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October 2, 2022

What Is a Central Bank Digital Currency & Why Do They Matter?

What Is a Central Bank Digital Currency & Why Do They Matter?

With the evolution of technology, the rise in usage of digital platforms, and the ever-evolving world of digital currency, it was only a matter of time before government organizations turned to exploring central bank digital currency.

While skeptics think it’s traditional bankers jumping on the crypto bandwagon and hoping nobody realizes – it’s actually much more than that. The world of finance is evolving, digital transactions are becoming the norm. In some parts of the world, paper money is near-obsolete, and central banks need to ensure they’re adapting and driving this change.

In this article, you’ll learn what central bank digital currency is, how it differs from cryptocurrency, the pros and cons, and some countries that are already using it.

Let’s get to it.

What Does CBDC Stand For?

CBDC stands for central bank digital currency.

Throughout this article, you’ll see both used, so we thought it best to make that clear before diving into the details.

What Is Central Bank Digital Currency?

Much like cryptocurrency, CDBC is a digital token tied to the value of that country’s fiat currency. CBDC tokens are issued by the central bank, whereas crypto is a decentralized ecosystem.

As you’d expect, the CBDC is controlled, regulated, and issued by the monetary authority of the nation of said central bank’s digital currency.

Traditionally, central bank currency came in the form of physical notes and coins. While this is still accepted as legal tender for buying goods, technology has enabled governments to move toward numbers on a screen. This evolution has led to central banks and governments exploring how a cashless and digital society could work.

Currently, many countries are assessing the potential of implementing digital currencies. In fact, many nations and central banks have already done so. CBDCs are being implemented and heavily researched by banks and authorities, so it’s important to understand them, how they work, and how they will impact day-to-day life.

What Is the Purpose of Central Bank Digital Currency?

Like most people, you’re probably thinking what’s the point? We already have a banking system that works, we can pay with cash or card, and everyone has access to financial services and ways of borrowing or lending money.

You might be surprised to hear that 5% of US adults don’t have a bank account, and 13% of US adults rely on high-interest loans.

CBDC intends to tackle this by providing an easy-to-access central banking service – its mission is to provide every citizen and business with services focused on privacy, accessibility, convenience, and financial security. It will do this by solving problems the current systems face, such as expensive inter-currency transactions and complex and slow infrastructures.

Central Bank Digital Currency vs. Cryptocurrency

Cryptocurrency ecosystems are driven by decentralization. They aren’t restricted by the government and financial institution regulations.

What’s more, transactions and tokens are near-impossible to counterfeit and tightly secured using a particular consensus mechanism.

Discussion around CBDCs suggests they are designed to be like cryptocurrencies. However, you lose key elements of them being decentralized and unregulated, and they may not require blockchain technology.

Central bank digital currency will be based on the value of traditional fiat currency, making them a more stable and safe currency. On the flip side, cryptocurrencies are volatile assets, with their value dictated by market sentiment, user interest, and usage.

The Promises & Perils of Central Bank Digital Currency

As with anything in life, CBDC comes with pros and cons.

Advantages of CDBC

Efficient Payment Systems

The introduction of CBDCs, the financial backing they have, and improvements to the technology they’re able to introduce would make retail and large-scale transaction systems much more efficient, secure, and user-friendly.

Improved Cross-border Payments

Currently, cross-border transactions come with large costs due to the complex distribution systems in place. A central bank digital currency removes these barriers, bringing costs down and making these transactions more efficient than ever.

Cement Influence on US Dollar

As the most used currency in the world, the introduction of a US central bank digital currency, could see the dollar become more dominantly used, as it will support digital transactions in addition to traditional fiat transactions.

Financial Services Expansion & Inclusion

Currently, there are millions of people across the world without access to any form of financial services. Banks are unable to serve people in remote parts of the world. Therefore, many go without bank accounts.

However, these people do have access to forms of technology, such as computers or cell phones. These devices, alongside a CBDC, give them access to a worldwide payment system.

Risks of CBDC

Lack of Privacy

As mentioned, cryptocurrency operates on anonymity. No government or financial institution needs to know your personal details for you to earn, store, transfer, or sell your tokens.

However, a central bank digital currency would lose this element of privacy. As with a traditional bank account, they’d require personal information to combat illegal activity, such as money laundering or funding drug trafficking.

Changing Financial Structures & Systems

Switching to a CBDC represents incredible structural changes to a centuries-old financial system. How this would impact government, household expenses, workplaces, education, investments, banks, inflation, interest rates, financial services, and the economy as a whole is completely unknown.

Online Security

The cryptocurrency space is a playground for hackers and scammers. These sophisticated cybercriminals will likely turn their attention to all central bank digital currency users.

As a CBDC will be more trusted and adopted by the masses, this makes people who aren't tech-savvy instant targets. A switch to CBDC digital currencies could see a spike in cybercrime, hacking, and scamming.

Types of Central Bank Digital Currency

There are two types of CBDC. One serves financial institutions, while the other is used by consumers and businesses. This is exactly how the current system works.

Wholesale CBDC

Currently, central banks have holding reserves at their disposal. Essentially, this is all the money or value of assets held in reserve by the central bank.

Wholesale CBDC will provide funds for institutional accounts. These funds are used for settling interbank transfers or for depositing funds.

Retail CBDC

This is how the vast majority of people will be using CBDCs. It is for consumers and businesses to complete transactions for goods and services. These government-backed digital currencies work much like cryptocurrency but without the inherent risk of losing assets.

There is debate whether retail CBDC will work like an existing bank account or whether it will be a tokenized system. For this reason, there are currently two options.

Account-based retail CBDC operates much like an existing bank account. With this system, account holders will need to supply personal data, such as digital identification, to open an account.

Alternatively, token-based retail CBDC functions on an anonymous basis. With funds accessed by a mixture of public or private keys held by the account owner.

Countries With CBDC

According to Atlantic Council’s Central Bank Digital Currency Tracker, there are currently 11 countries with CBDCs launched. These are:

The Bahamas

Jamaica

St. Vincent & The Grenadines

Grenada

St. Lucia

Anguilla

St. Kitts & Nevis

Antigua & Barbuda

Montserrat

Dominica

Nigeria

However, there are a total of 40 countries in the process of piloting, testing, and developing their own CBDCs, including China, Sweden, Russia, Sweden, Saudi Arabia, Canada, Australia, and Brazil.

Other developed economies, such as the US and UK are still in the research stages of their projects, while the European Union is apparently inactive.

Summary: Central Bank Digital Currency Explained

A central bank digital currency seeks to solve many of the issues cryptocurrency is tackling. It brings security, confidence, and mass-market buy-in that existing digital currencies can’t. However, the main benefit and selling point of crypto is decentralization. It gives individuals control over their own assets without the interference of a third-party financial institution.

While CBDCs will bring many benefits, such as access to financial services, even to the most disconnected parts of the world, it reverts to being invasive of privacy. How these projects develop remains to be seen, but it’s highly likely we’ll see the most powerful economies adopting a digital-first financial approach in the coming years.

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