Central Bank Digital Currency (CBDC)

What Is a Central Bank Digital Currency (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 fiat currency.

Many countries are developing CBDCs, and some have even implemented them into their financial systems. Because so many countries are researching ways to transition to digital currencies, it’s important to understand what they are and what they mean to society.

Key Takeaways

A central bank digital currency is the digital form of a country’s fiat currency.
A CBDC is issued and regulated by a nation’s monetary authority or central bank.
CBDCs promote financial inclusion and simplify the implementation of monetary and fiscal policy.
As a centralized form of currency, they may not anonymize transactions as some cryptocurrencies do.
Many countries are exploring how CBDCs will affect their economies, existing financial networks, and stability.

Understanding Central Bank Digital Currencies (CBDCs)

Fiat money is a currency issued by a country’s government. Traditionally, it came in the form of banknotes and coins. It is considered a form of legal tender that can be used to exchange goods and services. Technology has allowed governments and financial institutions to move from physical fiat money to a credit-based fiat model, in which balances and transactions are recorded digitally.

Physical currency is still exchanged and accepted; however, some developed countries have experienced a significant decrease in their use. In addition, the COVID-19 pandemic has accelerated the shift toward digital payment methods.

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

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, more than 5% of households—over 7 million—do not use banks. Around 20% of U.S. households have bank accounts but use expensive money orders, payday loans, and check-cashing services.

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

*A CBDC also provides a county’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 a government and controlled by a central bank, would provide households, consumers, and businesses with a stable means of exchange.

Types of CBDCs

There are two types of CBDCs, wholesale and retail. Wholesale CBCDs are primarily used by financial institutions. Retail CBCDs are used by consumers and businesses, much like physical forms of currency.

Wholesale CBDCs

Wholesale CBDCs are similar to holding reserves in a central bank. The central bank grants an institution 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 on reserve balances to influence lending and set interest rates.

Retail CBDCs

Retail CBDCs are similar to a government-backed digital currency generally reserved for institutions. In this case, the government extends it to consumers and businesses. Retail CBDCs eliminate intermediary risk—the risk that banking institutions might become bankrupt and lose customers’ assets.

There are two variants of retail CBDCs possible, depending on the type of access they provide:

Cash-based access involves CBDCs passed onto the recipient through a pseudonymous digital wallet.
Account-based access is similar to the access provided by a bank account.

*The two types of CBDCs are not mutually exclusive. Therefore, it is possible to develop a combination of both and have them function in the same economy.

Issues CBDCs Address and Create

The Federal Reserve has published what it believes are critical issues a CBDC meets, and issues that need to be addressed before one can be successfully designed and implemented.

Issues Addressed By CBDCs

Free from credit and liquidity risk
Cross-border payment improvements
Supports the role of the dollar
Financial inclusion
Expands access to the general public

Issues That Need Addressing

Financial structure changes
Fiancial system stability
Monetary policy influence
Privacy and protection
Cybersecurity

Issues a CBDC Addresses Explained

A CBDC eliminates the third-party risk of events like bank failures or bank 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 increasing jurisdictional cooperation between governments.
The dollar is still the most used currency in the world.5 A U.S. CBDC would add support and preserve its 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.

Issues a CBDC Creates Explained

The financial structure of the U.S. could drastically change. How a change would affect household expenses, investments, banking reserves, interest rates, the financial services sector, or the economy is unknown.
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 withdraws 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, cryptocurrency has 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 theft of assets and information would need to be significant.

CBDCs vs. Cryptocurrencies

The cryptocurrency ecosystems provide 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 prevent tampering. Central bank digital currencies are designed to be similar to cryptocurrencies, but they may not require blockchain technology or consensus mechanisms.6

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.

Central Bank Digital Currencies at a Glance

Many central banks have pilot programs and research projects intending to determine the viability and usability of a CBDC in their economy. There were nine countries as of February 2022 which have launched CBDCs.

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

There are 78 other countries with CBDC initiatives and projects. 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 August 2021. Its pilot program ended successfully in December 2021.
Sweden’s Riksbank began developing an electronic version of the krona (called e-krona) after the 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.
The Bank of England (BoE) is still investigating integrating CBDC into its financial system.
The Bank of Canada (BOC) continues to research implementing CDBC.
Australia, South Africa, Indonesia, Brazil, Peru, Chile, Uruguay, Thailand, Venezuela, Singapore, and many others.

Is CBDC a Cryptocurrency?

The idea for central bank digital currencies stems from cryptocurrencies and blockchain technology. CBDCs are backed by a government and recognized as legal tender where they have been implemented.

What Is the U.S. CBDC?

The Federal Reserve and its branches are researching CBDCs and ways to implement them into the U.S. financial system. As of February 2022, there is no CBDC in the U.S.

Is CBDC Based on Blockchain?

The Federal Reserve Bank of Boston is working with the Michigan Institute of Technology’s Digital Currency Initiative to develop a working CBDC model. Blockchain is included in the research; however, it’s still unclear whether CBDC will use distributed ledgers and consensus mechanisms.