What Are Central Bank Digital Currencies (CBDCs)?

What Are Central Bank Digital Currencies (CBDCs)?

Central bank digital currencies, or CBDCs, are exactly what the name suggests: they’re digital versions of a state’s fiat currency. This type of digital currency is issued by a central bank and tied to the country’s national currency.

Why do governments even want to have Central bank digital currencies? And which countries have launched CBDC projects?

What is a CBDC?

CBDCs are digital versions of a state’s fiat currency.

They are similar to stablecoins, which are pegged at a 1:1 ratio with a particular fiat currency. But stablecoins like Tether (USDT) are run by private entities that hold central bank-issued cash or cash equivalents. They hold those assets so that their stablecoins can reflect the exact value of fiat currencies.

A CBDC offers three main elements:

  • A digital currency

  • Issued by the central bank

  • Universally accessible

But why should a government issue a CBDC when fiat currency exists?

Central Bank Digital Currencies

Why issue a CBDC?

If a country issues a CBDC, its government will consider it to be legal tender, just like fiat currencies; both CBDC and physical cash would be legally acknowledged as a form of payment and act as a claim on the central bank or government.

A central bank digital currency increases the safety and efficiency of both wholesale and retail payment systems. On the wholesale side, a central bank’s digital currency facilitates the quick settlement of retail payments. It could improve the efficiency of making payments at the point of sale or between two parties (p2p).

No physical coins or notes are available to individuals in a digital society, and all money is exchanged in a digital format. If a country intends to become a cashless society, a digital currency with government / central bank backing is a credible alternative. The pressure for governments to adopt a CBDC is strong, as the market for private e-money is on the rise. If it becomes mainstream, beneficiaries are at a disadvantage because e-money providers aim to maximize their profits instead of the general public’s. Issuing a CBDC would give governments an edge over the competition from private e-money.

ALSO READ: What is Proof of Work and Proof of stake?

How does a CBDC work?

Sometimes the states developing central bank digital currencies tout blockchain as the underlying technology for CBDCs, but the central bank ultimately maintains authority over the ledgers. In contrast, cryptocurrencies are decentralized with no central authority.

There are many different ways that CBDCs may be practically deployed by the states. But if early projects are anything to go by, CBDCs tend to work on mobile wallets similar to Apple Pay or Google Wallet.

Pros and cons to Central bank digital currencies

Here are the biggest pros and cons of CBDCs:

Pros Cons
More efficient and secure payments. Central banks have complete control.
Allow consumers to use the central bank directly. Less privacy for users.
Eliminate the risk of a commercial bank collapse. Difficult to attain widespread adoption.
Easy to track. Possible competition between central and commercial banks.

SOURCE: AUTHOR.

There are several advantages to countries implementing their own CBDCs, including:

  • A CBDC could lead to transactions that are much faster, cheaper, and more secure, which benefits everyone involved.
  • In countries that create retail CBDCs, consumers can get direct access to central bank funds. Many countries have large unbanked populations, and CBDCs could help solve this problem.
  • Consumers wouldn’t need to risk storing their money with a commercial bank that could potentially collapse. As long as their country’s central bank is stable, their funds are safe.
  • Since all CBDC transactions are recorded on a digital ledger, money is much easier to track this way. That could help authorities detect fraud and other illicit activities.

On the other hand, there are also several potential drawbacks to CBDCs:

  • A country’s central bank would have full control over its CBDC. The central bank could, theoretically, decide to put restrictions on the types of transactions it allows.
  • The central bank would have data on every transaction and at least some data on the CBDC’s users. Anytime a large organization has so much user data, there’s the potential for privacy issues.
  • It will take time for CBDCs to catch on. Some members of the population won’t have the means to access digital currencies. Others may be reluctant because they don’t trust digital currencies.
  • If consumers have access to retail CBDCs, commercial banks could lose a significant portion of their business. This would be bad for banks and could also impact the stock market since bank stocks could drop in value.

The Reserve Bank of India is considering running a series of pilot programs for a proposed central bank digital currency (CBDC). While India’s government has previously shown an intent to ban cryptocurrencies outright, the mood has changed somewhat in recent months with signs of the country taking a more lenient approach and seeking to regulate the crypto market.

Conclusion

Central bank digital currencies are nothing but a digital form of fiat money whose implementation is far from over. They are fairly in the early stages of experimentation with blockchain technology, enabling frictionless, cross-border digital payments, among other benefits.

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