What Is a Central Bank Digital Currency (CBDC)?

Image Credit: Ajaib Crypto

The concept of a Central Bank Digital Currency (CBDC) has been around for several decades, but it has gained renewed interest in recent years as advances in technology have made it more practical to implement.

In the late 1990s and early 2000s, several central banks, including the Bank of Japan and the European Central Bank, conducted research on the possibility of issuing digital currencies. These efforts did not result in the issuance of a CBDC.

In recent years, however, the use of cryptocurrencies and other digital assets has grown significantly, and this has prompted many central banks to reconsider the possibility of issuing their own digital currencies.

In 2015, the People's Bank of China (PBOC) began researching the possibility of issuing a CBDC, and in 2020 it is piloting the project. Similarly, in 2020, the European Central Bank said it was launching a public consultation on the introduction of a digital euro. Also in 2020, the Bank of Japan announced it would begin researching the possibility of issuing a CBDC.

Many other central banks around the world, including the Federal Reserve and the Bank of England, are also researching or considering the issuance of a CBDC.

What Is a Central Bank Digital Currency (CBDC)?

A Central Bank Digital Currency (CBDC) is a digital version of a country's fiat currency that is issued and controlled by the central bank of that country. It can be thought of as a digital equivalent of physical cash, and like physical cash, it can be used for transactions, but it can also be used to hold savings and make payments online.

The key difference between a CBDC and physical cash is that a CBDC exists in digital form, and is therefore not a physical object that can be held in one's hand. This can have several implications, such as increased speed and efficiency of transactions, and the ability to implement monetary policies more effectively.

CBDCs are still in early stages of research and development by different central banks, but some are piloting projects or considering issuance.

How Do Central Bank Digital Currencies Work?

Central Bank Digital Currencies (CBDCs) work in a way that is similar to other digital payment systems, such as credit cards or online payment platforms, but with some key differences.

At a high level, CBDCs involve the use of a digital token that represents a unit of a country's fiat currency. This digital token can be transferred from one person or entity to another using digital wallets or other software.

When a person or entity wants to transfer a CBDC to another person or entity, they can do so by sending the digital token to the recipient's digital wallet. The recipient can then use the CBDC to make payments or transfer it to someone else.

CBDCs are different from traditional digital payment systems in that they are issued and controlled by a central bank, rather than a private company. This means that a CBDC can be used to implement monetary policy in the same way that physical cash can be used.

The CBDCs can be implemented in different ways, such as:

• Account-based system, where the central bank holds an account for each person and entity that holds the CBDC, and transactions are recorded by debiting and crediting these accounts.
• Token-based system, where each CBDC is represented by a digital token, and transactions are recorded by transferring these tokens between digital wallets.
• Additionally, the CBDCs can be designed to operate in different ways, such as being available for immediate use like cash, or in restricted way like saving accounts with restrictions on how many times it can be withdrawn per day.
• It's worth noting that at this stage most of the Central Banks are still researching and experimenting with different models, so the way a CBDC is implemented may vary between different countries and central banks.

Countries Using Central Bank Digital Currencies

As of my knowledge cutoff in 2021, only a few countries have begun to issue or pilot Central Bank Digital Currencies (CBDCs).

The People's Bank of China (PBOC) has been working on its own digital currency, the Digital Currency Electronic Payment (DCEP) since 2014, and piloting in several cities in 2020.

The European Central Bank has announced it was launching a public consultation on the introduction of a digital euro, while the European Union has launched a research platform for a digital euro in October 2020. The Bank of Japan (BOJ) announced in 2020 that it would begin researching the possibility of issuing a CBDC.

The Central Bank of the Bahamas has launched the "Sand Dollar" which is a digital version of the Bahamian dollar that can be used for everyday transactions in the Bahamas.

Other central banks, such as the Federal Reserve, the Bank of England, and the Reserve Bank of Australia, have stated that they are also researching the possibility of issuing CBDCs, but have not yet announced any concrete plans to do so.

It is worth noting that the development, testing and issuance of CBDCs is still in early stage and many central banks are exploring and researching the options with no final decision yet.

Pros and Cons of Central Bank Digital Currency

There are potential benefits and drawbacks to the implementation of a Central Bank Digital Currency (CBDC).

Pros:

• Increased efficiency and speed of transactions: With a CBDC, payments can be made almost instantly and without the need for intermediaries such as banks. This can make transactions faster and more efficient.
• Increased financial inclusion: A CBDC can provide an alternative to cash and traditional banking services, making it easier for people who are not currently served by the financial system to participate in the economy.
• Increased security and reduced fraud: By using digital wallets and other security measures, a CBDC can be made more secure than physical cash, which can be lost or stolen. Additionally, a CBDC can potentially be designed to reduce the risk of fraud, such as through the use of digital signatures and encryption.
• Increased monetary policy: A CBDC can be designed to give central banks more control over the money supply, as well as the ability to implement monetary policy more effectively.

Cons:

• Privacy and security risks: As with any digital payment system, a CBDC could be vulnerable to hacking or other types of cyberattacks. Additionally, the use of a CBDC could raise concerns about privacy, as transactions could be tracked more easily than with cash.
• Dependence on technology: A CBDC relies on technology to function and if a system failure occurs, it could cause disruptions to the economy.
• Interoperability challenges: If different countries or regions adopt different types of CBDCs, there could be challenges in allowing them to be used seamlessly across borders.
• Potential for financial instability: If a large number of people or institutions rapidly move their savings from traditional banking systems to a CBDC, this could cause significant disruption to the banking system, leading to financial instability.

It's worth noting that most of the cons are based on technical issues that could be addressed through proper security measures and regulations, and many central banks have different design and implementation choices for their CBDCs that could address some of the potential cons.

However, it's important for a central bank to conduct a thorough analysis of the potential pros and cons before deciding to issue a CBDC, as it would have significant implications for the country's economy and society.