What is a Central Bank Digital Currency (CBDC)?
The Central Bank Digital Currency is a new type of digital currency on which many countries are conducting research. Typically, it is a new variant of money proposed by the central bank which can or cannot be on a distributed ledger system. At this time, the definitions for CBDCs are unclear as there are various perceptions of the authority who are studying to implement them in the country.
The central bank’s digital currency is a consequent result of cryptocurrencies based on blockchain technology. However, the CBDC is backed by the national government and treated as a legal tender when enforced.
The CBDC is likely to have a future where new payment technologies are shaping the complete transaction system. The central bank currency is most likely to be established on blockchain technology to have a faster payment system with comparatively lower fees. According to the Bank of England, a CBDC is electronic central bank money that is broadly accessible to the public and offers support for retail transactions.
Moreover, the goal behind enforcing CBDC is to impart privacy to the consumers and businesses, convenience, accessibility, financial security, and transferability. Likewise, it also lessens the cross-border transaction costs and maintenance costs that a typical financial system requires. It can be a boost to people who prefer alternative money transfer options having lower costs.
According to CBDC architecture, there can be many possibilities to categorize the electronic central bank money. As it can be born by both financial institutions and the public, it can be classified into two different models. Let us learn more about different forms of CBDC and how it is used by the two different sectors.
Types of CBDCs
The two broad categories of CBDCs are-Wholesale and Retail. Wholesale CBDCs are preferred by financial institutions whereas Retail CBDCs are for consumers and businesses.
The Wholesale CBDC promotes payments along with transaction settlements in financial institutions. It acts similar to the holdings reserved in a central bank. The Central bank permits institutions or other financial banks to deposit funds and settle interbank transfers. It does means, that the central banks will have a direct influence on CBDCs for accessing financial institutions. Also, central banks use monetary policy tools such as money lending and set interest rates to brag to more and more consumers.
Fortunately, wholesale CBDC offers improvement in risk management, increases the effectiveness of the settlement process, and provides securities to the asset transfers. The categories of wholesale CBDCs are in two different forms.
- Domestic Payment Wholesale CBDCs: The domestic wholesale CBDCs function with security on domains that need dependability, fast-moving, and high-value domestic payment systems.
- Cross-border Payment Wholesale CBDCs: The cross-border wholesale CBDCs are very likely to bloom in the future. Presently, many intermediaries function in between the cross-border transaction for a single payment. To overcome the problem, the wholesale CBDCs can be differentiated into three brief categories: Local, local transferable, and Universal wholesale CBDCs.
A retail CBDC is equivalent to a digital form of cash and generally kept for institutions. It largely eliminates the risk of bankruptcy, loss of customer assets, and temporary loss of funds. More importantly, it focuses on payments in larger volumes between businesses and individuals.
Principally, the retail payment system consists of three varieties of a process known as
- The transaction process: It concerns the dispatching and delivery of payment instructions. It aims to focus on verification and authentication of the transactions from origination. Moreover, it possesses an extra job to validate the payment instructions.
- The clearing process: It draws direct attention to matching and processing the payment data. The critical function is the calculation of settlement claims and obligations. The clearing process makes sure complete and transparent submission of payment data to the settlement agent.
- The settlement process: It is the final process in the retail CBDC payment model and takes care of fund transfer among the involved parties through necessary verifications. After the verification, both the obligor and the beneficiary receive a confirmation of debit and credit respectively.
CBDC vs Cryptocurrency
Cryptocurrencies such as Bitcoin (BTC), Ethereum (ETH ) are decentralized digital currencies operated through a blockchain network and have no pre-established value of their own. On the contrary, CBDC is a centralized digital currency having a predetermined value similar to the fiat currency. For example: In February, Indian Finance Minister Nirmala Sitharaman proposed to implement CBDC namely ‘Digital Rupee’ where each digital rupee will be equal to one rupee.
Unlike cryptocurrencies, the central bank digital currencies may or may not require the blockchain technology consensus mechanism. Whereas cryptocurrencies run on the secured ecosystem of blockchain and skip the clumsy regulatory process of transaction approval. Moreover, the transactions are hard to replicate and tampering is impossible within the consensus mechanism.
Besides, cryptocurrencies are decentralized, unregulated, and their values are volatile in nature. Mostly, the values depend on user interest, market sentiments, and utilization. Meanwhile, CBDCs hold the mirror image of fiat currencies in terms of valuation, stability, and safety.
According to a Federal Reserve report, the CBDCs fight against some challenges like cross-border payment improvement, access to the general public, and being free from liquidity risk. But CBDCs have difficulty in managing issues like protection and security, financial system stability, cybersecurity, and monetary policy influence.
Global movement to implement CBDC
Today, many countries are looking into ways to enforce CBDCs in their financial systems. The cryptocurrencies and blockchain-based digital assets have raised a serious threat and concerns in the minds of respective governments. The central banks do not hold any accountability of transactions and payment systems on the decentralized exchange platform. Thus making them crippled and forced to regulate digital currency of their own as soon as possible in the crypto-savvy world.
Talking about countries like China, India, the Bahamas, The European Union, and even Sweden are working to pilot their plans and enforce a digital currency nationally.
As per atlanticcouncil.org there are 78 countries with CBDC initiatives and undergoing research projects and intend to test the usability of CBDC in their economy.
- In Sweden, the country accounted for a decline among the consumers to use cash. Instead, they preferred crypto transactions. The country is developing research to build the electronic form of this fiat currency.
- The United States is also looking into ways to enforce CBDCs into its domestic payment systems.
- India has offered to implement the digital rupee by end of the year 2023.
- Jamaica minted its very own CBDCs in August 2021. Their first pilot program was very much successful and ended in December 2021.
- The Bank of England and Bank of Canada are still investigating and researching for a better solution to instrument CBDCs in their financial system
Also, countries like Australia, South Africa, Indonesia, Brazil, Peru, Thailand, Singapore are some of the big nations with huge financial systems and possess a big crypto market. They all seek to execute central bank digital currency in their system once it passes all concerns and existing issues.