What You Need to Know About Central Bank Digital Currencies
What Is a Central Bank Digital Currency?
A central bank digital currency is a digital version of a country’s fiat currency that is issued and regulated by its central bank. It is a new form of digital money that can be used for everyday transactions and operates on a decentralized ledger system. CBDCs are backed by a government or central authority, making them more reliable and less volatile than cryptocurrencies. CBDCs aim to improve payment efficiency and financial inclusion and reduce transaction costs.
Is CBDC Cryptocurrency?
Central Bank Digital Currency is a digital currency issued by a central bank and is considered a digital version of fiat currency. While it shares some characteristics with cryptocurrency, such as being digital, it is fundamentally different as it is centralized and backed by a government, unlike decentralized cryptocurrencies like Bitcoin.
Are CBDCs Blockchain-based?
Central Bank Digital Currencies can be blockchain-based, but not all are. The design of a CBDC depends on the central bank’s preferences and priorities, and it may utilize different technologies, such as blockchain or centralized databases, to operate.
Types of CBDCs
CBDC is classified based on implementation models, underlying formats, and distribution models.
Wholesale vs. Retail
The distribution of digital currencies issued by central banks is limited to specific financial institutions in the wholesale model. However, the retail model offers a more inclusive approach, granting access to various entities such as corporations, small businesses, and individual consumers.
Account-based vs. Token-based
An account-based model for central bank digital currency links the CBDC to the payer’s identity. To conduct a transaction, the payer’s identity must be verified, resulting in a balance update for both the payee and the payer.
In contrast, a token-based model for CBDC links ownership of the CBDC to a token that serves as proof of ownership. The token must be verified to use CBDC for payment, typically through cryptography. In this model, a transaction means a change of ownership rather than a balance update.
Direct/Indirect and Hybrid Models
Three models exist for central bank digital currencies: direct, indirect, and hybrid. In the direct model, all transaction participants hold accounts in the central bank, and the bank backs payment transfers. The bank manages KYC and AML compliance. In the indirect model, CBDC tokens are distributed to commercial banks or non-bank financial institutions, which handle compliance requirements. The hybrid model involves distributing CBDC tokens to intermediaries, who manage compliance while the central bank retains claims.
CBDCs are becoming increasingly attractive to central banks due to the need for real-time updates on payments, efficient cross-border transactions, and cost reduction. The IMF believes CBDCs can improve financial inclusion and access to secure money flow.
Factors Motivating Central Banks to Test CBDC
Aid in the Automation of Economies
Central bank digital currencies have the potential to facilitate the central bank’s role in providing legal tender in the digital space. By utilizing these digital assets, central banks can offer access to digital payments through a general-purpose electronic medium with minimal or zero cost. This allows for greater efficiency in providing legal tender and opens up new possibilities for financial inclusion.
Existing Payment Systems Should Be Simplified
Central bank digital currencies provide various advantages to major banks. For starters, they provide lower operating expenses and lower currency handling risks, which boosts their value in the payments business. Moreover, when entrance hurdles are reduced, CBDCs encourage innovation and private-sector engagement. Additionally, CBDCs allow for speedier payment settlements, freeing up time for other operations.
Enhance Monetary and Fiscal Policy
Central Bank Digital Currencies (CBDCs) play a significant role in modernizing the distribution of government benefits to individuals, providing greater transparency and efficiency. Moreover, CBDCs can empower individuals with increased control over their financial transactions, enabling better tax control and compliance. In addition, CBDCs can offer a viable public alternative to privately issued currencies, promoting financial stability and resilience in times of liquidity squeezes. By leveraging the power of digital currencies, CBDCs can revolutionize how we interact with money and reshape the future of finance.
The Benefits and Drawbacks of CBDC
Benefits of CBDC
- Improves data confidentiality
- In terms of compensation, it levels the playing field.
- Contributes to the repression of unlawful activity
Drawbacks of CBDC
- It may result in bank runs.
To prepare for the future of finance, financial institutions must evaluate their capabilities to provide the services demanded by Central Bank Digital Currencies. This includes assessing their ability to offer custody services for digital assets and ensuring their programs are secure against cybercrime. Updating, integrating, or retiring systems may be necessary to accommodate CBDC design and implementation.
Financial institutions must also assess the skills of their personnel or recruit new talent with the necessary expertise to leverage CBDCs, manage liquidity, and identify CBDC customers. As countries move towards wholesale CBDCs, we can expect digital currencies to receive a significant boost, but only time will tell how the future of money will unfold.
Various models are being tested, from public-private partnerships to fully decentralized systems. Success in these models could involve varying degrees of involvement from the private sector. CBDCs can potentially transform the financial landscape and introduce new forms of currency.