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Understanding Central Banks Digital Currency

You've probably heard about cryptocurrencies like Bitcoin but, do you know about CBDCs? Central Bank Digital Currency is something else you may want to research. CBDCs are a form of digital money that could replace cash and transform the traditional banking system globally in a few decades.

Experts say Central Bank Digital Currencies could increase growth and reduce poverty in emerging countries, as well as eventually replace cash and cards as we know them. But what are CBDCs? And how do they work? Keep reading, because we're going to tell you everything you need to know about Central Bank Digital Currencies.

What is a Central Bank Digital Currency (CBDC)?

A Central Bank Digital Currency – also known as CBDC – is the virtual format of government-issued currency – or 'fiat money' – that is not backed by a physical commodity such as gold or silver. Like fiat money, CBDC is backed by the government who issued the currency. In essence, it is an electronic record or a digital token of the official currency of a government and is issued and regulated by its monetary authority. Because it's backed by a central bank, it's meant to be more stable and secure than cryptocurrencies.

Understanding Central Bank Digital Currencies

The idea behind Central Bank Digital Currencies stems from the need to invent a secure and immutable ledger able to track transactions and enable seamless and direct transfers, without intermediaries and between recipients. In the end, the goal is to simplify the implementation of monetary policy in any economy.

Cryptocurrencies may have been the inspiration behind CBDCs, but these have been designed to pre-empt any adverse effects of cryptocurrencies in the existing financial structure. In the end, CBDCs aim to bring the convenience and security of digital cryptocurrencies and the regulated, reserve-backed money circulation of the banking system.

As for October 2021, 81 countries were pursuing Central Bank Digital Currency development. This included Sweden's Riskbank's e-krona and China's e-yuan, that are in a pilot phase. In the US, the Federal Reserve has been actively researching the introduction of CBDCs in the monetary system to improve the domestic payments system. And the Bank of England has launched a joint taskforce with the Treasure to investigate a potential CBDC for the UK.

The consensus among central banks is that a CBDC will act as a general representation of a country's fiat currency. And like fiat currencies it will function as a unit of account, store value and will be a medium of exchange for daily transactions.

Central Bank Digital Currency vs Bitcoin

Although they may look similar, CBDCs and cryptocurrencies – Bitcoin is a cryptocurrency – are not the same. In fact, Central Bank Digital Currencies and cryptocurrencies and assets are fundamentally different.

To keep it short, cryptocurrencies are a type of digital currency that combines new payment systems with new currencies that are not issued by a central bank. Some examples of well-known cryptoassets are Bitcoin, Ether (Ethereum), XRP or Facebook's own Diem – formerly called Libra.

Although bitcoin and other cryptocurrencies have been around for a few years now you cannot really spend them 'on the high street'. They are still quite volatile and require of a lot of energy usage and expense to keep them going. CBDCs, on the other hand, may become mainstream methods of payment in the near future.

The main differences between CBDCs and cryptocurrencies like Bitcoin are these:

  • CBDCs use permissioned blockchains – Cryptocurrencies use permissionless (public) blockchains
  • CBDC users are tied to an existing central bank and are not anonymous – Cryptocurrency users are anonymous.
  • On CBDC networks, central banks decide the rules – On cryptocurrencies, the authority is on the user base, which makes decisions by reaching a consensus.
  • CBDCs can only be used for payments and monetary transactions – Cryptocurrencies can be used for payments and speculative purposes too.

Types of CBDCs

There are two types of Central Bank Digital Currencies: wholesale CBDCs and Retail CBDCs. And they depend on the actors involved in the transaction.

Wholesale CBDCs

Wholesale CBDCs are the ones that use the existing infrastructure of banking and financial institutions to settle transactions between existing financial transactions. For example, think about the transfer of money or assets between two banks

Retail CBDCs

Retail Central Bank Digital Currencies transfer central government-backed digital currency directly to consumers. They eliminate the risk that banking institutions might sink depositor funds by becoming illiquid.

There are two different types of retail CBDC, depending on the type of access they provide. They are not mutually exclusive, and, in fact, it is possible to have a combination of both functioning in the same economy.

  1. Value- or cash-based access – CBDC are passed to the recipient through a digital wallet that can be identifiable on a public blockchain. Much like cash transactions, it's difficult to identify parties.
  2. Token- or account-based access – Similar to the access provided by a bank account. In this type of CBDC, an intermediary verifies the identity of the recipient and monitors any illicit activity and payments between accounts. It provides more privacy than value- or cash-based access because personal transaction data is hidden from commercial parties and public authorities through a private authentication process.

Advantages of CBDCs

These are the advantages of CBDCs:

  • Make it easier to propagate money through the economy and, by doing so, simplify the implementation of monetary policy. Because CBDCs don't rely on intermediaries, the process money distribution is automated between banks through wholesale CBDCs and establish a direct connection between consumers and central banks via retail CBDCs.
  • Make it easier to transfer money across borders using technology. For that reason, a well-designed CBCD system could revolutionize the remittance industry.
  • Eliminate third-party risk because banks are less likely to run out of cash deposits. And any residual risk rests with the central bank.
  • CBDC systems allow for privacy features. For example, value-based retail CBDC works like cash and makes transactions pseudonymous, preserving privacy thus. While account-based access CBDCs function like a traditional bank account and can have privacy features.
  • CBDCs can be very helpful with financial inclusion for the unbanked population, particularly those in developing and poor countries with no access to traditional banking and financial systems. CBDCs establish a direct connection between consumers and central banks, eliminating the need for infrastructure.
  • Simplify government functions by streamlining the effort and processes for government functions like the distribution of benefits or the calculation and collection of taxes.
  • Prevent illicit activity and illegal transactions because central banks can track CBDCs throughout its jurisdiction by using cryptography and a public ledger. Central Bank Digital Currencies only exist in a digital format and do not require serial numbers for tracking.

Disadvantages of CBDCs

Read on to find out the disadvantages of CBDCs:

  • Because they depend on a central bank, CBDCs don't solve the problem of centralization.
  • Could erode privacy. Even if there is some room for privacy features, the government or third-party provider of the service would have access to all monetary transactions for a person. This could potentially release a lot of privacy issues like hacking or misuse by criminals. And central banks could also misuse their power and not allow transactions between certain citizens.
  • Law, rules, and regulations are not clear yet.
  • There is risk of a strong CBDC issued by a foreign country substituting the local currency of a weaker country.

FAQs

What is a Central Bank Currency?

A Central Bank Currency is another way of calling a Central Bank Digital Currency (CBDC). Also known as digital fiat currency or digital base money, it's a digital currency still in conceptual or trial stage of development that is issued or proposed to be issued by a central bank.

However, just in case you weren't thinking about its digital form, Central Bank Money or Currency is money issued by the central bank of each country. For example, in the US, dollar banknotes are what we call 'Central Bank Money' because they are issued by the Central Bank. Dollar coins, though, are issued by the Treasury and, because of that, cannot be considered 'Central Bank Money'.

What is the point of Central Bank Digital Currency?

We've already elaborated on the pros and cons of CBDCs but, to sum it up, the main point of Central Bank Digital Currencies is that they promote financial inclusion and simplify the implementation of monetary and fiscal policy. If you want to know more, scroll up and read the more detailed information above.

How do Central Bank Digital Currencies work?

CBDCs work are digital 'money' and depend on networks of electronic resources to create, track, and validate monetary transactions. Central Bank Digital Currencies are different from cryptocurrencies like Bitcoin in the sense that a central bank is the one issuing the currency, providing every 'e-dollar' or 'e-yuan' and controlling a central database for the 'money'. While most cryptos are decentralized anonymized, in the case of CBDCs, the central banks give a unique serial number to identify every e-currency they issue.

Will Central Bank Digital Currencies break the banking system?

There is no straight answer to the question of whether Central Bank Digital Currencies or Cryptocurrencies will break the banking system. The Economist thinks it may happen but also that might not be so bad. What's clear is that CBDCs will change the way things work in banking.

On one hand, CBDCs have plenty of advantages:

  • Making payments easier
  • 'Democratizing' central-bank money
  • Reducing the risk that cryptocurrencies replace government tender

But they could also compete with banks, and not just in times of crisis. They would be attractive assets to hold at any time and commercial banks might be drained of the deposits with which they fund their lending these days. If you want to read more about it, this article by The Economist is very interesting.

We hope that after reading this guide, you'll have a much better understanding of Central Banks Digital Currencies. But if you do want to read more, check out the rest of guides and find the latest market news. Or you could go deeper into our stock market news, learn more about the Fed Market, or Fixed Income markets. There's plenty to discover!

Sources:

  • https://en.wikipedia.org/wiki/Central_bank_digital_currency#:~:text=A%20central%20bank%20digital%20currency,issued%20by%20a%20central%20bank.
  • https://www.economist.com/finance-and-economics/2020/12/05/will-central-bank-digital-currencies-break-the-banking-system
  • https://www.bankofengland.co.uk/research/digital-currencies
  • https://www.atlanticcouncil.org/cbdctracker/

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