Central bank digital currencies (CBDCs)

Central bank digital currencies (or CBDC) are a kind of currency issued by a central bank which is in many ways similar to crypto currencies (however, they are not exactly the same). Their values are fixed and controlled by the emitting central bank, and equal that of the corresponding fiat currency of the country where they were issued. They can be called a digital form of local fiat currency and are aimed at simplifying monetary and fiscal policies’ implementation. Some countries are already using them, while others are in development of their own CBDCs.

Its main goal is to provide both consumers and businesses with privacy, financial security, acceptability and convenience. Introducing such a currency helps to take down costs of cross-border transactions and make any transactions more convenient and less complex. It also may help to control inflation and provide financial stability. More than that, CBDCs appear to be more secure than many digital currencies in their current form.

From the first sight, CBDCs seem like a new type of cryptocurrency issued by a bank, which is not true. There are several key differences:

• Cryptocurrencies are decentralized and are not regulated by a single person or authority. Their values depend on usage and investors’ and users’ interests. CBDC, on the contrary, is a kind of reflection of fiat currency, and is controlled by the central bank. The national financial institutions are able to monitor and restrict the central bank currency flow, which is impossible with any crypto currency. The level of privacy in case of CBDC is significantly lower than in case of cryptocurrency.
• Cryptocurrencies can be called ‘alternative currencies’, secured by consensus algorithms which prevent tampering. CBDCs may not require blockchain technologies and do not need consensus mechanisms. A CBDC can be based on a blockchain but it is not necessary.
• Cryptocurrencies are highly volatile. CBDC architecture emphasizes its robustness and low volatility.
• CDBCs are issued by the government and can be compared to a traditional means of payment of the country and a store of value. Cryptocurrencies are not issued by any governmental institutions and do not concern or limit themselves within national borders.

There is a significant difference between a central bank digital currency and a stablecoin. Although they both represent fiat currency in digital form, stablecoins are issued typically by private entities, represent fiat currency (or other assets) and can be redeemed for their value. Meanwhile, CBDCs are issued by governmental institutions as a form of fiat money, not just its representation. 

Types of CBDC

Central bank digital currencies produce a strong effect on the economy and bring about huge changes in the global monetary system. However, they are not all the same. Among CBDC two large groups can be distinguished, depending on their purposes and target user base.

• Retail CBDS. Such currencies focus on the public. They are based on the distributed ledger technology and have availability, anonymity and traceability features, as well as the possibility of interest rate application. Moreover, they help to reduce costs of printing cash. They present a type of central bank ‘money’, their supply focuses on the monetary policy of countries which issue them. Retain CBDC distribution associates with a one-to-one parity with central bank fiat currency, supporting flexible conversion against cash. Retail CBDS can be developed on open infrastructures by businesses to allow creation of services and products over it. To obtain it clients do not need a bank account, and transaction costs are lower than current charges, which is very convenient. To crown it all, retail CBDC is accepted as a legal mode of payment and can serve as a safe store of value both for government institutions and individuals. It presents a quicker shift to a society free of cash.
• Wholesale CBDC. Unlike the previous category, such currencies are used by financial institutions which hold reserve deposits in central banks. A wholesale central bank digital currency helps to improve payment efficiency and security and resolve liquidity concerns. It ensures support for reserves in the central bank by means of a restricted-access digital token (a specific token, which serves as a bearer asset), with the help of which the transaction of values from sender to receiver can be carried out directly, without intermediaries. In addition, wholesale CBDCs have capabilities to raise the speed and improve security for wholesale financial systems without paying exceptionally high fees and charges. It shows benefits for payment and settlement systems. Some of them are already bringing such benefits (such as CADcoin in Canada).

Retail CBDCs are more common and favorable in emerging economies, while being less liked in advanced economies due to considerable risks of allowing anyone but the central authority to use electronic central bank money. Retail currencies in such economies suffer from limitations, while wholesale shows notable advantages. It provides support by linking securities and Forex platforms directly with the resulting better availability. The transaction speed rises significantly while the risk of settlement is taken down. Instant wholesale CBDC systems help to improve the settlement speed on ONC markets and foster cross-border payment systems by eliminating unnecessary intermediaries.

What are the advantages?

CBDCs introduce novel benefits and challenges, and can have a significant impact on the economy and financial system of a country. Needless to say, the use of CDBC makes banking operations more convenient than using cash, especially when huge sums are concerned.

First, any citizen has access to a low-cost banking account. Then, it is less time-consuming. Traditional money transfers even within the country can take from several minutes to several days, while digital currency is transferred as quickly as a message passes. It became especially vital during the pandemic, when banks had to work faster, the number of transactions grew dramatically, while people could not leave their homes and they almost gave up on cash. CBDC helped financial institutions implement changes into their monetary policy directly. A central bank digital currency helps to eliminate third-party risks (such as bank failures or human factors) and discourage criminal activity. Cross-border payments would become more efficient and less complicated with its help, than they used to be in traditional form.

On the other hand, there are still issues to be resolved. The effect on financial stability is presently hard to calculate precisely (for instance, in case of a financial crisis central banks may suffer liquidity shortage for withdrawal facilitation). A central bank may be lacking necessary tools to influence the local economy. Concerning criminal activity, central bank digital currencies are as attractive for hackers, thieves and fraudsters, as cryptocurrency. CBDCs are currently monitored for such activity (thus, anonymous transactions are not possible and the level of privacy is much lower), but the threat of criminal intervention is not eliminated completely.