What is CBDC or Central Bank Digital Currency?

What is CBDC

Central bank digital currencies are digital tokens, similar to cryptocurrency, issued by a central bank. They are pegged to the value of that country’s or the central bank or bankers’ fiat currency.

Many countries are developing CBDCs, and some more developed countries have implemented them. Because so many countries are researching ways to transition to digital currencies, it’s essential to understand what they are and what they mean for your country and society.

Central or Federal Reserve Bank digital currency (CBDC) is ‘the first digital currency or electronic form of a former federal reserve or government-issued currency, digital euro or first digital form of euro issued by its former central bank or federal reserve bank.’ This simple summative definition points towards two rife elements of a CBDC:

  1. That it is a currency, which implies it can be used as a means of exchange and
  2. It is digital, implying that it employs adept technologies

This article covers all you need to know about CBDCs so that you will feel enlightened the next time you hear about one being launched.

Summarized table based on the collected data regarding the status of CBDCs in various countries in 2024:

European UnionPreparationN/AEuropean Central Bank preparing for a digital euro
ChinaActiveRetailConducted international transactions with e-CNY
IndiaPilotRetailThe digital rupee pilot attracted numerous users
BrazilPilotN/AEngaged in CBDC exploration
JapanPilotN/AEngaged in CBDC exploration
russiaPilotN/AEngaged in CBDC exploration
NorwayResearchRetailExploring retail-focused CBDC
PakistanResearchRetailExploring retail-focused CBDC
AustriaResearchWholesaleExploring wholesale CBDC
EcuadorCancelledRetailDiscontinued CBDC initiative
SenegalCancelledRetailDiscontinued CBDC initiative
United StatesUndecidedN/AFederal Reserve exploring potential benefits of CBDC

This table provides a snapshot of the varied stages of CBDC development across different countries. While some are in the active or pilot phase, others are still exploring or have canceled their plans. The implementation type (retail, wholesale, or both) also varies, indicating the diverse approaches to adopting digital currencies at the central bank level.

History of Central Bank Digital Currency (CBDC)

Because CBDCs are the latest forms of digital money and money laundering, it is paramount first to understand how we got here. The picture below offers a nuanced 101 insight into how money has evolved from time immemorial.

The above picture does well but fails to tell us where and when this digital currency originated. That’s what we’re pivoting to right away.

Consider the economy as an old diesel-powered train, its fuel as currencies, its railroad as the technologies developing its fuel, and its central bankers and banks as the engineers who double up as the traffic marshalls on this railroad to open and close the gates to each station.

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Our train can only move as fast as the efficiency of our fuel and how well the engineers will allow it to run.

A noble person uttered sheer wisdom when they said, ‘You cannot fight an idea whose time has come.’ In the various private sector and financial services sectors, blockchain and other technologies have been developed and adopted to birth cryptocurrency digital wallets that seamlessly support international settlements.

Central banks, the financial services sector, and other stakeholders in financial systems have been skeptically observing this adoption, and some other monetary systems have finally accepted that they must do more to adopt such or similar technology.

Because of their skepticism towards digital assets, payments, digital payments, money wallets, payments, and domestic payment systems, payments as well as the risks associated with cryptocurrencies and domestic payments system, central banks are considering launching their digital currencies, which they can fully back like their fiat currencies.

This is the brief position for most economies worldwide – their trains are at their garage stations, and engineers are trying to figure out whether and how to adopt this new fuel technology they have heard and seen from cryptocurrencies.

CBDCs were and continue to be birthed upon this premise. Let’s highlight some of the standard features of this new development so that we understand it.

What is CBDC or Central Bank Digital Currency

Common CBDC features

It is a child of the central banking system, financial, or banks. This implies that it is issued and regulated by the monetary authorities issuing it, per se, the central financial system or banks of their economies.

From the brief history picture above, central banks abolished the gold standard in the 1930s and have issued fiat currencies since then. (The trust of its issuing authority, often the Federal Reserve System, the central bank, backs a country’s fiat currency only. Reserves do not back it.)

As such, the digital currencies reissued by central banks birth are in tandem with fiat currencies based on their earlier issued currencies. As central banks issue a third digital currency or digital form of currency, they also enjoy a ‘legal tender’ status, implying that parties must take them into a settlement for financial transactions.

Such currencies ride on distributed ledger technologies to settle transactions, such that they can initiate and terminate debit and credit transactions digitally through entries in the ledgers. These features can be summarily presented as follows;

Key Takeaways from the most common features of CBDCs

  • They are issued and regulated by central banks
  • They are fiat currencies
  • They are legal tender.
  • They employ distributed ledger technologies.

What Is the Difference Between Cryptocurrency and CBDC?

There are some glaring differences between the features of cryptocurrencies and CBDCs. Here are the key ones at a glance.

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Cryptocurrencies Central Bank Digital Currencies (CBDCs)

  • Issued by private entities
  • Are not a legal tender
  • Their values are not pegged on any currency
  • Based on blockchain technologies
  • Anonymize transactions
  • Issued by central banks
  • Are a legal tender
  • Their values are pegged to currencies
  • Not necessarily based on blockchain technologies
  • Do not necessarily anonymize transactions

How does central bank digital currency (CBDC) work?

We noted earlier that CBDCs are based entirely on the fiat currencies of the issuing central banks. CBDCs work the same way as fiat currencies but with digital convenience.

Consider this: you were shopping for a car and came across a slightly used 2021 Tesla Model 3, your most coveted electric vehicle. The dealer asks US $50,000 for it on a first-come-first-served basis, implying that whoever offers US $50,000 first drives home with it.

Of course, the dealer doesn’t want to handle payments with your money in physical paper currency or cash for all the valid reasons, so they demand that money in the amount be deposited into their accounts or you swipe cash on your credit card. Unfortunately, this amount of money is above your daily card limit, so your bank cannot authorize the transaction even though you have more money than that in your account.

You’re left with just one option if you want to bag the deal – rush to your bank to make the deposit. So you walk to the next block into your banking hall, authorize the transaction to your dealer’s account, and bring him the bank’s receipt note.

If they bank with a different bank, that amount of fiat money may not even hit their bank accounts once again for a few hours or days after depositing it. This is the time it takes for the banks to settle the transaction on your and your dealer’s behalf.

Now consider a situation where your country’s central bank operates a CBDC. With the advent of technology, you need not go to the central bank for such a transaction, and your dealer does not need to wait hours or days before the money hits their bank accounts either. And yes, you won’t even be charged a fortune for this transaction by the banks!

You log in to a platform provided by your central bank, and after authenticating yourself, you instantly transfer the US $50,000 to your dealer! Yes, and almost at zero in transaction costs and charges!

Does this sound like a dream? Some are already living it because that’s precisely how CBDCs work!

Types of CBDCs

Central bank digital currencies (CBDCs) are of three major types: majorly just two types, and the third is a hybrid of the two.

  1. Wholesale CBDCs—These are CBDCs primarily used by financial institutions, predominantly those that hold deposits with central banks. They are used primarily for interbank transfer settlements.
  2. Retail CBDCs are primarily used by consumers and businesses to settle financial obligations, much like physical currencies.
  3. Hybrid CBDCs – these types of CBDCs have both retail and wholesale characteristics.
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It is worth noting that retail CBDCs are further classified into two depending on how their users can access and use their currencies. They can be either bank account-based or token-based.

Account-based retail CBDCs require user accounts with digital identification to operate digital wallets and access their payment systems, whereas token-based retail CBDCs require private/public keys.

The implication of retail CBDCs being either account-based or token-based is that token-based ones offer anonymity in transactions, as public/ private keys are required to authenticate and use the CBDCs, unlike account-based ones, which require individuals to authenticate their central bank money or account and profiles with the central bank money or banks.

Goals of Central Bank Digital Currencies

Without beating around the bush, CBDCs’ main goal is to employ existing technology to provide convenience, accessibility, and transferability of payment systems and increase financial inclusion, financial stability, security, consumer protection, and layered privacy for businesses and consumers in an economy.

It is beyond common knowledge what more CBDCs can do, but it is appropriate to include the following among the goals of CBDCs:

  1. To provide convenience in financial transactions by improving access, transferability, economic security, and privacy.
  2. To improve financial inclusion in an economy by serving those who may not be served by other financial institutions (banks).
  3. This provides central banks another avenue for monetary policy to affect economic growth, curb inflation, and stabilize an economy.
  4. To reduce the infiltration and reliance on other forms of currencies, such as cryptocurrencies, which are prone to economic volatility.

Issues CBDCs Address and Create

Although sufficient data do not elaborately back monetary policy transmission for a short time, they have existed, addressed, and created some issues in the financial environment. Key among the financial system stability problems fronted that the monetary and fiscal policy they address include the following:

  1. Financial inclusion by expanding access to the general public
  2. Reducing the reliance on cryptocurrencies, which are prone to volatility
  3. Reduction in the cost and time it takes to make settlements.
  4. Reduction in the dependence of banks to fulfill financial transactions

Although CBDCs nobly address the issues above, they also bring about the following issues:

  1. Cybersecurity entails privacy and protection when carrying out financial transactions
  2. Monetary policy influences by affecting the role of commercial banks in financial transactions

Central Bank Digital Currency

Risks of Central Bank Digital Currency

The significant risks and potential benefits associated with CBDCs involve dealing in/ with fiat currencies and digital technologies.

Since central banks issue CBDCs in physical currency, their risks are minimal compared to those of fiat and digital currencies issued elsewhere; thus, the significant risks entail cybersecurity concerns when dealing with digital currency technologies.

Pros and cons of CBDC

Summarily, the following are the key pros, potential advantages, potential benefits, and cons relating to CBDCs

Pros of CBDCs Cons of CBDCs

  • Increase the efficiency, speed, and convenience of financial transactions.
  • Reduce the exposure risk of businesses and consumers in case commercial banks fall.
  • This may bring about competition between commercial banks and central banks.
  •  Increase cybersecurity risks.

Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.