LearnCrypto

CBDC Explained

What are CBDCs?

Central bank digital currencies (or CBDC) are digital cryptographic tokens, which, as the name states, are issued by a central bank. The CBDC is pegged to the value of the country’s national currency – USD, EUR, JPY, RMB, etc.

In general, CBDCs are traditional money, but in a digital form that citizens can use for payments and stores of value and are influenced by the country’s monetary policies. This currency could be based on a digital ledger or may not use blockchain technology.

CBDCs are an equivalent of electronic cash, like prepaid cards or balances in digital wallets, which, like cryptocurrencies, try to eliminate third parties (such as commercial banks).

Currently, a lot of countries are developing their CBDC designs, but there are a few factors that are left unanswered as to how to implement the technology:

• Access and availability
• Degree of anonymity or privacy
• Interest-bearing ability
• The ability of CBDCs to completely replace notes and coins
• Understanding the benefits of CBDCs and their impacts on the broader payments landscape is essential as the technology is gaining steam, and we may soon see mass adoption.

Traditional money, or fiat money, is a government-issued currency with no backing from a physical commodity. Traditionally, fiat money came in the form of banknotes and coins. Still, technology has allowed governments and financial institutions to supplement physical fiat money with a credit-based model in which balances and transactions are recorded digitally.

As the COVID pandemic shook the world, the usage of banknotes fell drastically, and ideas of cashless societies came about. This led the banks, institutions, and governments to research the feasibility of introducing a new form of digital money.

CBDC goals

Alternatives to your typical banking services are in high demand since much of the world’s population is bankless. Not everybody has access to a bank account. And even if you do, people use other more user-friendly alternatives that at least provide instant payments and relatively low transaction fees, such as Revolut.

Thus CBDCs come into play.

One of the main goals of the central bank digital currency is to establish a connection between consumers and central banks, as well as to bring financial access to the unbanked population. CBDCs eliminate the need for third parties and the risks of bank failures or runs that go along with them. By reducing the complex distribution systems and increasing jurisdictional cooperation between governments, cross-border transaction costs could be reduced significantly.

The main goal of CBDCs is to provide businesses and consumers with privacy, transferability, convenience, accessibility, and financial security. CBDCs could also decrease the maintenance a complex economic system requires, reduce cross-border transaction costs, and provide those who currently use alternative money transfer methods with lower-cost options.

As we all know, cryptocurrency can be highly volatile and have no government backing – CBDCs can overcome these concerns using DLT (Distributed Ledger Technology). If a country implements a CBDC as a legal tender, anyone can use them for payments, and every merchant must accept them.

But why should a government issue a CBDC when fiat currency exists?

Why issue a CBDC?

If the world strives towards becoming a cashless society, fiat money could become obsolete, and a credible alternative backed by the government will be needed.

Yes, when you issue a CBDC, it becomes legal tender along with the nation’s fiat currency.

Since the market for private electronic cash is on the rise, the pressure for governments to adopt a CBDC is intense. Issuing a CBDC would give governments an edge over the competition from private e-money. A CBDC could provide constant availability.

Implementation possibilities for CBDC

CBDCs can be categorized into two different groups based on the targeted users:

Retail CBDC

Retail CBDCs target consumers and local businesses in the form of an alternative for cash for e-commerce, disputing social benefits, as well as point-of-service and bill payments – all of this enables seamless peer-to-peer transactions for both banked and unbanked users.

This group of CBDCs, based on distributed ledger technology, is traceable, anonymous, and available around the clock. A retail CBDC is designed for the public, not corporate structures and financial institutions.

Wholesale CBDC

Wholesale CBDCs target financial institutions (banks and nonbanks) and large corporate treasuries and aim to improve settlement efficiency. This may or may not involve providing nonbanks with direct access to central-bank accounts.

This CBDC resolves liquidity and counterparty risk issues and increases payments and security settlement efficiency. With their capability to improve wholesale financial systems’ speed and security, even central banks consider wholesale CBDC a favored alternative to existing systems today.

Design considerations for CBDCs

When considering the design for CBDCs, there are two standard formats – those that are based on tokens and those that are based on accounts. Both forms differentiate mainly by the infrastructure and access and privacy levels.

The first format utilizes digital tokens where access and claims require users to know the token – public/private key pair. In this case, the CBDC system offers a high degree of anonymity. However, if the central bank decides, it can require personal identification to use the network.

In this case, there is a need for distributed ledger technology in order to verify the chain of ownership in each token and verify the transaction. Token-based CBDCs provide universal access – however, they could prove to be a challenging method for law enforcement, compared to other designs, regarding compliance with know your customer (KYC), anti-money laundering (AML), and combating finance terrorism (CFT) regulations. Compliance with these regulations is delegated to commercial banks.

Account-based CBDCs are linked to a bank account tied to the account holder’s identity. This method is relatively restrictive for universal access because it still requires a banking relationship. Transactions need to be verified using user identities, and therefore, robust identity management systems are required to maintain a unique identifier per individual across payment systems.

In this case, central banks are responsible for compliance with KYC and AML/CFT regulations. Verifying transfers in an account-based system depends on establishing appropriate safeguards against identity theft, fraud, and unauthorized transfers from valid accounts.

To summarize, the type of verification required when exchanging a token versus account-based money is a crucial differentiator.

The approach that central banks consider when implementing CBDC technology is based on four basic components.

• Form (digital or physical)
• Issuer (central bank)
• Technology (token or account-based)
• Accessibility (general or restricted)

Transactions on the blockchain are irrevocable once they are settled, and the assets can’t be reimbursed if the third party (e.g., crypto exchange) doesn’t cooperate with the legal authorities. Also, the authorities can’t compel cooperation since the recipient could be an unknown person from overseas not subject to abide by the laws and regulations of the CBDCs’ jurisdiction.

First, a CBDC needs a proper management infrastructure wherein transactions can be verified and modified under the jurisdiction’s law. Second, CBDC also needs to report its state (account balances, transactions, etc.) to relevant regulatory bodies, which can be more than just the transactions’ state—this includes information on IP addresses or account IDs.

CBDCs vs. Cryptocurrencies

When talking about CBDC, many people think of cryptocurrencies. While, to some extent, the central bank digital currencies are considered similar to traditional cryptocurrency, the difference is that a CBDC does not require a blockchain to function. Crypto tokens are usually unregulated and decentralized, whereas investor sentiments, usage, and user interest determine the asset’s value.

They are volatile assets more suited for speculation, which makes them unlikely candidates for use in a financial system that requires stability, unlike CBDCs, which represent the value of fiat currency and are designed for stability and safety.

Does the world need CBDCs?

Currently, world economic structures are amid rapid digitalization and are looking for instruments for more efficient real-type payment processors for international and domestic transfers.

The International Monetary Fund (IMF) suggests centralized technology such as CBDCs can reduce expenses, facilitate the seamless flow of money, improve financial inclusion, and provide safer access to cash through digital channels.

At the same time, many central banks are concerned about potential impacts on the financial system.

Four key drivers have pushed central banks to explore CBDCs:

• Improving financial inclusion
• Streamlining current payment systems
• Supporting digitization of economies
• Enhancing monetary and fiscal policy

CBDCs could support competition, efficiency, control, and innovations in the payments sector and address the declining usage of physical money.

The good and the bad of CBDC

With the help of CBDCs, implementing monetary policies is a lot easier. Also, the governments could benefit when calculating and collecting taxes by reducing workload and processes. CBDCs solve problems with third-party risks. If the central bank has complete control, the danger from those third parties is averted. What happens when the bank runs out of cash deposits? The damage to the whole monetary system could be catastrophic. There is only one point of failure in this case.

A token-based retail CBDC works like currency and protects personal information by keeping transactions anonymous. Account-based CBDCs, on the other hand, works like a conventional bank account and can include privacy protections.

CBDCs can be easily traced using cryptography and a public ledger, restricting criminal activities and illegal transactions. Also, CBDCs can link customers and central banks directly, obviating the need for costly infrastructure.

However, there are a few cons that come with the implementation of CBDC. First, centralization can always be considered a problem – all your money in the hands of the central bank (government) could be troubling.

Because the administrator is responsible for collecting and disseminating digital identifications, users would have to give up some privacy. Every transaction would be visible to the service provider. Criminals could, for example, hack and misuse information, or central banks could prohibit citizen-to-citizen transactions.

On the other hand, different legal and regulatory frameworks create a considerable barrier to cross-border payments. It would be challenging to bring these frameworks together.

CBDCs may have unintended effects on foreign exchange markets.

e.g., China’s digital Yuan is meant to threaten the dollar’s dominance. So, if CBDC becomes the primary payment tool in China, global companies will be forced to use it to do business, potentially affecting the dollar’s role.

Which countries are exploring CBDCs?

CHINA

Back in 2014, the People’s Bank of China, the country’s central banking authority, started researching ways to implement a digital Yuan (eCNY). 6 years later, the project gained some traction since China announced the testing of a CBDC prototype. The first test was held in October 2020 in Shenzhen. The second pilot program took place in Suzhou City at the beginning of 2021. As per reports, the Chinese digital Yuan will impact China’s $27 trillion payment market. As of 2022, more than 20 regions in the country are probing the use of the CBDC.

There are currently seven commercial banks that are eligible to provide e-CNY: ICBC, Agricultural Bank of China, Bank of China, China Construction Bank, Bank of Communications, Postal Savings Bank of China, China Merchant’s Bank
And two online banks: WeBank (WeChat Pay) and MyBank (Alipay)

Tencent also announced that it would enable users to use the digital Yuan as a payment option on its social media and payment app, WeChat.

USA

The United States Federal Reserve is currently pursuing the idea of a central bank digital currency, or CBDC, and is exploring the potential benefits and risks of CBDCs from various angles, including through technological research and experimentation.

The project’s objective is to create a digital dollar in order to improve financial settlements. The Biden administration has recommended the creation of a digital dollar, and the US has begun putting resources into the effort.

The pilot program’s participants include BNY Mellon, Citi, HSBC, Mastercard, PNC Bank, TD Bank, Truist, U.S. Bank, and Wells Fargo. Global payments provider Swift is also participating in the effort, along with the New York Innovation Center (NYIC), part of the Federal Reserve Bank of New York.

EUROPEAN UNION

Maybe not a country, but the EU is researching and developing its own CBDC – the digital euro.

The digital euro would provide an electronic payment accessible to everyone in the Eurozone. It would be secure and easy to use – as cash currently is. As a central bank currency issued by the ECB, it would be different from ‘private money,’ but you could also use a card or phone app to pay with it.

The exploratory phase started in October 2021 and is expected to take about two years, i.e., to be completed in October 2023.

The European CBDC should operate like cryptocurrencies but with some special caveats. Essentially, the digital euro is a virtual currency that will have legal value guaranteed by the European Central Bank and can be used alongside banknotes to make payments in the 19 countries in the Eurozone.

SWEDEN

In 2017, the world’s oldest bank, Swedish Riksbank, began its CBDC project called e-krona. E-krona intends to offer a robust alternative in case of emergency or turmoil of private payment service providers, thereby ensuring the Swedish payment system remains stable. In collaboration with Accenture PLC, a pilot took place from 2020 until February 2021, and the project was extended until February 2022.

BAHAMAS

In 2019, the Bahamas also began their CBDC project called “Sand Dollar” — fully deployed in October 2020. The project was initiated in two districts: Exuma and Abaco Islands. Each Sand Dollar constitutes an additional digital variant to the Bahamian dollar, which is, in turn, kept at a 1:1 peg with the US dollar. The project delivers inclusive access to financial services and regulated payments.

These are just one of the few central banking authorities that are developing their very own digital currency. We are mentioning them because, right now, they are in the center of the spotlight. Many more authorities are currently exploring new ways to implement the technology, and we may soon see many more come into play.

Future of CBDC

To summarize, CBDCs are aiming to disrupt the current fractional reserve system, allowing commercial banks to create money by lending out more than they have in liquid deposits. Banks require deposits for them to make loans and investment decisions.
Traditional banks would have to become “loanable funds intermediaries,” borrowing long-term funds to finance long-term loans like mortgages if all private bank deposits were shifted into CBDCs.

Implementing a CBDC will make the central banks considerably better equipped to prevent bank runs and monitor private banks’ risky credit/lending choices.

Central bank digital currencies will allow for an integrated open finance architecture that welcomes competition and innovation. It will also maintain democratic control over the currency.

According to a report by the Bank of International Settlements (BIS), over 80% of central banks are already researching CBDC. It begs the question: why are these institutions preoccupied with CBDCs?

The effects of a CBDC-based system on the financial system’s stability are unknown. As we all know, the economic structure of the US could drastically change. The benefits that a new form could bring to the monetary system’s stability could outweigh the negative aspects. Further R&D is necessary before the central banks decide whether to integrate CBDCs. Central banks must ensure they have the tools they need to influence the economy positively.