- Central bank digital currencies (CBDCs) aim to offer an improved monetary system to citizens as a digitally native form of a country’s fiat currency.
- CBDC pros: Disintermediation, faster transactions, lower transaction costs, financial inclusion, monitoring illegal activity, and improved tax collection processes.
- Potential drawbacks include centralisation and reduced privacy.
- CBDCs work by being implemented through a central bank or government. There are two types of CBDCs: Wholesale and general purpose.
- Countries such as China, India, and the Bahamas have already launched CBDCs at varying levels. Some are still in the pilot testing stages, while others have been fully implemented.
- CBDCs and cryptocurrencies are not the same. Cryptocurrencies tend towards decentralisation and self-governance, whereas CBDCs are centrally controlled and may reduce the amount of financial privacy someone might have.
Introduction to Central Bank Digital Currencies (CBDC)
The world is in a global shift towards a more digital lifestyle — accelerated by the COVID-19 pandemic and digital payments reaching mainstream status. A central bank digital currency (CBDC) may have as one of its aims the cultivation of a more inclusive global financial system by facilitating cross-border transfers. The idea of a CBDC has been around since the introduction of digital currencies like DigiCash in 1989 and e-gold in 1996. But CBDCs may not have gained as much traction without the emergence of Bitcoin, which has encouraged governments to revisit the topic of CBDCs.
What Is a CBDC?
A CBDC is a digital form of a country’s fiat currency. This type of currency is issued by a central bank or government. While these are digital currencies like cryptocurrencies, there are differences and aspects that make them distinct.
Governments are generally perceived to see CBDCs as a way to utilise blockchain technology to bring a better and faster national monetary system to their citizens. In theory, a CBDC could process transactions faster than a fiat currency, as everything is verified and tracked digitally and in real time.
Pros of CBDCs
There are many positive benefits that CBDCs can, in theory, provide to a country. From financial inclusion and technological innovation to more efficient transactions and economic growth, here are some advantages that could potentially come with adopting CBDCs:
Disintermediation — CBDCs allow for transactions to take place without the need for intermediaries. This means there is not as much of a reliance on banks, which theoretically could allow for transactions like payments or money transfers to be made quicker and in real time.
Faster Transactions — Typically, when paying for goods and services, merchants and individuals both expect payments and verifications to be completed in a timely manner. The issue arises when there is a slow payment process where the merchant must take on the risk of the payment not being verified or completed. A model CBDC would eliminate this risk, as transactions are, in theory, verified almost instantly.
Lower Transaction Fees — With current payment systems, a transaction fee is usually required to use them. Popular payment systems like American Express, Mastercard, and Visa all require fees when using their services. Depending on the implementation of a CBDC, there may be no fee to be paid, as most CBDCs that have been launched so far do not impose a transaction fee.
Financial Inclusion — Implementing CBDC accounts at a central bank could foster financial inclusion, as it could allow any citizen or legal resident of the country to access the country’s financial system without the process of creating a traditional bank account.
Monitoring Illegal Activity — A CBDC is able to more accurately track funds since every unit issued by a central bank is digital, meaning every transaction from minting onwards has a digital trail and can be tracked by the issuing central bank. This could allow for easier detection of criminal activity and assist in the prevention of crimes like money laundering.
Improved Tax Collection — Tax evasion and avoidance may be rendered more difficult with a CBDC, where everything is tracked, making it much harder for someone to conceal funds, whether as an offshore bank account or through other means.
Transaction Record — With a CBDC also comes a digital record and proof of transaction recorded by a central authority. With a record of the transaction, issues like giving someone the wrong amount of change can be identified and remedied, as the relevant elements of the transaction are logged and accounted for. Furthermore, the victim of a crime or the sender of a mistaken transfer of funds could, with a CBDC, more quickly have a CBDC transaction reversed (when compared to a fiat transaction) and their funds returned.
Cons of CBDCs
Lack of Decentralisation — Since CBDCs are created by a central bank or government, they are also centrally controlled. A lack of decentralisation can be seen as a major risk, as it means that there is one point of failure that can cause an entire system to stop functioning correctly.
Lack of Privacy — With the currently proposed models for CBDCs, everything is tracked, as the central authority records all of the transactions. Some see this as an issue since the government or central bank would always know how much money users have and what they are spending it on.
How do CBDCs Work?
A central bank or government is required in order to implement a CBDC, where a database collects all the information about the various everyday transactions. This would, in principle, also mean that the central authority knows how much of the CBDC every individual, company, or entity owns at any time.
Types of CBDCs
Wholesale-only CBDCs — These types of CBDCs are implemented with banks that use them to keep reserve deposits with a central bank. A wholesale-only CBDC helps to increase payment efficiency and could also be used as a way to bolster central bank reserves. It is a way for banks to move money amongst themselves and a central bank more efficiently.
General-purpose CBDCs — A general-purpose CBDC is distributed to the general population by the central bank. This is one of the more popular types of CBDCs, as it can serve the goal of promoting financial inclusion to the general population, as well as allow for more benefits with a paperless society by cutting out fiat currency.
Which Countries Are Using CBDCs?
While many countries are currently studying CBDCs, there are only a few that have actually launched the process of building a CBDC. Here are some countries that are exploring the implementation of CBDCs:
China — China continues to make efforts to implement a digital yuan. It is currently in the pilot stages, and plans to continue to make sure everything is in order before officially launching. Most recently, China announced the advancement of its digital renminbi (or, e-CNY) by allowing citizens to use the e-CNY on trains, buses, and subways in multiple local cities.
India — India continues pilot testing for its CBDC. The current aim is to release it in three steps, and the Reserve Bank of India is set to begin testing with some public sector banks. While the CBDC has not been fully implemented yet, India is far along in its pilot testing.
The Bahamas — The Bahamian Sand Dollar is a CBDC launched in the Bahamas. This CBDC is currently available for retail and wholesale application and aims to provide more financial inclusion to those living in the Bahamas. The Bahamian Sand Dollar is one of the most developed CBDCs around the globe, insofar as it is readily available to the public.
CBDCs vs Cryptocurrencies — What’s the Difference?
While CBDCs may have been inspired by the same technology that underpins cryptocurrencies, they are not the same. One main distinction is decentralisation, one of the most publicised qualities of cryptocurrencies like Bitcoin. Cryptocurrencies, in principle, do not answer to one entity, and transactions are verified and stored to varying extents by many different people, companies, and entities. On the other hand, a primary trait of a CBDC is that it is run by a central bank or government.
Many cryptocurrencies are transparent and permissionless. And many run on public blockchains where everything can be recorded, which allows for them to be self-governed. On the other hand, CBDCs are more than likely run on private blockchains and controlled by a central bank or government.
With cryptocurrencies, users do not necessarily need to reveal their identity and, to an extent, can choose how much to reveal about themselves. Yet, with a CBDC, ample personal identity information would most likely be required and catalogued by central banks for record-keeping purposes such as in relation to taxes.
Some cryptocurrencies are pegged to fiat currency, such as USDC to the United States Dollar. A CBDC, however, is not pegged to a fiat currency, as it is the fiat currency itself in digital form. So, in that case, a CBDC United States Dollar would be the same as a printed fiat United States Dollar.
As the world continues to become more digital, it’s no wonder governments have begun to look into CBDCs as a way to stay ahead of the curve. However, CBDCs are not the same as cryptocurrencies, and the distinction should be noted. While there may be trade-offs in terms of privacy and centralisation, there are several benefits that may come from CBDCs, such as financial inclusion.
Now that you know your way around CBDCs, familiarise yourself further by learning more about the difference between crypto tokens and coins.
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