A CBDC is it a digital currency?

A virtual currency backed and issued by a central bank is known as a central bank digital currency, or CBDC. As the use of cryptocurrencies and stablecoins has increased, central banks all over the world have come to the conclusion that they must offer an alternative to traditional forms of payment or risk missing out on the future of money.

Numerous cryptocurrencies, or digital currencies, have already been produced in their thousands. Although centralised, governments do not issue cryptocurrencies; for example, take a look at the Facebook-founded Diem project. However, decentralised cryptocurrencies like Bitcoin and those it competes with exist.

Due to the fact that cryptocurrencies are built on distributed ledger technology (DLT), multiple global nodes rather than a single central hub constantly verify the accuracy of each transaction.

A digital ledger, which may or may not be a blockchain, is used to administer CBDC, which speeds up and secures payments between banks, organisations, and people.

One of the most innovative developments in the current global financial ecosystem are central bank-issued digital currencies. There have been many inquiries in the financial industry regarding the Crypto vs. CBDC debate. Let’s examine several CBDC principles and contrast cryptocurrencies with central bank digital currency.

What use do CBDCs serve?

The ability of cryptocurrencies to usher in a new era of inclusive global finance and streamlined financial services infrastructure has been hailed. But rather than serving as a means of exchange, their importance comes from their ability to serve as a store of value. This gap is rapidly narrowing as commercial organisations and monetary authorities both issue stabilised cryptocurrencies and CBDCs as workable solutions for mainstream payments.

However, the fundamental idea of a digital currency—replacing the need for paper money with assets based on computers that resemble money—has been around for more than 25 years. The first digital currencies, including DigiCash in 1989 and e-gold in 1996, were released by central governments.

However, the launch of Bitcoin in 2009 fundamentally altered this model in two ways: first, it established a decentralised (blockchain-based) ledger for transaction execution and record-keeping, and second, it produced a currency that is now widely traded and is not controlled by any sovereign monetary authority.

CBDCs are receiving more attention as a result of the COVID-19 pandemic’s growing importance of digital money, the transition to digital payments, aspirations to use international CBDCs in cross-border transactions, and worries about financial exclusion.

As a result, major central banks throughout the world are competing to produce the first real instance of digital currency. For instance, China is testing a digital Renminbi that enables consumers to make purchases with their mobile devices.

Similar to this, Europe declared the development of a digital euro as part of the five-year plan. The pandemic accelerated the shift to contactless transactions, highlighting how important it is for everyone to have access to safe, efficient, and affordable payments.

In light of technological platforms integrating digital private money into the US payments system and foreign authorities researching the potential uses of CBDCs in cross-border payments, the Federal Reserve is also accelerating its research and public engagement on central bank digital currency.

According to various public pronouncements, CBDCs look to be more than merely a digitally native copy of conventional banknotes and coins. In addition to addressing the issue of greater financial inclusion, some governments regard CBDCs as programmable money—instruments for monetary and social policy that might restrict their use to basic needs, particular regions, or predetermined times.

CBDC can take many different forms, each with different effects on financial system structure and stability, transmission of monetary policy, and payment systems.

Characteristics of CBDCs

A CBDC should possess institutional, systemic, and instrumental traits.

The blossom of money

The term “money blossom” describes a Venn diagram representing the taxonomy of money.

It focuses on the relationships between four key elements:

  • Issuer (central bank)
  • Form (digital or physical)
  • Accessibility (general or restricted)
  • Technology (token or account-based)

One of two technologies—accounts or stored-value tokens—is often the foundation of money. While reserve account balances and the majority of commercial bank money are based on accounts, cash and many digital currencies are based on tokens.

One key distinction between exchanging tokens and account-based money is the sort of verification needed. For token-based currency to function, the payee must be able to verify the legitimacy of the payment object (or payment systems). Contrarily, account money systems place a strong emphasis on verifying the identity of the account holder.

The nucleus of the money blossom is digital central bank money. In accordance with the taxonomy, CBDCs are divided into three categories (the dark grey shaded area). There are both account-based and token-based forms accessible.

Who gets access varies between the two token-based forms, depending on how the CBDC will be used in the future. One is a widely used payment method that was created primarily for retail transactions but has further uses.

The other is a digital settlement token with limited use for settlement and wholesale payment purposes. As described in the sections below, they are known as general-purpose tokens and wholesale only tokens.

varieties of CBDCs

There are various ways in which the creation of a general-purpose or wholesale-only CBDC could benefit payment, clearing, and settlement systems.

General-purpose CBDCs

A CBDC that will be given to the broader public is referred to as “general-purpose CBDC.” availability, traceability, and anonymity Retail CBDC based on DLT has features including availability around-the-clock, 365 days a year, and the viability of an interest rate application.

Due to a desire to take the lead in the rapidly expanding fintech sector, advance financial inclusion by accelerating the shift to a paperless society, and reduce the expenses associated with printing and managing currency, this idea is gaining popularity among central banks in emerging nations.

CBDCs exclusively for wholesale

Banks that maintain reserve deposits with a central bank are eligible for a wholesale CBDC. It could be used to lower counterparty credit and liquidity concerns and boost the effectiveness of payments and securities settlements.

A value-based wholesale CBDC would replace or complement central bank reserves with a restricted-access digital token. A token would be a bearer asset, which means that throughout the transaction, the sender would transmit value directly to the receiver without the use of any middlemen.

In contrast to the current system, which allows the central bank to debit and credit accounts without actually moving money, this would represent a big change. The wholesale CBDC is the most desired idea among central banks because it has the potential to enhance current wholesale financial systems more quickly, inexpensively, and safely.

Therefore, we discussed the different types of Central Bank Digital Currencies in the discussion that came before (CBDC). The differences between retail and wholesale CBDCs are outlined in the infographics below.

Which nations have CBDCs?

Prior to COVID-19, central bank digital currencies were mostly an academic exercise. The development of cryptocurrencies and the need to distribute massive amounts of monetary and fiscal stimulus globally, however, have made central banks quickly recognise that they cannot afford to lose out on the evolution of money.

The Atlantic Council claims that 81 nations, accounting for more than 90% of the global GDP, contemplated creating a CBDC. In May 2020, just 35 nations were considering a CBDC.

China is ahead of the curve by allowing foreign visitors to pay for forthcoming Winter Olympics tickets with digital Yuan and furnish the People’s Bank of China with their passport details. The European Central Bank, the Bank of Japan, and the Bank of England are the other two major central banks that the US Federal Reserve lags behind the most.

Five countries have now officially adopted a digital currency. The Bahamian Sand Dollar was the first CBDC to be widely accessible. 14 countries, including developed ones like Sweden and South Korea, are testing (i.e., at the pilot stage) CBDCs in preparation for a full launch.

Cryptocurrency vs. CBDC

Central bank-issued digital currencies are frequently confused with other forms of cryptocurrency. As previously mentioned, every transaction involving central bank digital currencies has the central bank at its core. However, cryptocurrencies—like Bitcoin—are distributed networks or blockchains that use cryptographic techniques to create digital tokens.

Blockchains used by cryptocurrencies are permissionless (public), whereas blockchains used by CBDCs are permissioned (private). In a public blockchain, anyone can join and take part in the essential operations of the blockchain network. Anyone can read, write, and audit the current operations on the public blockchain network, which aids in maintaining the self-governed character of a public blockchain. On the other side, a private blockchain is a distributed ledger that is not decentralised and works as a closed, secure database based on cryptography principles.

A central bank establishes the limitations for CBDC networks. On crypto networks, the user base is given authority and decides by coming to a consensus.

As a result, CBDCs are centralised as opposed to cryptocurrencies, which are decentralised. Additionally, cryptocurrencies offer anonymity, and CBDCs let central banks track who owns what. Unlike cryptocurrencies, which are frequently created using blockchain, CBDCs are more likely to run on unique technology platforms.

Additionally, stablecoins, which are currencies anchored to a fiat currency like the US dollar, are not the same as CBDCs. A CBDC would be the fiat currency itself rather than being tied to a fiat currency. For instance, a CBDC dollar bill and a dollar bill are the same thing.

CBDCs can only be used to make payments; hoarding or investing in them is strictly forbidden. Cryptocurrencies can, however, be used for both business transactions and speculation.

A CBDC would be less concerned about data and privacy than a cryptocurrency. With a peer-to-peer architecture, the cryptocurrency industry is undeniably autonomous, whereas certain constraints limit central banks.

Because cryptocurrencies are peer-to-peer, users can decide how much and what sort of information they want to share. Contrarily, transactions involving CBDC will automatically transmit a tremendous amount of data to regulatory and tax authorities.

What distinguishes CBDCs from Bitcoin?

Although it may have been the first cryptocurrency to become widely accepted and it undoubtedly dominates conversations about blockchain and cryptocurrencies, bitcoin is only one of the many crypto assets that are currently available.

The popularity, usefulness, and fundamental ideas of Bitcoin have not been diminished or diminished by the emergence of various crypto variations. Instead, the development of stablecoins, CBDCs, and other blockchain and cryptocurrency-related applications has enhanced the general health of the ecosystem.

The ecosystem surrounding Bitcoin provides a glimpse of a different type of financial system where transaction conditions are not constrained by onerous regulations. One of the most well-known cryptocurrencies in the world is Bitcoin, which was established in 2009. Bitcoin doesn’t represent actual, transferable coins. Instead, trades are made and records of them are kept in a publicly accessible, encrypted ledger. The mining process enables the validation of all transactions. Bitcoin is not backed by any banks or governments.

CBDCs are intended to be used in place of fiat money. The goal is to give customers both the convenience and security of digital payments and the controlled, reserve-backed circulation of traditional banking systems. They are designed to work as a medium of exchange in daily transactions, a unit of account, and a store of wealth.

Like fiat money, CBDCs will have the full support of the government issuing them. Central banks or monetary authorities will be solely accountable for their actions.

Central bank digital currencies: advantages and disadvantages

Pros CBDCs facilitate the implementation of monetary policy and governmental processes. Retail or general-purpose CBDCs are used to connect clients and central banks directly, and wholesale CBDCs are used to automate the process between banks. These digital currencies can help other government services by streamlining work and procedures, such as benefit distribution and tax calculation and collection.

Money is distributed through middlemen, which adds a third-party risk to the deal. If the bank’s cash deposits are exhausted, what happens? What if a bank run happens as a result of a rumour or an outside event, such a financial crisis? The delicate balance of a monetary system may be disturbed by such events. Because the central bank is in charge of any residual risk in the system, a CBDC completely eliminates the threat of a third party.

Privacy properties in a CBDC system can be adjusted. A value-based retail CBDC functions as money and shields user information by maintaining the anonymity of transactions. On the other hand, account-based access to CBDCs functions like a typical bank account and may incorporate privacy measures.

Because they are digitally stored and do not require serial numbers to be traced, CBDCs can discourage unlawful activity. Using cryptography and a public ledger, a central bank may readily track money throughout its territory, outlawing unlawful CBDC transactions and criminal activity.

For large portions of the unbanked population, especially in developing countries, one of the obstacles to financial inclusion is the cost of building the banking infrastructure necessary to provide them access to the financial system. By establishing a direct connection between clients and central banks, CBDCs can eliminate the need for expensive infrastructure.

CBDCs aren’t always the solution to the centralization issue. A central authority still has the power to conduct transactions, and that power is vested in it (i.e., the central bank). It continues to have an impact on data and transaction levers between citizens and banks as a result.

Users would have to give up some privacy because the administrator is in charge of gathering and distributing digital identifications. The service provider would be able to see every transaction. This might raise privacy issues akin to those faced by internet service providers and IT firms (ISPs). For instance, criminals might hack computers and utilise stolen data, or governments could forbid transactions between citizens.

CBDCs can assist with cross-border and cross-currency transactions that are unrestricted by the hours of operation or national holidays in different time zones. On the other hand, varying legal and regulatory frameworks significantly hinder cross-border payments. It would be difficult to combine these frameworks.

CBDCs might impact foreign exchange markets inadvertently. For instance, China’s CBDC aims to undermine the dollar’s hegemony by forcing international corporations to transact in the digital yuan, which might potentially undermine the dollar’s position.

The future route

Commercial banks would be able to create money by lending out more than they have in liquid deposits thanks to the CBDCs, which would upend the current fractional reserve structure. Banks need deposits in order to make judgments about loans and investments.

If all private bank deposits were transferred to CBDCs, conventional banks would have to transform into “loanable funds intermediaries,” borrowing long-term capital to support long-term loans like mortgages.

The fractional-reserve banking system would be replaced by a constrained banking system, mostly regulated by the central bank. That would represent a financial revolution, one that has many benefits. To stop bank robberies and keep an eye on private banks’ dangerous credit/lending decisions, central banks would be vastly superiorly equipped.

The new payment ecosystem will be able to arrange itself around a well-designed CBDC, which will be a secure and impartial payment and settlement asset. It will make it possible to create an integrated, open-finance architecture that encourages innovation and competition. Additionally, democratic control over the money will remain.

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