In the ever-evolving landscape of global finance, digital currencies have become more prominent, attracting millions of users and investors. While stalwarts like Bitcoin, Ethereum, and Dogecoin have dominated the cryptocurrency realm, central banks are launching their digital currencies, aptly named Central Bank Digital Currencies (CBDCs).
These novel assets share similarities with cryptocurrencies but also bear distinctive characteristics. This guide explains what CBDCs are, what they do, and how they differ from other digital currencies.
Why CBDCs?
A CBDC is a digital version of a nation’s fiat currency, issued and governed by the central bank. CBDCs are entirely electronic, enabling smooth digital transactions and storage, unlike physical cash or regular bank deposits.
While CBDCs may seem like a recent development, certain central banks have utilized digital currency for interbank transactions for several decades.
The surge in interest surrounding CBDCs arises from a multitude of factors:
- Technological Advancements: The widespread adoption of blockchain technology and cryptocurrencies offers swifter, more cost-effective, and transparent transactions.
- Shift from Cash to Digital Payments: The reduced reliance on physical cash and the surge in digital payments, particularly accelerated by the COVID-19 pandemic.
- Geopolitical Significance: The strategic implications of possessing a digital currency capable of rivaling major currencies or challenging the dominance of the US dollar.
- Enhanced Financial Inclusion and Stability: Addressing the need for improved financial inclusivity, stability, and efficiency, alongside combatting money laundering, tax evasion, and cybercrime.
As of mid-2023, the Bank for International Settlements (BIS) reports that 86% of the world’s central banks are actively researching or experimenting with CBDCs. Some have even taken the step of launching or piloting their own, including China (with the Digital Yuan or e-CNY), The Bahamas (with the Sand Dollar), Sweden (with the e-krona), and Nigeria (with the eNaira).
More nations, including Japan, South Korea, Canada, and France, are considering or developing their CBDC initiatives.
How CBDCs Work
The intricate design and implementation of CBDCs can vary substantially, influenced by each central bank’s distinct objectives and preferences. However, certain commonalities and challenges persist:
- Access: CBDCs come in two types: wholesale and retail. Wholesale CBDCs are for financial institutions like banks for large-value interbank transactions. Retail CBDCs, however, are for the public and used in everyday transactions through digital wallets or accounts provided by the central bank or authorized intermediaries.
- Technology: CBDCs use diverse technologies for transaction recording and verification. Blockchain or distributed ledger tech (DLT) with decentralized nodes offers security and transparency. However, central banks might choose centralized or hybrid systems for more control and adaptability over the network.
- Distribution: CBDC distribution methods depend on central banks’ involvement. Direct distribution, where the central bank issues CBDCs directly through its platform, is efficient but may pose operational risks. Indirect distribution involves central banks providing CBDCs to commercial banks or intermediaries, leveraging existing infrastructure but introducing potential risks and regulatory complexities.
- Design Features: Central Bank Digital Currencies come with different features that affect how they work. Such features include:
Interest: CBDCs can earn interest or not. If they do, the central bank can adjust it based on policies to control inflation. But this adds complexity for users managing their money.
Anonymity: Some CBDCs offer more privacy, like cash, while others are more traceable, like bank accounts. This raises concerns about privacy and security.
Limits: CBDCs may restrict transactions, like amount, frequency, or where they can be done. This can prevent certain activities and make them less convenient for users.
CBDCs And Cryptocurrencies: How They Differ
While CBDCs and cryptocurrencies are digital and facilitate paperless transfers, there are notable distinctions between them.
Issuance: CBDCs are issued and governed by the central bank, with their supply and value determined by the country’s monetary policy. Cryptocurrencies, in contrast, are created and regulated by algorithms or protocols, with their supply and value dictated by predetermined rules or market forces.
Backing: CBDCs derive their value from the credit of the issuing government, rendering them legal tender with a stable value equivalent to fiat currency. Cryptocurrencies lack real-world asset backing or guarantees. Hence, they are unacceptable as legal tender and exhibit a volatile value contingent on supply and demand dynamics.
Access and Privacy: CBDCs are accessible to individuals through digital wallets or accounts provided by the central bank or authorized intermediaries. In contrast, cryptocurrencies can be accessed through various platforms or services independent of central banks or governments.
Regarding privacy, CBDCs offer varying degrees of anonymity based on design choices. However, cryptocurrencies’ anonymity levels are determined mainly by the type of blockchain they employ.
Regulation: CBDCs are subject to the laws and regulations of the issuing country, which may vary across jurisdictions. On the other hand, cryptocurrencies contend with limited or inconsistent regulation across countries, resulting in potential legal ambiguity or risks for users.
Final Thoughts
CBDCs represent a form of digital currency issued and regulated by central banks, offering advantages and disadvantages for users, businesses, governments, and society. Meanwhile, the trajectory of digital currencies hinges on their evolution and integration into the existing financial system.
As digital finance continues to evolve, the interconnectedness between CBDCs and cryptocurrencies will undoubtedly shape the financial landscape of the future.
