What are Central Bank Digital Currencies (CBDCs): Complete Guide

The way we pay, bank, and transact is undergoing a radical shift with the rise of digital technologies. Central Bank Digital Currencies or CBDCs represent a key emerging trend that could transform the future of money and finance. As central banks consider developing their own government-issued digital currencies, many questions about how CBDCs work, the potential benefits they offer, and their wider economic impact come to the forefront. 

In this blog, we seek to explore the concept of CBDCs, covering topics such as what a CBDC is, different CBDC models under consideration, and the benefits they provide. We will also discuss their impact on banking and how to utilize CBDCs in cryptocurrencies. Through this discussion, we aim to develop a deeper understanding of this potentially disruptive financial innovation and gain insights into the future of money.

What is a CBDC?

A Central Bank Digital Currency (CBDC) is the digital form of a country's fiat currency controlled and issued by its central bank. It provides digital access to central bank reserves that backs the physical currency. In essence, a CBDC is the digital equivalent of paper notes and coins issued by central banks.

It allows citizens to make electronic payments and transfers using a digital currency that is issued and backed by the central bank. Unlike cryptocurrencies which are decentralized, a CBDC is a sovereign currency issued and regulated by a central monetary authority. It represents a liability of the central bank, just like physical cash.

CBDCs offer many potential benefits like faster and cheaper transactions, increased financial inclusion, easier cross-border payments, and programmable functionality. It also provides the ability to trace transactions for tax compliance and anti-money laundering purposes. However, CBDCs also raise concerns about privacy, surveillance, cybersecurity, and the stability of the banking system.

Types of CBDCs

There are two main types of CBDC models under consideration:

• Wholesale CBDC: This model gives digital currency access to financial institutions and banks. The central bank issues CBDC to commercial banks who then provide retail services to end users. This aims to streamline interbank transfers and settlements.
• General Purpose or Retail CBDC: In this model, the central bank issues CBDC directly to individuals and businesses for use in retail payments, purchases, and other transactions. It acts as a digital equivalent of physical cash available to the general public.

Within these two broad categories, CBDCs can differ in architectural design:

• Access Model: Direct-only where the central bank directly interfaces with users or Two-tier where financial institutions act as intermediaries.
• Ledger type: Centralized ledger where the central bank controls the ledger or Distributed ledger like blockchain.
• Functionalities: Simple payment token or programmable token with additional features.

Benefits of CBDCs 

Here are some of the main benefits of Central Bank Digital Currencies:

• Faster Payments: CBDCs have the potential to enable real-time or near-real-time payments and settlements, especially across borders. This could significantly improve payment efficiency.
• Financial Inclusion: CBDCs may help bring more people into the formal financial system by providing access to digital payments even to those without bank accounts. This could promote financial inclusion.
• Lower Costs: CBDCs have the potential to reduce transaction costs since intermediaries like banks may not be needed for every transfer.
• Increased Security: CBDCs since they are issued and backed by central banks, have an inherent level of trust and security. This could make them appealing alternatives to existing digital payment methods.
• Improved Monetary Policy: Central banks may gain additional tools and insights to implement and monitor the impact of monetary policies through CBDCs.
• Fraud Reduction: Advanced features like programmed rules in CBDCs could make them less prone to fraud and illicit usage compared to other digital currencies.
• Faster Settlement: CBDCs enable real-time settlement of funds which can reduce credit, liquidity, and settlement risks for businesses.

Impact of CBDC on the banking industry 

Central bank digital currencies have the potential to significantly impact commercial banks and the broader banking industry. On the positive side, CBDCs could provide banks access to cheap and stable central bank funding which they can lend out at higher rates. Additionally, CBDC interbank settlement systems could reduce dependency on correspondent banking networks, lowering costs for banks. CBDCs can also enable the development of new banking products and services leveraging the advanced features and capabilities of digital currencies.

However, CBDCs also pose risks for banks. Retail CBDCs that provide digital cash directly to consumers could potentially undermine banks' deposit bases and profit margins. Customers may shift some of their deposits from commercial bank accounts to CBDC digital wallets, impacting banks' liquidity and lending capabilities. Moreover, CBDC systems that facilitate peer-to-peer transactions without intermediaries may cut into banks' transaction fee revenues from services like wire transfers. 

Overall, CBDCs offer some opportunities for banks to innovate, develop new revenue streams, and access cheaper funding. They also threaten aspects of the traditional banking model by potentially disintermediating banks from certain activities and transactions. Banks will need to adapt to this changing landscape by exploring ways to provide value-added services on top of the basic CBDC rails.

How to invest in CBDCs?

Most Central Bank Digital Currencies are still in the planning stages and have not been officially launched. Once CBDCs are rolled out and allow token ownership by the general public, individuals may be able to invest in CBDCs in a few ways. First, CBDCs may be bought and sold on regulated cryptocurrency exchanges like other digital assets. Second, financial products and funds tied to CBDCs may emerge that allow indirect investment. 

However, since CBDCs are not designed as investment tools, their value is unlikely to see high volatility like cryptocurrencies. Rather, CBDCs will mostly function as a digital form of fiat money, acting as a stable store of value and medium of exchange. So investing in CBDCs directly may have limited upside potential.

How CBDC is used in crypto? 

Central Bank Digital Currencies can potentially play an important role in the future of cryptocurrencies and digital assets. Since CBDCs are issued by central banks, they offer an element of trust, legitimacy, and stability that many cryptocurrencies currently lack. CBDCs could act as an on-ramp for individuals to enter the crypto economy by first familiarizing themselves with the benefits of digital currencies. 

CBDCs may also serve as a stablecoin pegged to national fiat currencies, providing a stable store of value for crypto investors. Some cryptocurrency exchanges are already exploring the option of supporting CBDCs once they are rolled out. Overall, CBDCs have the potential to catalyze mainstream adoption of cryptocurrencies by acting as a bridge between traditional fiat currencies and more volatile crypto assets.

Difference between CBDC and fiat money

The key differences between CBDC and fiat money are:

• Form: Fiat money currently exists primarily in physical forms like banknotes and coins. CBDC on the other hand is a digital representation of fiat currency. It exists only in electronic form.
• Access: Fiat money is accessible to the general public directly from the central bank or commercial banks. CBDC models differ in their access structure - some are for banks only while others give access directly to individuals.
• Speed: Transactions using fiat money, especially cash, are often slower. CBDCs enable near-instantaneous transactions due to their digital nature.
• Programmability: Fiat money is "dumb" in the sense that it has no programmable features. CBDCs have the potential to be "smart money" with features like time locks, limits, and triggers that can be programmed in.
• Cost: Fiat money has marginal costs associated with producing, distributing, and storing physical notes and coins. CBDCs, being digital, have much lower recurring costs.
• Anonymity: Fiat Cash provides a high degree of anonymity. CBDCs may offer varying levels of anonymity depending on their design and architecture.
• Security: While both fiat money and CBDCs are backed by central banks, CBDCs offer additional security features through cryptography and other technologies.

Check out the difference between Wholesale Vs Retail Central Bank Digital Currencies: Advantages & Disadvantages

What countries have CBDC?

Several countries around the world are exploring or piloting Central Bank Digital Currencies. China is the global leader in CBDC development with the world's first official retail CBDC called the Digital Currency Electronic Payment (DCEP) already in the testing phase. The Bahamas has launched its 'Sand Dollar' CBDC which is now used for retail payments. Other countries running CBDC pilots include Sweden, Cambodia, and Thailand. 

Several major economies like the US, UK, EU, Japan, and India are in the research and experimentation stage for a potential CBDC launch. However, there are still several hurdles to full-scale adoption of CBDCs and most countries are likely years away from an official rollout and issuance of CBDCs.

When will CBDC be released?

While many central banks around the world are exploring and researching CBDC initiatives, very few have actually launched a full-fledged CBDC so far. The Bahamas launched Sand Dollar - the first retail CBDC - in 2020. China has been testing its e-CNY app since 2019 but a firm launch timeline has not been confirmed yet.

In developed countries, most central banks are still in the research and experimentation phase. The Bank of England and European Central Bank have indicated they will not issue any CBDC for at least 3-5 years. The US Federal Reserve has said it will act carefully and only if there is a genuine need or user demand. So a widespread launch and adoption of retail CBDCs are likely still a few years away as central banks remain cautious and focus on getting the technological and policy aspects right. Several hurdles around privacy, security, interoperability, and regulatory clarity remain before large-scale CBDC implementation.

The process to launch CBDC

The process of launching a Central Bank Digital Currency involves several steps and considerations. Central banks must first conduct extensive research and feasibility studies to evaluate the benefits, risks, and economic impact of a CBDC. They then proceed with technology prototyping, POC development, and small-scale pilots or proofs of concept. Based on the results, central banks make decisions on the design features and access model of the CBDC. Next comes the development of the legal and regulatory framework to govern the CBDC. Finally, central banks implement the technology infrastructure and issue CBDC to the chosen pilot participants - whether the banking industry or the general public. After evaluating the results of the pilot, central banks determine if a full-scale rollout of the CBDC is feasible based on the objectives defined at the start.

Conclusion

Central Bank Digital Currencies have the potential to revolutionize the future of money and finance. However, for CBDCs to realize their full potential benefits while avoiding pitfalls, central banks will need to carefully navigate issues around technology, regulation, economic impact, and adoption. There are still many open questions and uncertainties around CBDCs that will require extensive research, experimentation, and careful policymaking. while CBDCs are likely years away from widespread usage, the concept represents an important step in the evolution of money toward a more digital, efficient, and inclusive system. 

The rise of CBDCs will undoubtedly reshape the financial landscape in fundamental ways. As central banks continue to explore CBDCs, we also need broader discussion around how this innovation can be harnessed to create a future of money that works for all. CBDCs may herald a new era for money, but achieving that promise will depend on getting both the technology and the policy framework right.