CBDCs are all the rage in cryptocurrency – but what is a CBDC? – a central bank digital currency and how will they impact investors and consumers
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Essentially, central bank digital currencies are like a cryptocurrency but distributed by a central bank, such as the Bank of England or the Federal Reserve in the US.
CBDCs are pegged to the fiat currency – so GBP or USD in the above two examples.
With over 100 governments currently looking at developing a CBDC, are they the potential future for crypto, and how does a CBDC work in practise?
CBDC Explained
A CBDC is issued as a digital token, an electronic version of the existing currency. These alternative currencies are regulated and created by the central bank and offer benefits such as financial inclusion while simplifying fiscal policies.
Because a CBDC is centralised, it works like a cryptocurrency in many ways but is not anonymous n the same way crypto is traded and recorded on a blockchain network.
Fiat currencies, such as Sterling, Euros or US Dollars, are created by the relevant government and are not supported by a physical asset such as gold. Instead, legal tender is used as bank notes or coins and used in countless transactions.
Technological advances and the growing familiarity with digital currencies offer central banks a way to supplement at least part of the physical fiat currency supply with electronic money.
Although central banks won’t replace physical banknotes and coins in the immediate future, there are several use cases, especially in developing nations where a lack of banking infrastructure poses an issue.
During the pandemic, governments have also looked for opportunities to change how they issue currency, prioritising safety, accessibility and trends toward a cashless society.
Cryptocurrencies and blockchain networks have paved the way, showing how a government-backed digital currency might work and how a CBDC could be managed, issued and regulated.
Benefits Of Issuing A CBDC
Part of the challenge for central banks is that financial services access is not universal. In the UK:
- 1.2 million adults do not have a bank account.
- Consumers borrow over £1.3 billion a year from alternative sources, such as payday loans.
- PayPal usage is the highest in Europe, with over 330,000 daily users in 2019.
UK Finance reports that work to tackle access to banking services has been partially successful. Still, these statistics show that many people do not use conventional banks, do not have convenient access, or use high-cost borrowing.
The prevalence of digital banking and services such as PayPal indicates a readiness to adopt digital currencies and a growing preference for online or app-based services instead of drawing cash or issuing a cheque.
A CBDC aims to meet changing consumer appetites and address inequalities by providing convenient, secure and accessible financial services while ensuring that cross-border transactions are cheaper and easier.
Millions of people rely on third-party money transfer solutions and pay high charges for the privilege. In contrast, a CBDC could replace these options, reduce consumer costs, and increase the uptake of central bank services.
One of the primary advantages for central banks is that introducing a CBDC means they can control growth, manage inflation and provide stability with oversight over trends, statistics and behaviours.
Another is that a CBDC could reduce the risks inherent with using unregulated digital currencies – bearing in mind the reluctance of regulators to accept crypto markets as a viable alternative to conventional financial transactions.
Crypto is volatile and untested in many scenarios with potential scalability barriers.
Offering a central bank-backed alternative could alleviate the pressure on regulators to control cryptocurrency trading and usage while improving economic stability by increasing reliance major currencies that feedback into fiscal policies.
Different Types
There are two classes of CBDC: retail and wholesale.
- Wholesale CBDCs are intended for use by banks and other financial institutions.
- Retail CBDCs are designed for use by businesses and consumers.
Wholesale CBDCs act like a central bank reserve, where the bank opens an account for the institution to deposit funds or settle outstanding amounts owing in interbank transfer transactions.
The central bank can use monetary policies such as reserve balance interest to direct lending and select appropriate interest rates.
Retail CBDCs act more like a cryptocurrency, a digital form of money that businesses and consumers typically use. A retail CBDC solves the issue of third-party risk, where a transaction relies on a third party to deliver the funds or close the transaction.
There are a further two categories of retail CBDC:
- A retail CBDC based on a token method allows users to access their currency with a private or public key, allowing anonymity.
- Account-based CBDCs need the user to verify their identity digitally to log into an account and complete their intended transaction.
Wholesale and retail CBDCs are not mutually exclusive, so a central bank can develop both without choosing one option.
Challenges That CBDCs Pose And Address
Cryptocurrency markets may have created an avenue for CBDC introductions – but the different nature of a CBDC both resolves existing challenges and poses new potential issues.
The risks to central banks are that:
- Financial structures are more prepared to adjust to a CBDC, but implementation and integration requirements are unknown and could be complex.
- Switching to a CBDC might disrupt the stability of a financial system in scenarios where the central bank doesn’t have the liquidity to facilitate large volumes of withdrawals.
- Monetary policy tools to direct lending, spending, interest and inflation are untested in a CBDC environment.
Security and privacy are also primary factors. Cryptocurrencies have, in part, been successful because of the anonymity of transactions. A new CBDC would require authority oversight and financial monitoring to prevent the possibility of money laundering or financial crimes.
A CBDC would also need to include high-security levels to mitigate crime risks, digital theft and hacking attempts that have, at times, had disastrous impacts on cryptocurrency markets.
The positive outcomes that may outweigh those risks include:
- Eliminating the third-party exposure that exists when consumers rely on private or independent banks or financial services providers to offer access.
- Reduced cross-border transaction costs to support improved cooperation between different governments and simplify the currently complex distribution systems.
- Enhancing accessibility by breaking down barriers to accessing traditional financial institutions, ensuring populations use secure, regulated services.
A final consideration is that a CBDC connects the central bank directly with consumers, streamlining fiscal reporting and removing the requirement for some of the more expensive elements of the financial system infrastructure.
Contrasts Between Cryptocurrencies And CBDCs
There are several comparisons between cryptocurrencies and CBDCs, as a new currency alternative that operates on a digital ecosystem – but in real-world usage, a CBDC functions somewhat differently.
While some central banks might draw on inspiration from consensus mechanisms, there is little likelihood that a CBDC will be managed through blockchain technology.
Cryptocurrencies are unregulated and controlled by the user community, whereas CBDCs are managed by the central bank and subject to controls initiated in response to broader economic conditions.
Therefore, while a CBDC is more like a cryptocurrency than the physical cash we currently deal in, it would be less volatile and less subject to investor speculation.
FAQ
How do CBDCs and cryptocurrencies differ?
The concept of a digital currency is doubtless impacted by the emergence of cryptocurrency and blockchain tech, but a CBDC is a different idea. Rather than a decentralised blockchain network, a CBDC is a digital form of an existing fiat currency regulated and controlled by the central bank.
Where are CBDCs already in use?
CBDCs have already been launched in several countries, including the Bahamas, St Kitts and Nevis, St Lucia, Grenada, Nigeria, Dominica, St Vincent and the Grenadines, Montserrat and Antigua and Barbuda.
- The Indian central bank announced in February 2022 that it intended to create a digital rupee by December 2023.
- Jamaica minted a CBDC in August 2021, with the digital currency expected to launch at some point this year.
- Swedish Riksbank has started work on an e-krona following issues with drops in cash usage.
- The US president instructed federal agencies to assess the necessary infrastructure to create a CBDC in March 2022.
The Bank of England and Bank of Canada have confirmed that they are researching the potential to integrate a CBDC into their respective financial systems.
Does the UK have a CBDC?
The Bank of England has said it is considering creating a CBDC.
Are CBDCs based on blockchain technology?
While a CBDC could incorporate blockchain technology, they don’t necessarily have to. For example, some researchers feel that distributed ledgers are not the correct infrastructure for a CBDC in terms of scalability and efficiency.
Will they replace the cash in my pocket?
It seems unlikely that a CBDC would replace physical cash altogether and would be more of a digital alternative. However, the UK central bank has clarified if it develops a CBDC, it will work alongside existing bank deposits and cash-based systems.
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