
CBDCs can give central banks more effective tools to implement monetary policy. It will enable central banks to monitor and control the money supply, as well as track the velocity of money, which can help to stabilize the economy and prevent inflation.
Another potential benefit of a CBDC is that it can provide a more secure form of payment compared to traditional payment methods. With CBDCs banks can reduce the risk of fraud, counterfeiting, and theft, making it a more reliable and secure form of payment.
CBDCs can also help to increase financial stability by reducing the risk of bank runs and the reliance on commercial banks for liquidity. It can also improve the resilience of the financial system by providing a safer and more stable form of money.
What are the potential risks of a Central Bank Digital Currency?
There are also several potential risks associated with the implementation of a CBDC, including:
- Privacy: A major risk would be that CBDCs would raise concerns around privacy and surveillance. Because all transactions would be recorded on a distributed ledger, there could be concerns around the tracking and monitoring of individuals' financial activities. While this may be a good deal for some people, the majority might not be too happy about their neighbors potentially finding out how they spend their money.
- Cybersecurity: A CBDC would rely heavily on digital technology, which could be vulnerable to cyberattacks and hacking. If it were to be compromised, that could have significant implications for the financial system and the economy of the affected country.
- Financial Disruption: The implementation of a CBDC could potentially disrupt the existing financial system, particularly if it results in a significant shift away from traditional payment methods. This could have significant implications for financial institutions and the wider economy.
- Adoption: To be effective, a CBDC would require widespread adoption, which could be challenging in some countries. It may take time for individuals and businesses to become comfortable with using a digital currency, particularly if it is a new concept or if they have concerns around its security or privacy.
- Centralization: A CBDC could potentially increase the centralization of the financial system, particularly if it is used to replace traditional payment methods. This could adversely impact competition and innovation within the financial sector.
Difference Between CBDCs and Cryptocurrency
CBDCs (Central Bank Digital Currencies) and cryptocurrencies are both digital currencies, but they differ in several ways.
In the end, people's choice of which digital currency to use would depend on what they are trying to achieve. If they prize security, privacy or decentralization more, that would determine whether they favor cryptocurrency or CBDCs.
Below are some differences between the two types of digital currencies:
- Issuer: The main difference between CBDCs and cryptocurrencies is the issuer. CBDCs are issued and backed by central banks, whereas cryptocurrencies are not issued by any central authorities, financial institutions or governments.
- Legal tender: CBDCs are likely to be legal tender, which means that they will be accepted as a means of payment and settlement of debts. Cryptocurrencies are not generally accepted as legal tender and their use as a means of payment is not yet widespread.
- Control: Central banks have greater control over CBDCs, including the ability to monitor transactions, track the flow of money, and set monetary policy. Cryptocurrencies, on the other hand, are mostly decentralized and cannot be controlled by any single entity.
- Privacy: CBDCs may be designed to provide greater privacy and anonymity for users, but central banks may also have the ability to monitor transactions and gather data about users. Cryptocurrencies generally provide greater privacy and anonymity, but they can also be used for illegal activities such as money laundering or financing terrorism.
- Volatility: Cryptocurrencies are known for their volatility, with their value fluctuating wildly in a short period of time. CBDCs, on the other hand, are likely to be more stable, as they are backed by the central bank.
Although the creation of Central Bank Digital Currencies is still a vastly untested terrain, it is obvious that it is not going away soon.
As long as cryptocurrency and other digital advancements continue to take center stage in the global economy, central bodies cannot afford to ignore this aspect of financial innovation.
Besides, its numerous use cases and potential benefits cannot be ignored by truly astute entities. Hence it only stands to reason that each country would do its best to explore this technology and its benefits while working out ways to mitigate potential risks.