CBDCs explained: Definition, technology, benefits, and future trends of CBDCs
What are Central Bank Digital Currencies?
What is a CBDC? CBDC, short for Central Bank Digital Currency, is a digital version of a country’s fiat money issued on a blockchain under the direct control of the central bank. It is worth noting that CBDCs are largely theoretical concepts, with only three CBDCs in the world being fully operational: Bahamas, Jamaica, and Nigeria. Many other countries have CBDCs at some stage of development, from research to pilot projects. Like fiat money, CBDCs represent the fair value of that country’s fiat currency.
CBDC definition and characteristics
One common mistake is conflating CBDCs with digital money. Although CBDCs are a kind of ‘digital money,’ digital versions of fiat currency have existed for some time. Here are the critical defining features of CBDCs:
– Nature of the currency: the most fundamental difference is that digital money is promissory, representing a claim on the issuer (typically a commercial bank). At the same time, CBDCs are the digital form of fiat currency issued by the central bank. In other words, CBDCs are a direct liability on the central bank, similar to physical cash, rather than a promise to pay.
– Central bank issuances: CBDCs differ from other forms of money, such as digital currencies, that commercial banks or private companies issue. Instead, CBDCs are directly issued and backed by the central bank, precisely as with physical cash.
– Monetary policy tool: Central banks can directly use CBDCs to implement monetary policy, including setting the interest rate on CBDC deposits or even varying the supply of CBDCs.
– Programmability and intelligent contracts: CBDCs have the potential to include smart contracts. Smart contracts allow for condition-based transactions, including time-limited transactions, conditional payments, automatic tax deductions, spending restrictions, programmed interest rates, and multi-signature approvals.
– Universal accessibility: CBDCs are intended to be available to every citizen of that country, which is beneficial for enhancing financial inclusivity. This differs from the current system, which requires a bank account to interact with the digital monetary ecosystem.
The technology behind CBDCs
Blockchain technology’s role influences the nature of CBDCs in their operation. Financial institutions play a crucial role in the operation and distribution of CBDCs, leveraging blockchain technology to process digital transactions efficiently. Let’s explore the advantages and disadvantages of using blockchain for CBDC implementation:
Advantages
– Decentralized verification of transactions
– Enhanced security and transparency
– Reduced counterfeiting
– Improved traceability
Disadvantages
– Scalability challenges
– High energy consumption
– No privacy
CBDC vs cryptocurrency: key differences and similarities
While central bank digital currencies (CBDCs) and cryptocurrencies share some similarities, they also have significant differences.
Similarities:
– On a blockchain
– Autonomy of funds to the owner (in non-smart contract circumstances)
Differences
– Centralization: CBDCs are centralized, whereas most cryptocurrencies are decentralized to varying degrees
– Volatility: CBDCs are stable insofar as the government backs them, while cryptocurrencies tend to be far more volatile
– Regulation: CBDCs are backed by the government, whereas cryptocurrencies writ large are often unregulated
Benefits of CBDCs for Financial Inclusion
Overall, CBDCs offer the following advantages.
– More effective and safer payment methods
– Reduced transaction times
– Financial inclusion and accessibility
– CBDCs can provide financial services to individuals without traditional bank accounts, thereby increasing financial inclusion.
– Enhanced monetary policy implementation
– Programmable money features
– Better control over money supply and circulation
Challenges and risks of CBDCs
Despite their benefits, CBDCs also present challenges, such as
– Potential issues of privacy as a result of the application of blockchain technology
– Direct government power to change money/contracts
– Cyber security risks, such as phishing attacks
– Money laundering: Robust anti-money laundering standards are crucial to protect against financial crimes and ensure the integrity of financial systems in the context of CBDCs.
Are CBDCs legal tender?
CBDCs, by definition, are legal tender in whichever country they are issued. However, this is up to the nation itself. Further, it is also a function of whether the CBDC is fully operational, as is the case with the Bahamas, Jamaica, and Nigeria, or limited to a few test cases during a pilot program, as is the case with the digital Ruble in Russia and the digital Renminbi in China.
The future of CBDCs
Looking forward, CBDCs will likely play a very important role in the future of money and the global financial system. A country’s central bank will play a pivotal role in implementing and regulating CBDCs, ensuring their stability and integration into the financial system. In the new Web 3 economy, CBDCs could be crucial in onboarding individuals and providing access to the wider ecosystem—should that country allow it.
Predictions and trends
Global adoption: Although only 3 CBDCs are live currently, many countries are in various stages of development, including 36 in Pilot, 30 in Development, and 44 in Research. The adoption of CBDCs will likely increase, with a real breakthrough coming when more developed countries join the fore. The European Central Bank is actively exploring various models of CBDCs, including a digital euro, to enhance financial inclusion and payment efficiency.
Cross-border payments: CBDCs are likely to be an easy tool for cross-border payments. Examples of such initiatives include Project mBridge, a collaboration between the Bank of International Settlements (BIS), the Bank of Thailand, the Central Bank of the United Arab Emirates, the Digital Currency Institute of the People’s Bank of China, and the Hong Kong Monetary Authority. This collaboration is a testing ground for bridging CBDC payments between countries.
Enhanced financial inclusion: as more central banks continue to issue CBDCs, we could see a large rise in financial inclusion for the underbanked and unbanked, especially in the developing world
Evolution of monetary policy: Central banks may create new forms of monetary policy based on the programmability of CBDCS, which may result in more efficient interventions in the economy.
Potential impacts on global finance
Remittances: CBDCs can potentially cut the cost and time of border transactions, which is good news for millions of migrants and their families.
The financial services sector will undergo significant changes as CBDCs are adopted, prompting institutions to adapt to new digital transaction models.
– Banking Sector Transformation: CBDCs may pose a threat to traditional banks in the sense that they may eliminate intermediaries in some financial transactions, hence calling for a change of business models among traditional banks.
– Financial System Stability: CBDCs could give central banks real-time information on money flows, enabling them to respond faster to economic shocks. However, they can also create new sources of systemic risk that must be addressed and controlled.
– Geopolitical Implications: CBDCs’ implementation may affect the international monetary system by challenging the hegemony of present reserve currencies such as the US dollar.
Will cash become obsolete?
While CBDCs are likely to reduce the use of physical cash, it’s unlikely that cash will become completely obsolete in the near future:
– Digital Divide: Technology has not reached all the populations; hence, there is a need for cash for financial inclusion.
– Privacy Concerns: Some people may prefer to make the transactions in cash since they do not reveal their identity.
– Resilience: Physical currency can be used in case of a technology failure or hacking of the digital currency system.
– Cultural Factors: In some societies, cash has a cultural value that might act as a brake to its displacement
Which coins are CBDCs?
As stated, the landscape of central bank digital currency (CBDC) development is still in its infancy.
Launched CBDCs: Currently, the Bahamas has launched its CBDC called Sand Dollar, Jamaica has launched JAM-DEX, and Nigeria has launched eNaira.
Pilot Programs: Of the major economies, China’s digital yuan (e-CNY) is the most developed as large-scale testing is being conducted. More than 60 nations are either experimenting with or actively considering CBDC issuance at the moment.
Development Stage: Currently, most G20 nations, such as Brazil, Japan, India, Australia, South Korea, South Africa, Russia, and Turkey, are either exploring or working on CBDC.
Cross-Border Projects: Some multi-country experiments include Project Dunbar with Australia, Malaysia, Singapore, and South Africa and Project Jura between France and Switzerland.
Conclusion
CBDCs can potentially be a great step forward from the traditional notion of money as fiat money backed by the state, with the added benefits of blockchain technology. In the future, it will be important to proceed cautiously and conduct further research to minimize potential problems and enhance the benefits of CBDCs.
CBDCs are expected to be adopted more widely worldwide, with technological advancements and a gradual transformation of global financial systems. Despite the existing issues, including privacy, security, and financial solidity, CBDCs can transform the digital world’s monetary system and financial transactions.
As this technology advances, it is crucial for policymakers, banking institutions, and the general public to remain abreast of the discourse on CBDCs’ potential for our monetary future.