Central Bank Digital Currency

Central Bank Digital Currency (CBDC) is the digital currency issued by the central bank that is legal tender in digital form. Examples of digital currency projects include Project Jasper, launched by Payments Canada, and Digital Euro, issued by Eurosystem.

The CBDC can outshine physical currencies when compared since physical currencies demand expensive storage, efficient management, and distribution and expose users to counterfeits and other security concerns. Furthermore, the programmable central bank digital currency can restrict certain usages and functions based on predefined rules.

• Central bank digital currency definition refers to a digital currency issued by the central bank. Its supply is controlled as per the monetary policies of the central banks.
• It is categorized into different types: wholesale CBDCs and Retail CBDCs.The former enables the transactions between financial institutions, while the latter enables the settlement of transactions between individuals and businesses.
• Cryptocurrencies are based on distributed ledger technology. Also, there is no central authority to manage cryptocurrencies. In contrast, CBDCs are the legally backed and digital form of fiat currency issued by the countries' central banks.

Central Bank Digital Currency definition suggests centrally controlled digital currencies issued by the central bank and tied to the country's national currency. It is a digital representation of fiat money in the digital economy. Its implementation is based on the database run by the central bank, government, or government-approved entity. The database is significant in tracking the flow of CBDC.

Banking International Settlements (BIS) survey report discloses that CBDCs are being investigated by nine out of ten central banks, and more than half are now creating or conducting actual trials with them. In particular, the development of retail CBDCs has advanced. Moreover, 90% of central banks in the study are working on CBDC projects, which is a record percentage. Altogether the report provides meaningful insight into central bank digital currency and the future of monetary policy.

The two main types of CBCDs are wholesale CBDCs and retail CBDCs. The former primarily focuses on the country's financial institutions, and the latter concentrates on individuals and businesses for day-to-day transactions.

#1 - Wholesale CBDCs

A wholesale CBDC is a type of CBDC for financial institutions. Wholesale CBDCs are used to settle interbank transfers and associated wholesale transactions. One of the instances when they are utilized in the interbank system, is making a cross-border payment using central bank digital currencies. Furthermore, central bank reserves and wholesale CBDCs both function similarly.

#2 - Retail CBDCs

A retail CBDC is a form of digital money that is distributed to the people directly by a central bank. In today's digital economy, when the use of cash is gradually reducing, a retail CBDC, if available to everyone, may undoubtedly be an advancement in the digital economy. The supply of CBDC would entirely depend on the monetary policy of the central bank in a country.

Let us look at the central bank digital currency example to understand the concept better:

Project Bakong, the National Bank of Cambodia's blockchain-based nationwide payment system, launched in October 2020, is one of the world's first CBDCs. Bakong's smartphone app is useful for making store payments and money transfers. Bakong registration does not require a bank account unless the user has a Cambodian mobile phone number.

Users can send money to others by scanning QR codes or entering the recipient's phone number. In addition, Bakong app transactions can be done in Cambodian riel or US dollars. In the financial system, interoperability of CBDCs among various stakeholders not only improves end-user experience but also assists in bridging the gap between banked and unbanked populations.

CBDCs are becoming increasingly popular among international financial institutions due to the development of blockchain technology and cryptocurrencies. However, various CBDC pros and cons depend on how they are implemented in different countries.

Let's look into some of the drawbacks and benefits of the central bank digital currency:

Benefits

• CBDC promotes financial inclusion by developing and contributing to an inexpensive, accessible, and secure payment system.
• Its usage can enhance cross-border transactions by reducing the time of transactions by eliminating the intermediaries who add credit and settlement risks.
• Individuals and financial services will benefit from the shift from hard cash to digital currencies as it will trade off the overhead cost associated with managing the money.
• Promote real-time payments.
• Reduces the dependence on intermediaries like banks.
• Reduces complexity by simplifying the transaction process.

Drawbacks

• CBDC infrastructure management will add costs to the existing financial ecosystem because it must be resilient and always available.
• It will bring transaction traceability, making it difficult for customers and businesses to do transactions anonymously.
• Cyberattacks are a concern following the adoption of CBDCs, threatening the viability of the CBDC projects and raising security concerns.

CBDCs and cryptocurrencies are examples of digital currencies, but they share significant differences. Some of the differences are the following:

• CBDC may not use distributed and decentralized public ledgers like blockchain for its implementation, unlike cryptocurrencies making use of blockchain as its underlying technology.
• CBDCs are centralized and controlled by central banks of corresponding nations, while cryptocurrencies are unregulated and decentralized. Therefore, even the issuing authority can track and control the flow of CBDC.
• The design of CBDC points to its stability, resilience, and low volatile features hence a safer option compared to highly volatile cryptocurrencies.

This article has been a guide to What is Central Bank Digital Currency. We explain its types, benefits, drawbacks, differences from cryptocurrency, and an example. You can learn more about it from the following articles -

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