New forms of digital money, such as privately-issued cryptocurrencies, are well on their way to mainstream use. Another category of this new digital money has piqued the interest of governments around the world. Almost one hundred countries have begun research, development, and trials of digital forms of central bank money, known collectively as Central Bank Digital Currencies (CBDCs).
At present, there are two types of money most commonly used by people and businesses: physical cash issued by central banks, and commercial bank money, which takes electronic form as people’s bank deposits.
Central banks do also produce digital money: the reserves held with them by regulated financial institutions. Up until recently, however, this hasn’t been available to the wider public, and in most countries, this is still the case. But CBDCs are changing this.
CBDCs are an electronic form of central bank money that is available to the general public and non-financial businesses to make payments and store value. Unlike cryptocurrencies, they are issued and fully backed by central banks, so carry the same stability and value as the fiat currency in their country of origin. But instead of cash, they’re digital tokens.
Stablecoins and CBDCs have some similarities; however, the major difference is that stablecoins are issued by private sector entities, and not backed by any central party, whereas CBDCs are issued and backed by central banks, carrying the same ‘risk free’ characteristics as cash or central bank reserves.
Either way, in a CBDC model, control of underlying technology and the ability to create and ‘destroy’ tokens reside with the central bank, most likely on the basis of a clear legal and regulatory framework.
Another difference is how they hold their value. CBDCs are the tokenized version of their country of origin’s fiat currency. Like cash, they are fully backed by the issuing central bank, which will typically be mandated to maintain the value of that fiat currency, and publicly accountable for its activities.
Private stablecoins, meanwhile, seek to overcome the price fluctuations associated with other crypto assets by pegging their value to another asset, most commonly a national fiat currency. Stablecoin issuers have backing assets in place, so their users can redeem any coins they hold in fiat currency when they want or need to.
CBDCs are more similar to stablecoins than they are to cryptocurrencies, which are volatile and not pegged to a fiat currency.
Unlike stablecoins, cryptocurrencies can exist without a peg or link to real-world assets, with their value derived by market fundamentals and speculative appetite. Cryptocurrencies differ from CBDCs when it comes to the type of blockchain they are hosted on, their structure, their anonymity features and finally, by their usage.
Unlike CBDCs, cryptocurrencies are typically hosted on permissionless (or public) blockchains, making them decentralized and anonymous by nature–although there are exceptions. Public blockchains are self-governing by nature, with its information open for anyone to read, write and audit. Meanwhile, private blockchains are distributed ledgers and closed databases managed by a central party, which in the case of CBDCs, would be a central bank.
When it comes to usage, cryptocurrencies are typically used for payments and speculative trading whereas CBDCs can be used for payment and other monetary transactions.
Yes, CBDCs are based on what's called ‘permissioned’ distributed ledger technology (DLT), which enables the secure and immutable recording of all transactions.
As with any blockchain, this ledger is based on a network of computers, each of which uses cryptographic algorithms to verify and record new transactions. However, unlike the public blockchains used by cryptocurrencies, each node (computer) must have permission to join, and the network is supervised by the issuing authority, the Central Bank. That means only the participants involved in a transaction can see it.
CBDCs should be seen in the context of a central bank’s core payment-related functions: providing its country’s unit of account (i.e. its fiat currency), ensuring final settlement of payments between its financial institutions, and overseeing the smooth working and integrity of its country’s payment system.
As part of this central bank framework, it is envisaged that different types of CBDC would be used for specific circumstances. They fall into two main categories: wholesale CBDCs and retail CBDCs.
Wholesale CBDCs would be used to settle interbank transfers and other wholesale transactions between regulated financial institutions, domestically and potentially across borders. They would operate similarly to financial institutions’ existing reserve accounts with central banks. But they might also enable new forms of conditionality, such as final settlement of a payment or transaction being dependent on the delivery of a separate payment or asset. As such, they could improve the efficiency, safety and speed of wholesale payments.
Retail CBDCs are essentially a digital form of fiat currency, intended for use by people and non-financial businesses to make and receive payments. They could be structured in two ways, offering either token-based, anonymous access to users, or account-based access rooted in verifying a user’s identity through some form of digital ID scheme. They offer the potential for transactions that are person-to-person, person-to-business, and even government-to-person.
There are some additional areas where CBDCs can be used.
The pace of digital fiat currency development has accelerated significantly over the past couple of years. As of June 2023, 11 countries have implemented CBDCs, with an additional 53 countries in the advanced planning stages and 46 now researching the technology.
The Bahamian Sand Dollar, which went live in October 2020, was the world’s first digital fiat currency in use. The Sand Dollar can be accessed via smartphones or physical payment cards that are tied to a digital wallet. Sand Dollar offers some offline features. If a network connection is lost, users can make small-value payments and the user’s wallet will be updated when a connection is made.
Other countries that have launched a CBDC are Nigeria, Jamaica, Anguilla, and seven countries within the East Caribbean Currency Union (ECCU). However, the penetration of CBDCs (as determined by share of use within overall currency in circulation) in these countries is still at less than 1%.
China’s CBDC, which currently reaches an estimated 260 people, is still in its pilot phase, which involves testing the digital currency in more than 200 scenarios, including public transit, ecommerce, and stimulus payments.
Elsewhere, the Bank of England and the Bank of Japan are developing CBDC prototypes in consultation with the public and private sectors, and the European Central Bank is about to pilot a digital euro.
The reasons for CBDC development vary significantly by country. One of the most common is that, in a world where around 1.7 billion people don’t have access to basic financial services, CBDCs have the potential to improve financial inclusion for unbanked or underbanked populations.
That’s because digital currencies can be used by anyone with a smartphone - they don’t have to have a bank account - and can offer a cheaper and more efficient way for consumers to access their money.
CBDCs may also be introduced to encourage competition in domestic payments markets, as programmable money created for one specific purpose (e.g. as fiscal stimulus that can only be spent on specific goods and services), or to improve monetary and fiscal policy.
The status of a US CBDC is currently uncertain. According to the Atlantic Council, progress on retail CBDC has stalled, although the country is moving forward with a wholesale, or bank-to-bank, CBDC.
In September 2023, the House Financial Services Committee passed a bill that would prohibit the Federal Reserve from developing on a CBDC.
The bill has support from 60 members of Congress from across the aisle, as well as various financial groups. House opposition to CBDC is based around the potential for the Federal Reserve to monitor users’ transactions, which could infringe on their right to privacy, and to block specific individuals from using the currency or making certain purchases.
However, in a House Financial Services Subcommittee, some participants urged the US to “provide leadership “ as an increasing number of countries adopt digital fiat currencies, and suggested that a CBDC could be designed to avoid threats around privacy and government surveillance.
The key benefits of CBDCs are encouraging financial inclusion, improving security, and fighting fraud.
CBDCs link the user’s unique digital identity directly to their CBDC wallet, providing a reliable way for central banks to verify their identity. This reduces the risk of fraud by ensuring that only authorized individuals can participate in CBDC transactions. Additionally, by providing an immutable record of the flow of money, CBDCs can help to fight money laundering and terrorist financing, and to promote overall trust in the digital payments ecosystem.
At the same time, as participants only need a smartphone, CBDCs democratize access to financial services, especially for those in remote areas who may struggle to access traditional banks. They also provide opportunities for interoperability across different financial sectors. For example, an individual can use their CBDC wallet to make ecommerce purchases and to access lending and insurance services.
For financial institutions, CBCs have the potential to improve the functioning of payment systems. That’s because they reduce the need for intermediaries in the payment flow, making transactions quicker and cheaper.
Finally, by providing more control and visibility of the money supply, CBDCs give central banks a more accurate and timely way to assess the health of the economy, allowing them to take immediate and effective action over monetary policy.
There are, however, some downsides to CBDCs, including:
It's paramount to remember that CBDCs are mostly still in development – or early infancy, where they do already exist. There is some way to go before we know what place CBDCs will occupy in the wider spectrum of new digital money emerging around the world, and whether they will become a mainstream payment method and store of value for consumers.
And there are some fundamental questions that still need to be answered, spanning the philosophical (how user privacy should be balanced with the capability to track illicit activity) systemic (whether, and how, traditional banking models and reserve currencies could be impacted) and technical (can CBDCs interoperate with existing payment systems).
However, the broad direction of travel looks set, and it'll likely be a question of when, not if, more countries launch their own CBDCs.
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