What is a Central Bank Digital Currency (CBDC)? A comprehensive guide

Understanding Central Bank Digital Currency

A central bank digital currency (CBDC) is a type of digital currency issued by a nation's central bank. Unlike cryptocurrencies, its value is pegged to the country's fiat currency and is controlled by the central bank.

Numerous countries are exploring or have already introduced CBDCs. As nations move towards digital currencies, it's crucial to grasp the significance and implications of CBDCs for society.

Fiat money is a government-issued currency that lacks a physical commodity like gold or silver backing it. It serves as legal tender for transactions involving goods and services.

Historically, fiat money has primarily existed in the form of banknotes and coins. However, advancements in technology have enabled governments and financial institutions to complement physical fiat money with digital records of credits and transactions.

While physical currency remains widely circulated and accepted, some developed nations have observed a decline in its use, a trend that was exacerbated during the pandemic.

The emergence of cryptocurrencies and blockchain technology has further catalyzed interest in digital currencies and the concept of cashless societies.

Purposes of Central Bank Digital Currencies

In the United States and numerous other countries, a significant portion of individuals lacks access to financial services. As of 2023, approximately 6% of adults in the U.S. did not possess a bank account, with much higher figures in many other nations. Considering this, the primary aims of CBDCs are as follows: to offer businesses and consumers engaging in financial transactions privacy, transferability, convenience, accessibility, and financial security. They also aim to decrease the maintenance costs associated with a complex financial system, lower cross-border transaction fees, and provide individuals currently reliant on alternative money-transfer methods with more economical options. Additionally, CBDCs seek to mitigate the risks posed by current forms of digital currencies, such as cryptocurrencies, which are characterized by their high volatility and fluctuating value. Such instability could potentially create severe financial strain for many households and impact economic stability overall. By contrast, CBDCs, backed by governmental support and under the control of central banks, promise to furnish households, consumers, and businesses with a secure channel for exchanging digital currencies.

Types of CBDCs

CBDCs come in two main forms: wholesale and retail. Financial institutions primarily use wholesale CBDCs, whereas retail CBDCs are used by consumers and businesses.

Wholesale CBDCs

Wholesale CBDCs operate similarly to holding reserves at a central bank. Financial institutions receive accounts from the central bank to deposit funds and settle interbank transfers. Central banks utilize monetary policy tools like reserve requirements and interest on reserves to manage interest rates and influence lending.

Retail CBDCs

Retail CBDCs are government-backed digital currencies intended for use by consumers and businesses. They eliminate intermediary risk, such as the potential for private digital currency issuers to go bankrupt and lose customer assets.

There are two types of retail CBDCs distinguished by how individual users access and utilize their currency:

• Token-based retail CBDCs: Accessed using private keys, public keys, or both, allowing for anonymous transaction execution.
• Account-based retail CBDCs: Require digital identification to access an account.

Addressing Issues with CBDCs

• Mitigate third-party risks such as bank failures or runs, shifting remaining risks to the central bank.
• Reduce steep cross-border transaction fees by simplifying distribution systems and enhancing international cooperation among governments.
• Potentially bolster and safeguard the dominance of the U.S. dollar, which remains the most widely used currency globally.
• Eliminate the expenses associated with establishing a financial infrastructure within a country to extend financial access to unbanked populations.
• Forge direct links between consumers and central banks, obviating the need for costly infrastructure.

Issues Arising from CBDCs

• The potential overhaul of the U.S. financial system raises uncertainties about its impact on household expenses, investments, banking reserves, interest rates, the financial services sector, and the broader economy.
• Transitioning to a CBDC could pose risks to financial system stability, such as potential inadequacies in central bank liquidity to facilitate withdrawals during financial crises.
• Central banks utilize monetary policy to influence inflation, interest rates, lending, and spending, which are critical for employment rates. It is essential for central banks to possess effective tools to positively impact the economy.
• CBDCs, unlike cryptocurrencies which prioritize privacy, necessitate a certain level of oversight by authorities to monitor for financial crimes like money laundering and terrorism financing.
• Just as cryptocurrencies have been targeted by hackers and criminals, a centrally issued digital currency would likely attract similar threats. Therefore, robust measures would be necessary to prevent system breaches and safeguard assets and data.

CBDCs vs. Cryptocurrencies

Cryptocurrencies offer a vision of an alternative currency system free from the constraints of stringent regulations governing every transaction. These transactions are resistant to duplication or counterfeiting and are safeguarded by consensus mechanisms that prevent tampering. Cryptocurrencies operate in a decentralized and unregulated environment, with their value determined by investor sentiment, adoption, and user interest. They are highly volatile assets, often subject to speculation, which makes them less suitable for use in stable financial systems.

In contrast, CBDCs are designed to mirror the value and stability of fiat currency. They are issued by central banks and prioritize stability and safety in financial transactions.

The purpose of a CBDC (Central Bank Digital Currency) is to introduce government-backed digital currencies that leverage blockchain or distributed ledger technology. These currencies aim to improve access to financial services and reduce the operational costs associated with existing monetary systems.

As for the United States, it is currently in the research phase regarding CBDCs. The Federal Reserve and its branches are studying CBDCs and exploring potential implementations within the U.S. financial system. President Joe Biden has directed the development of a national strategy concerning digital currencies.

Several countries have already launched CBDCs, including Jamaica, Nigeria, and The Bahamas.

Regarding whether CBDCs pose a threat, the consensus is that they should complement and strengthen existing financial networks and fiat currencies rather than replace them. Implementing a CBDC to entirely replace a fiat currency could potentially disrupt the financial system, though no country has attempted such a transition, so the actual effects remain hypothetical.