Central Bank Digital Currencies: All You Need to Know

 

     We have all heard of fiat currencies. It is used as a medium of exchange across different countries. The example of fiat currencies we have today are the dollar, euro, yen, pound/sterling. Now all fiat currencies have one thing in common. They are all printed by a country's central bank. With a basic understanding of that, let's talk about CBDCs.

    Central bank digital currencies(CBDCs) are digital tokens similar to cryptocurrency issued by a central bank. They are pegged to the value of country's fiat currency. Many countries are developing CBDCs and some are already implementing them because numerous countries are researching ways to transition to digital currencies. So why do we have these digital currencies created by central banks and what does this mean for the average Joe? Keep reading through this article and you will learn all about this.

Understanding CBDCs

     Fiat money is a government issued currency that is not backed by a physical commodity like gold or silver. It is considered a form of legal tender that can be used to exchange goods and services. Traditionally, fiat money came in form of banknotes and coins but technology has allowed governments and financial institutions to supplement physical fiat money with a credit based model or framework where balances and transactions are recorded digitally. Physical currency is still widely exchanged and accepted however some developed countries have experienced a significant decline in its use and that trend accelerated during the COVID-19 pandemic.

     The introduction and evolution of cryptocurrency and blockchain technology have created further interest in cashless societies and digital currencies. Thus government and central banks worldwide are considering utilizing government-backed digital currencies. When and if they are implemented, these currencies would just like fiat currencies receive the full backing and credibility of the government that issued them.

Goals of Central Bank Digital Currencies

     In the U.S and many other countries, many people do not have access to financial services. In the U.S alone, 5% of adults do not have a bank account . An additional 13% of U.S adults have bank accounts but use expensive alternative services like money orders, payday loans and check-cashing services. The main goal of CBDCs is to provide business and consumers with privacy, transferability, convenience, accessibility and financial security. CBDCs also drastically decreases all the maintenance required by a complex financial system, reduces costs of cross border transactions and provides alternative money transfer methods with lower cost options. A CBDC also provides a country's central bank with the means to implement monetary policies to provide stability, control growth and influence inflation.

     Central bank digital currencies would also reduce the risks of using digital currencies in their current form. Cryptocurrencies are highly volatile with their value constantly fluctuating. This volatility could cause severe financial stress in many households and affect the overall stability of an economy. CBDCs backed by the government and the central banks would provide household consumers and businesses with a stable means of exchanging digital currency. There are two types of CBDCs namely: Wholesale and retail CBDCs.

Wholesale CBDCs

     These are similar to holding reserves in a central bank. The central bank grants an institution and an account to deposit funds or use to settle interbank transfers. Central banks can then use monetary policy tools such as reserve requirements or interest and reserve balance to influence lending and fixed interest rates.

 

Retail CBDCs

     These are government-backed digital currencies used by consumers and business. Retail CBDCs eliminate intermediary risk-the risk that private  digital currency issuers might become bankrupt and lose customer's assets.

     There are two types of retail CBDCs. They differ in how individual users access and use their currency ;

Token-based retail CBDCs are accessible with private/public keys. This method of validation allows users to execute transactions anonymously.

Account-based retail CBDCs require digital identification to access an account.

     The two types of CBDCs, wholesale and retail are not mutually exclusive. It is possible to develop both and have them function in the same economy

Implications Of CBDCs

     A central bank digital currency(CBDC) addresses the following issues:

- A CBDC eliminates the third party risk of events like bank failures or runs. Any residual risk that remains in the system rests with the central bank.

- High cross border transaction costs can be lowered by reducing the complex distribution systems and increases jurisdictional cooperation between governments

- A dollar is still the most used currency in the world. A U.S CBDC could support and preserve its dominant position. 

- Removes the cost of implementing a financial structure within a country to bring financial access to the unbanked population.

- CBDCs can establish a direct connection between consumers and central banks thus eliminating the need for expensive infrastructure.

     A central bank digital currency(CBDC) poses the following issues;

- With the evolution of CBDCs, there would have to be a drastic change in the financial structure of the U.S. What is unknown however is how this change would affect household expenses, investments, banking reserves, interest rates, the financial services sector or the economy.

- The effects a switch to CBDC would have on a financial system's stability are unknown. For example, there may not be enough central bank liquidity to facilitate withdrawals during a financial crisis.

- Central banks implement monetary policy to influence inflation, interest rates, lending and spending which in turn affects employment rates. Central banks will need to ensure they have the tools they need to positively influence the economy

- Privacy is one of the most significant drivers behind cryptocurrency. CBDCs would require an appropriate amount of intrusion by authorities to monitor for financial crimes; monitoring is also important because it supports efforts to combat money laundering and the financing of terrorism. 

- As has been witnessed on several occasions, cryptocurrencies have been the target of hackers and thieves. A central bank issued digital currency would likely attract the same crowd of thieves so efforts to prevent system penetration and thefts of assets and information would need to be significant.

CBDCs vs Cryptocurrencies

     The cryptocurrency ecosystem provides a glimpse of an alternate currency system in which cumbersome regulations do not dictate the terms of each transaction. They are hard to duplicate or counterfeit and are secured by consensus mechanisms that prevents tampering. Central bank digital currencies are designed to be similar to cryptocurrencies but they do not require blockchain technology or consensus mechanisms. 

     Additionally, cryptocurrencies are unregulated and decentralized. Their value is dictated by investor sentiments, usage and user interest. They are volatile assets more suited for speculation which makes them unlikely candidates for use in a financial system that requires stability. CBDCs mirror the value of fiat currency and are designed for stability and safety.

           Adoption of The CBDC Masterplan

     Many central banks have pilot programs and research intending to determine the viability and usability if a CBDC in their economy. As of March 2022 , there were none countries and territories that had launched CBDCs:

The Bahamas, Antigua and Barbuda, Grenada, Nigeria, Monserrat, St. Kitts and Nevis, St Lucia, St. Vincent and the Grenadines.

     We have 80 other countries with CBDC initiatives and projects underway. Here are a few:

In February 2022, India's central bank announced that it would introduce a digital rupee by the end of 2023. Jamaica minted its first batch of CBDC in 2021. The Bank of Jamaica is expected to launch its CBDC in 2022. Sweden's Riskbank began developing an electronic version of their fiat currency (krona called e-krona) after a country experienced a decline in the use of cash. The United States is investigating CBDCs to improve the domestic payments system, increase efficiency and reduce costs. And in March 2022, President Biden directed federal agencies to evaluate the infrastructure that would be needed to issue a U.S CBDC. Much recently, Biden passed executive order 14067 which opts for the creation of a digital framework for the dollar. The BRICS(Brazil, Russia, India, China and South Africa) disclosed at the latest Smit in China the research and development of a digital currency to stand as the future reserve currency. The Bank of England(BOE) is already investigating into integrating CBDC into the financial system. The Bank of Canada(BOC) continues to research implementing CBDC. 

     CBDCs have a massive role in shaping the future of our economy. With the rise of digital trends like cryptocurrencies, the government and authorities are steadily researching and implementing utilities to measure up with this digital pace. I hope you enjoyed this article. If you did, you can leave a comment below.