What is a Central Bank Digital Currency? A Guide to Understanding CBDCs
A Central Bank Digital Currency (CBDC) seeks to take the benefits from blockchain-founded digital currency and merge it with fiat currency under the central bank’s control.
Cryptocurrencies have exposed the conventional payment systems’ inefficacies, while central banks have begun exploring the idea of central bank-provided digital currencies.
The sections below offer a detailed guideline differentiating CBDCs from cryptocurrencies, their risks and opportunities, and the controversy surrounding them.
Central Bank Digital Currency Explained
A CBDC is a blockchain-founded digital fiat currency provided and managed by a central bank. CBDCs are a blockchain-enhanced version of a nation’s national currency, making them legal tender and can be utilized for payments.
CBDCs’ main idea is to provide a government-approved digital payment system that solves payment inefficacies within a nation.
Understanding How CBDC Differs from Cryptocurrency
CBDCs solely acquire inspiration from cryptocurrencies. However, the two are considerably different.
The decentralized aspect is a critical feature of cryptocurrencies. Decentralized digital currencies like Bitcoins are permissionless, borderless, and resistant to censorship.
Peer-to-peer (P2P) transactions happen on public blockchains, and nobody can instruct a user how to use their digital money. In CBDCs, the central bank manages the currency and monitors transactions, permitting them to execute actions like blacklisting digital wallet addresses and freezing funds.
It also allows them to incentivize people to utilize their money rather than save it, particularly if the CBDC is programmable.
Most CBDCs are in the conceptual stages. Thus, people must wait and see how they will run, particularly past national borders.
CBDCs Types Explained
The two major types of CBDCs are wholesale and retail, and classification relies on the targeted users.
Wholesale CBDCs target financial institutions, which can be used for bank transactions. Retail CBDCs target the public for daily transactions, such as sending money and purchasing goods and services.
Retail CBDCs will complement cash and traditional bank accounts. Nevertheless, it must still be early in the concept and implementation phase to establish the effect on conventional financial systems.
Opportunities and Risks of CBDCs
CBDCs are capable of altering the financial landscape. Nevertheless, it is still too early to know if the net change will benefit or harm society. The opportunities and risks involved are explained below:
Benefits
Eradicate Third-party Risk – The system depends on the stability of the central bank. This differs from traditional finance, in which commercial banks are counterparties.
Financial Inclusion – CBDCs could introduce a financial framework that enhances access to financial services.
Low Transaction Cost – Central banks will ensure direct contact with the public, eradicating the present banking structure. This can reduce transaction expenses.
Challenges
Erodes Confidentiality – CBDCs will need a significant amount of private data. The issuing central banks are tasked with fraud monitoring and verifying transactions’ legality. The government would acquire access to financial data without involving third parties to access it.
Centralization Risk – With CBDCS, central banks might be the only entity controlling digital currency. This will develop a single failure point hackers can utilize, which may affect the economy in case a hack happens.
Government Control of Consumer Behavior – The government can utilize CBDCs to encourage specific practices. For instance, a government can program its CBDC to be used to purchase specific goods and services and exclude others.
Bottom Line
A major traditional finance issue is the control by third parties, such as banks, on transactions. CBDCs might take more control and offer the government direct access to all people’s financial data.
A programmable CBDC would permit the government to actively incentivize or disincentivize some behaviours. For instance, it would directly avert natives from buying things such as cigarettes or alcohol, in case the government would seek to actively prevent use.
In a world where individuals criticize the absence of confidentiality from surveillance and government intrusion, CBDCs would only worsen the situation.
