What Is a CBDC and Why Are Central Banks Interested in Adopting Digital Currencies?

Blockchain technology has transformed the financial landscape by facilitating peer-to-peer transactions, eliminating intermediaries. The emergence of Central Bank Digital Currency (CBDC) has further revolutionised blockchain, reshaping the future of payments for both businesses and individuals. Banks and governments have increasingly turned to digital assets in their operations. The U.S. President's executive order, "Responsible Development of Digital Assets," exemplifies the public recognition of the importance of judiciously advancing such assets.

In this article, we shall delve into the concepts and various aspects of Central Bank Digital Currency (CBDC) to fully grasp fundamental information about this digital currency.

What is a Central Bank Digital Currency (CBDC)?

A Central Bank Digital Currency (CBDC) is a digital form of central bank money, serving as legal tender established and backed by a central bank. It signifies a claim against the central bank, not a commercial bank or Payment Service Provider (PSP). Managed on a digital ledger, which may or may not be a blockchain, CBDC expedites and enhances payment security among banks, institutions, and individuals. Recent research by the Bank for International Settlements reveals that over 70% of institutions are actively exploring and developing proofs of concept for CBDCs.

Three defining aspects of a CBDC include being digital assets recorded in a digital ledger (distributed or not), backed by the central bank, and subject to complete control and determination of supply by the central bank.

Understand Central Bank Digital Currency (CBDC).

Fiat money is a government-issued currency or legal tender that can be used to exchange commodities and services. Traditionally, fiat money came as banknotes and coins. However, technological advancements have allowed governments and financial institutions to supplement physical fiat money with a credit-based model that records balances and transactions digitally.
Physical currency is still widely used, but some developed countries have witnessed a drop in its use. That trend further accelerated during the pandemic. With blockchain technology and cryptocurrency's inception and evolution, societies have inclined towards a cashless future.

Goals of CBDCs

The primary objective of Central Bank Digital Currencies (CBDCs) is to offer businesses and individuals enhanced privacy, transferability, convenience, accessibility, and financial security. Additionally, CBDCs could cut the maintenance costs of a complex economic system, lower cross-border transaction expenses, and provide more economical options for users of alternative money-transfer methods. Moreover, CBDCs aim to mitigate the risks associated with the current volatility of cryptocurrencies, ensuring a secure and stable means of exchanging digital currency for households, consumers, and businesses.

Types of CBDCs

CBDCs include two types – the wholesale CBDCs and the retail CBDCs. Financial institutions primarily use wholesale CBDCs, while consumers and businesses favour retail CBDCs.

Wholesale CBDCs

Wholesale Central Bank Digital Currencies (CBDCs) resemble holding reserves within a central bank. An institution is provided with an account by the central bank for depositing funds or facilitating interbank transfers. This allows central banks to employ monetary policy instruments like reserve requirements or interest on reserve balances to impact lending and establish interest rates.

Advantages of Wholesale CBDC

1. Enhanced Interbank Settlement:
   • Automation and decentralised netting solutions in CBDC enable instantaneous settlement between counterparties on an individual order basis, minimising the risks associated with overnight batch processing and collateralisation.
2. Reduced Counterparty Risk:
   • CBDC addresses credit risk in cross-border payments by facilitating payment-versus-payment settlement for transfers involving different currencies.
3. Participation in Digital Asset Markets:
   • With the emergence of tokenised asset markets, CBDC serves as a large-scale, decentralised clearing house and asset register, contributing to the evolution of the digital assets landscape.
4. Competitive Edge:
   • Despite the reduction in real-time money transfer costs by platforms like SEPA in Europe, many financial institutions charge customers above cost. CBDC enables end users to benefit from a streamlined banking infrastructure and ensures central banks maintain a role in interbank settlement, especially amid the broader adoption of stablecoin technology.

Retail CBDCs

Retail Central Bank Digital Currencies (CBDCs) are government-supported digital currencies that individuals and businesses utilise. They mitigate intermediary risk, where private digital currency issuers may face bankruptcy, risking the loss of customers' assets.

There are two varieties of retail CBDCs, differing in user access and currency utilisation:

1. Token-based retail CBDCs are accessed with private or public keys, enabling anonymous transactions.
2. Account-based retail CBDCs necessitate digital identification for account access.

Advantages of Retail CBDC

1. Enhanced Accessibility:
   • Digital currency distributed on mobile devices widens access for individuals far from bank branches, offering increased usability for those without access to physical cash.
2. Efficient Reconciliation:
   • A CBDC, being inherently digital, eliminates the need for laborious and costly reconciliation processes in e-commerce and cross-border payments, streamlining operations.
3. Stimulated Digital Innovation:
   • The platform-based software model of CBDC lowers entry barriers for new firms in the payments sector, fostering competition innovation and encouraging financial institutions to globalise services.
4. Improved Monetary Policy:
   • CBDC grants central banks direct control over the money supply, simplifying the distribution of government benefits and enhancing transaction control for tax purposes.

CBDCs: Addressed and Emerging Challenges

The Federal Reserve highlights crucial requirements and considerations for designing and implementing Central Bank Digital Currencies (CBDCs).

Addressed Issues:

Cross-Border Cost Reduction:
By streamlining distribution systems and fostering international cooperation, CBDCs can lower high cross-border transaction costs.

International Dollar Role:
CBDCs can support the dominance of the U.S. dollar, the most widely used global currency.

Financial Inclusion:
CBDCs remove the need for a costly financial structure, providing direct access between consumers and central banks, thus enhancing financial inclusion.

Expanded Access:
Establishing a direct connection between consumers and central banks eliminates the need for expensive infrastructure, expanding access to the public.

Challenges Introduced:

Financial Structural Changes:
The impact of drastic changes on household expenses, investments, banking reserves, interest rates, and the financial services sector remains uncertain.

Financial System Stability:
The effects of a CBDC transition on financial system stability are unclear, with potential liquidity challenges during crises.

Monetary Policy Influence:
The unknown effects of CBDCs on central banks' ability to implement effective monetary policy are crucial for influencing inflation, interest rates, and economic indicators.

Why have central banks become interested in CBDCs?

Several trends likely fuel central banks' interest in Central Bank Digital Currencies (CBDCs):

1. Declining Cash Usage:
   • Cash usage has significantly dropped, with Europe experiencing a one-third decrease from 2014 to 2021. In Norway, only 3% of payments involve cash, prompting central banks to reconsider their role in the monetary system.
2. Growing Interest in Private Digital Assets:
   • In the U.K., 10 per cent of adults hold or have held digital assets like cryptocurrencies. The European Central Bank notes that up to 10 per cent of households in six E.U. countries own digital assets, posing a potential challenge to fiat currency as a value unit.
3. Reduced Perception of Central Banks as Payment Innovators:
   • CBDCs present an opportunity for central banks to regain leadership in discussing the use cases of cash in a public context, addressing the diminishing perception of central banks as innovators in payments.
4. Emergence of Global Payment Systems:
   • As global payment systems expand, many central banks aim to assert local governance. CBDCs are a potentially stabilising force for local digital payment systems amid the increasingly global nature of payments.