What is CBDC?
Central Bank Digital Currencies or CBDCs in short are a type of digital currency similar to cryptocurrencies but issued by central banks across the world. These CBDCs aren’t different from our traditional currencies. Instead, their prices are often tied up with fiat reserves at a 1:1 ratio with the advantage of providing citizens with an efficient way to make instant transactions at less fees.
According to Christine Madeleine Odette Lagarde, President of ECB (European Central Ban), over 80 central banks are looking to launch their own digital currencies backed by governments. The history of CBDC began in April 2020, when, for the first time, China’s Central Bank, also known as the People’s Bank of China, issued a digital currency called RMB. The value of RMB is equivalent to renminbi, also called YUAN or CNY.
The Need for CBDC
Since the introduction of Cryptocurrency and Blockchain technology in general, the interest in cashless currency is increasing both on individual and institutional levels, because they are easy to manage compared to traditional currencies or notes, require less maintenance cost, and because you can easily transfer them cross-border instantly at a lower cost.
Some of the key advantages offered by Central Bank Digital currencies (as an alternative to banknotes and coins) include, ease of transfer, accessibility, assets security, and privacy.
Even so, physical currencies, like paper money, are still widely accepted all around the world as a medium of exchange. However, recent statistics show that some developed countries have seen significant drop in its usage since the start of the pandemic outbreak at global a level in 2020 and onward.
Benefits of CBDC
Efficiency
CBDC offers faster settlement times (transaction validation) compared to traditional payment methods, thanks to its peer-to-peer transfer technology that doesn’t require intermediaries to verify information manually. This improves overall efficiency and economic productivity.
Central Bank Digital Currencies have potential to streamline and enhance experiences within the widespread financial ecosystem by operating as a medium of exchange that can facilitate seamless cross-border transactions and foreign exchange conversions.
Financial Inclusion
Although traditional banking systems are quite famous among retail investors and institutions, statistics show that many individuals around the world, including the United States, don’t have access to financial services. According to data available on Wikipedia (2020), 5% of adults from USA don’t have bank accounts, while more than 13% who had bank accounts, don’t use them frequently.
By providing a digital payment infrastructure that can connect both unbanked and underbanked countries, and people who previously weren’t able to access traditional banking services, CBDCs have potential to promote financial inclusion.
Via smartphones, individuals in remote areas of the world can access basic financial services, from savings payments to remittances, thanks to Central Bank Digital Currencies.
Transparency
Transparency is what differentiates CBDCs from traditional fiat banking system. Just like Cryptocurrencies, Central Bank Digital Currencies also uses Blockchain distributed ledger technology, which makes it possible to transact transparent, yet immutable, transfers. As blockchain uses smart contracts to execute transactions, this reduces the risk of fraud and corruption.
Reduced Counterfeit Risk
Central Bank Digital Currency significantly reduces the counterfeit risks compared to physical fiat, unless you are utilizing an unknown CBDC asset that claims to be government owned but isn’t issued by Central Bank. Additionally, as CBDCs are launched on top of Blockchain technology, everyone on the internet can verify integrity of assets and transactions through public ledgers.
Monetary Policy Tools
As such digital currencies utilize blockchain technology for transparency and accessibility, it becomes easier for Central Banks to directly influence the supply of currency, interest rates, and liquidity in the market, making it easier to control fluctuation and manage inflation. However, it is worth noting that the supply and interest rate nature of CBDCs can vary depending on the rules of specific assets set at the times of implementation by Central Banks.
Challenges and Considerations
CyberSecurity
Central Bank Digital Currencies are new to adoption and haven’t yet been attacked by hackers. But looking at the track record of the cryptocurrencies that are in the market long before the launch of CBDCs, most have been actively targeted by hackers and thieves.
This indicates that mass-level adoption of CBDC will also likely attract online thieves.
Unlike with cryptocurrencies, in CBDCs hackers would not only be able to steal money, but also sensitive user data that can later be used to spy on citizens’ financial transactions, since Central Bank Digital Currencies are backed by governments and require proper documentation from users and institutions to be able to accumulate them.
This is one of the major challenges, and needs to be addressed by Central Banks to protect their customers against hacking, fraud, and data breaches.
Privacy
Because of the decentralized open-source nature of blockchain technology to promote transparency, CBDCs raises concerns about the privacy of users’ transactions. From my perspective, Central Banks must create a balance between transparency and privacy by establishing strong privacy frameworks and data protection regulations to ensure that each user’s personal information remains private, and is not exploited by security attacks.
There are plenty of privacy-enhancing technologies already introduced in the crypto industry that can be utilized such as zero-knowledge proofs, which protect user identities and transaction details by only displaying opening and closing balances, while still enabling regulatory authorities to monitor everything.
Operational Resilience
If you are familiar with Bitcoin, Ethereum and other popular cryptocurrencies then you might have idea that crypto market in general is facing scalability issues because of low transactions throughput and high validation costs in times of high network traffic. CBDCs also can face similar issues that need to be addressed.
User Adoption
The widespread adoption of digital assets is a worthwhile considering point for Central Banks. By taking steps like ensuring user-friendly interactive interfaces, and seamless integration with traditional (existing) payment systems, and awareness campaigns about the benefits and functionalities of these digital assets, Central Banks can play an important role in user adoption which is essential for success.
Interoperability
Collaboration between different central banks and organizations around the globe can play an important part in making CBDCs interoperable assets and promoting financial inclusion. Interoperability between multiple CBDCs systems will also enable seamless instant transfer of value cross-border in different digital currency platforms.
Types of CBDC
Central Bank Digital Currencies have two types, wholesale and retail. Wholesale CBDCs are mainly used by institutions as a medium of reserve holding in the Central Bank. On the other hand, retail CBDCs are used by consumers (individuals) and businesses.
The Role of Blockchain Technology in CBDC
Blockchain technology plays a key role in the execution of, and settlement of, peer-to-peer transactions among two or more parties. As Blockchain uses smart contracts to execute transactions without a need for a third party, it has potential to improve efficiency of transactions and decrease costs.
CBDC vs Cryptocurrencies
Though both Central Bank Digital Currencies and Cryptocurrencies use similar technology, such as Distributed Ledger, to record and verify transactions, both have different purposes and working mechanisms. Some of the major differences between CBDC and Crypto are defined below in the table.
| CBDC | Cryptocurrencies |
| They are backed by Central Banks. | Financial institutions and banks have no control over cryptocurrencies. |
| CBDCs’ supply and interest rates can be controlled by governments. | Because of its temper-proof nature, supply of cryptocurrencies can’t be edited. |
| Central Bank Digital Currencies are centralized in nature. | Most of cryptos have decentralized open-source nature meaning anyone can access and see all the information recorded on Ledger. |
The Future of CBDC
Based on my analysis and the facts discussed above, I believe CBDCs have a great future ahead. By making it easy for everyone to access financial services securely through their smartphones, Central Bank Digital Currencies have potential to impact financial inclusion. However, there is still a lot of work needed to be done for greater financial stability and improved cross-border transactions.
FAQs
What is the primary purpose of CBDC?
The purpose of Central Bank Digital Currencies is to provide institutions and individuals alike with a secure, convenient, and yet accessible digital payment medium to promote cashless economy.
Can CBDC be used for cross-border transactions?
Yes, facilitating cross-border, low-cost transactions is one of the primary use cases of CBDCs.
Is CBDC a form of cryptocurrency?
No, CBDC is not a form of cryptocurrency. Although its concept was driven from crypto, they aren’t the same because crypto is a completely decentralized industry that promotes transparency and utilizes public ledgers. In contrast, Central Bank Digital currencies are controlled and issued by governments.
Will CBDC affect traditional banking?
Yes, because they are introduced as an alternative to traditional banking services and fiat currencies. Hence, they’ll affect them unless they adopt it.
Will CBDC replace physical cash?
It’s been just three years (2020-2023) since the launch of Central Bank Digital Currencies. So, it’s hard to say whether or not it will be able to replace physical cash. However, it is worth noting that CBDC was actually introduced to replace physical cash.
