Everything You Need to Know About CBDCs

Central Bank Digital Currencies (CBDCs) are digital tokens created by national central banks and are tied to the value of a country's fiat currency

Central Bank Digital Currencies (CBDCs) are the digital tokens of a country’s currency issued by the central bank. They are units of account, a medium of payment, and a store of value, just like cash but in digital form.

They are direct claims on the central bank and are pegged to the value of the national fiat currency, such as the US dollar, euro, or yen. Unlike cryptocurrencies, which are decentralized, CBDCs are issued and controlled by central banks, ensuring that they are stable and reflect the value of traditional currencies.

Essentially, CBDCs offer a digital alternative to physical money, functioning similarly to prepaid cards or digital wallet balances but without the need for third-party intermediaries like commercial banks.

While many countries are still in the early stages of developing CBDC models, important considerations remain, such as accessibility, privacy, interest-bearing capabilities, and the potential to replace cash entirely.

As society moves towards digital payments, the demand for alternative financial services is growing, especially among the unbanked population.

CBDCs aim to provide greater access to central bank money, reduce reliance on intermediaries, and potentially lower the cost of cross-border transactions, which could be especially beneficial for institutions and large corporations. They could also help to mitigate the risk of bank failures and streamline monetary policies.

The COVID-19 pandemic accelerated the shift away from physical cash as governments and financial institutions sought new ways to provide financial assistance and services during lockdown measures.

This increased interest in digital currencies, ultimately leading to the development of CBDCs. The primary goal is to offer a safe, efficient, and accessible form of money for businesses and consumers, enhancing privacy, convenience, and financial inclusion.

The introduction of CBDCs also comes in response to the rise of private electronic money systems, such as digital wallets and cryptocurrencies.

Unlike cryptocurrencies, which are decentralized and can be highly volatile, CBDCs are designed to be stable and are backed by the government, rendering them suitable for use in everyday transactions as legal tender.

Although CBDCs are often compared to cryptocurrencies, there are crucial differences. Cryptocurrencies operate on decentralized networks, without government backing, and their value is driven by market sentiment and speculation.

In contrast, CBDCs are centrally regulated, stable coins pegged to the value of national currencies, and are intended to be used for large-scale adoption in financial systems.

There are two main types of CBDCs: retail and wholesale. Retail CBDCs are designed for use by the general public for seamless peer-to-peer payments, efficient online transactions, and facilitating financial inclusion.

On the other hand, wholesale CBDCs are focused on improving settlement efficiency for financial institutions and large corporations, addressing issues related to liquidity and counterparty risks in financial markets.

When designing CBDCs, central banks must choose between two main structures: token-based or account-based systems. Token-based systems offer a higher level of anonymity, with users relying on cryptographic keys to manage their tokens and transactions, similar to private cryptocurrencies.

In contrast, account-based systems are linked to users’ bank accounts, requiring personal identification and adherence to regulatory standards like Know Your Customer (KYC) and Anti-Money Laundering (AML) laws.

The implementation of CBDCs could lead to more streamlined and secure payment systems, reducing fraud and facilitating faster transactions. However, the hyper-centralization of financial control may raise concerns over privacy violations and increased government surveillance.

Additionally, while cross-border payments could become more efficient, legal and regulatory hurdles would need to be overcome for seamless cross-system transactions.

Several countries are already in the advanced stages of exploring the potential of CBDCs. For example, China’s digital yuan, known as the e-CNY, is rapidly advancing, with the country launching pilot programs in various cities to test the central bank token in real-world scenarios. The US is also engaging in research on a digital dollar, with the Federal Reserve working with leading banks, including Citi and Wells Fargo, to assess the potential benefits, risks, and best practices for introducing a central bank digital currency.

The European Union is developing the digital euro, which would offer a stable, government-backed alternative to private digital currencies in the EU, similar to how the euro is a central bank currency. Sweden is progressing with its e-krona project, while the Bahamas have already launched their Sand Dollar. These initiatives highlight the growing momentum towards introducing CBDCs in major economies.