What Is Central Bank Digital Currency (CBDC) – Finding The Answers

In the last few years, the adoption of blockchain technology and cryptocurrency has gained significant momentum and 2020 turned out to be a major game-changer. The traditional finance system was dealt a hefty blow due to the global COVID-19 pandemic and forced people to consider cash-less options. The heightened popularity and support of Bitcoin, the pioneer cryptocurrency, and the emergence of numerous Blockchain-based projects have pushed governments to see the importance of these decentralized and regulation-free finance systems and how they can be used for avoiding such disastrous situations again.

Even though the concept of Central Bank Digital Currencies (CBDCs) is heavily influenced by decentralized cryptocurrencies, such as Bitcoin, it is not exactly an embracing of these digital currencies. In fact, it has come more as a reaction to them because central banks see cryptocurrencies as a threat that needs to be managed. Their solution is a CBDC, which refers to Central banks using the concept of stablecoins for gaining in-depth knowledge of the crypto space for the purpose of developing their own digital currency. This would be regulated and operated by the respective central banks or monetary authorities of a particular country. Let’s explore in more detail:

What is CBDC?

In simple terms, the digital form of a country’s traditional fiat money is referred to as Central Bank Digital Currency (CBDC). The existing concept uses blockchain and the distributed ledger technology, such as cryptocurrencies. However, CBDCs are a tad different from cryptocurrencies and virtual currencies because the latter are decentralized and haven’t been issued by the state. Plus, they also don’t have the legal tender status issued by the government. The purpose of coming up with a CBDC is to combine the benefits of both worlds; the security and convenience of digital solutions like cryptocurrencies, and the reserve-backed, regulated money circulation associated with the traditional financial system.

Every unit of CBDC would be used as a secure digital equivalent of its fiat counterpart and can be used as a store of value, payment mode, and a unit of account. Each CBDC unit will have a unique serial number like fiat currency, which means that it will also be distinguishable for preventing imitation. Since it will be part of the money supply of the central bank, it would work along with the other forms of fiat currencies. There are two different kinds of CBDCs that have been given distinct purposes and are known as Wholesale and Retail CBDCs.

Wholesale CBDCs refer to the digital currencies used in transactions between the central bank and other private banks. They can also be used for making cross-border transactions between various banks. Project Inthanon-Lionrock is one such example, as this is a cross-border digital payment system developed used by the Bank of Thailand and the Hong Kong Central Bank.

As far as Retail CBDCs are concerned, they are basically the retail money that would be used by individuals for conducting transactions in everyday life. Cash could actually be rendered obsolete due to retail CBDCs and it will also be traceable, which could help in mitigating numerous criminal activities.

Benefits of CBDCs

Thanks to the introduction of new technology every once in a while, the financial system has become quite dynamic and the development of digital currency has also brought changes. Some of the benefits that could be enjoyed due to the adoption of CBDCs are:

• The safety and productivity of wholesale as well as retail payment solutions could be improved with the help of a CBDC. These improvements include wholesale interbank payments, which would lead to quicker settlement options, and retail providers using online, point of sale, or P2P solutions.
• As cryptocurrencies are bringing about a cashless society, the transition from fiat currency options to digital solutions would certainly be eased by a CBDC, as there would be a regulatory body in place for preventing and monitoring illicit activities.
• Making cross-border digital transactions between parties will become seamless and fast with the advent of a government-backed digital currency.
• In recent years, there has been a major decline in the use of physical cash and this reached new heights in 2020, as more people switched to payment settlement applications and cards. If a CBDC were to be issued by a country and given the status of legal tender, the use of cash would be further reduced. This would help alleviate some of the downsides of the use of cash, such as money laundering, tax evasion, and illegal transactions, amongst others.
• Governments will be able to observe and track the flow of money, which will reduce criminal activities, as mentioned above, and also help in highlighting trends.

Risks of CBDCs

While there is no denying that a Central Bank Digital Currency (CBDC) could be beneficial, it is also important to take a look at its risks. First off, if people start adopting CBDCs fully, then it would result in the disintermediation of commercial banks. It could lead to a vicious cycle because banks may be prompted to increase deposit rates for attracting more money. As a result, it would mean that less bank credit would be provided at higher interest rates. There are also concerns about central banks having to deal with KYC and AML processes for a CBDC, something which is usually handled by commercial banks.

The reputational risk also needs to be taken into account because a CBDC could suffer from different types of errors, cyberattacks, and glitches that could have an adverse impact on the reputation of the central bank. Moreover, even though the benefits of cross-border transactions do exist, CBDCs could be a danger to economies with volatile exchange rates and high inflation because of the risk of dollarization.

Nevertheless, a number of central banks from all over the world are exploring the feasibility of these digital currencies and most of them are in the research phase, while a few have entered the planning phase with China making the most progress and Japan not far behind. Other countries taking an interest include Sweden, Thailand, France, and Uruguay.