In the realm of finance and economics, the term “digital currency” has become increasingly prevalent. Among the various digital currency types (such as cryptocurrencies and stablecoins) and payment technologies (such as blockchain and IoT payments), Central Bank Digital Currencies (CBDCs) stand out as a potential game-changer in the global financial landscape. As governments and central banks explore the possibilities offered by digital currencies, understanding what CBDCs are and how they function can help us get ready for the future that might not be so far ahead.
What are CBDCs?
Central Bank Digital Currencies are digital forms of a country’s fiat currency, issued and regulated by the central bank. Unlike decentralized cryptocurrencies such as Bitcoin or Ethereum, CBDCs are centralized and typically operate on a permissioned blockchain or distributed ledger technology (DLT) controlled by the central authority.
CBDCs can take various forms:
- Wholesale CBDCs: Restricted for use by financial institutions for interbank settlements and wholesale transactions.
- Retail CBDCs: Accessible to the general public for everyday transactions, serving as a digital alternative to physical cash.
How Are CBDCs Used?
CBDCs offer a range of potential use cases and benefits, both for central banks and individuals:
1.Efficiency in Payments
One of the primary motivations for exploring CBDCs is to streamline payment systems. Digital currencies can facilitate faster, cheaper, and more secure transactions compared to traditional payment methods. This efficiency can benefit both individuals and businesses, reducing settlement times and transaction costs.
2.Financial Inclusion
CBDCs have the potential to improve financial inclusion by providing access to banking services for the unbanked and underbanked populations. According to ESBG analysis of the Global Findex Database 2021, more than 13 million adults, or 4% of the adult population, face financial exclusion in the EU. With CBDCs, individuals can have a digital wallet directly linked to the central bank, bypassing the need for traditional banking infrastructure.
3.Monetary Policy Tools
Central banks can use CBDCs as a tool for implementing monetary policy. By directly controlling the digital currency supply, central banks can more precisely manage interest rates, liquidity, and credit conditions to achieve their policy objectives.
4.Counteracting Cryptocurrencies
Cryptocurrencies have become incredibly popular, leading to worldwide adoption and the influence of cryptocurrencies on markets and governments. Some central banks view CBDCs as a means to maintain control over the monetary system and mitigate the risks posed by decentralized digital currencies. CBDCs offer a regulated alternative that incorporates the benefits of digital currencies while preserving central bank oversight. For example, banks can set limits on CBDC holdings to prevent large-scale flights from bank deposits.
5.Cross-Border Payments
CBDCs could facilitate cross-border transactions by simplifying the settlement process and reducing reliance on intermediaries. This could lead to faster and cheaper international transfers, benefiting business.
What are some examples of CBDCs usage worldwide?
While rapidly gaining more conversation in the media, the widespread adoption and use of CBDCs on a global scale have not yet been realized. Only some countries have experimented with CBDCs. Here are the examples.
China (Digital Currency Electronic Payment – DCEP)
China has been one of the pioneers in developing a CBDC. The People’s Bank of China (PBOC) has been conducting extensive pilot programs for its digital currency, known as the Digital Currency Electronic Payment (DCEP) or digital yuan (also eRMB or e-CNY) in several cities across the country. The DCEP aims to provide a digital alternative to physical cash and enhance the efficiency and security of payments.
Sweden (e-krona)
The Riksbank, Sweden’s central bank, has been experimenting with issuing an e-krona, a digital version of the Swedish krona. The Riksbank has conducted various pilot projects and feasibility studies to assess the potential benefits and challenges of introducing a CBDC in Sweden, where cash usage has been declining rapidly. When making payments, a digital central bank currency like the e-krona could offer the public a continuous option to choose between state and private money. It could also allow the bank more control over digitization challenges and strengthen the resilience of the payment market.
The Bahamas (Sand Dollar)
The Central Bank of The Bahamas launched the Sand Dollar, which is not only a great name but also a digital version of the Bahamian dollar. The launch happened in October 2020, almost right after China pioneered Digital Currency Electronic Payment.
The Sand Dollar is the world’s first central bank digital currency to be fully deployed nationwide.
Spanning across 700 islands, The Bahamas faces a challenge for commercial banks to operate ATMs or physical branches in remote, thinly populated areas. Moreover, the high risk of extreme weather events increases the cost of maintaining infrastructure. As a result, the unbanked population and the need for regulated digital payment are especially needed in the Bahamas.
Eastern Caribbean Currency Union (DCash)
The Eastern Caribbean Central Bank (ECCB) introduced DCash, a digital currency, in March 2021 across eight Eastern Caribbean countries. DCash is designed to facilitate secure and efficient digital transactions, particularly for individuals and businesses in remote or underserved areas. The bank announced that DCash is “a safer, faster, cheaper way to pay for goods and services and send EC funds to other DCash users all using a smart device.” Using it is very straightforward ― one just needs to install a DCash App from Google Play or Apple Store.
Central banks and governments continue to study and evaluate the potential benefits, risks, and implications of CBDCs before making any decisions regarding their implementation. As technology advances and regulatory frameworks evolve, the landscape for CBDCs may change, potentially leading to broader adoption in the future.
What are some challenges with CBDCs?
While CBDCs hold significant promise, as you might expect, their implementation poses several challenges and considerations:
1.Technology Infrastructure
Developing robust and secure digital infrastructure is essential for the successful deployment of CBDCs. Central banks must invest in advanced technology capable of handling large-scale transactions securely while ensuring data privacy and protection.
2.Regulatory Frameworks
Introducing CBDCs requires clear regulatory frameworks to address issues such as anti-money laundering (AML) and know-your-customer (KYC) requirements, consumer protection, and cybersecurity. Collaborative efforts between central banks, governments, and regulatory authorities are necessary to establish comprehensive regulations.
3.Privacy Concerns
Balancing the benefits of digital currencies with individual privacy rights is a critical consideration. CBDCs must incorporate privacy features that protect users’ sensitive financial information while complying with regulatory requirements and preventing illicit activities.
4.Interoperability
Achieving interoperability between different CBDC systems and traditional payment networks is essential for seamless integration with financial software into the existing financial infrastructure. Standardization efforts are needed to facilitate cross-border transactions and ensure compatibility between CBDCs issued by different central banks.
As with any disruptive technology, it’s also the understanding and the opinion of the global public that has to be taken into account. Right now, the world is still largely unfamiliar with the kinds of digital currencies and how they can affect and simplify the life of an ordinary citizen.
What might be the Future of CBDCs?
As central banks continue to explore the potential of CBDCs, collaboration and experimentation are key. Pilot projects and research initiatives from the Federal Reserve, Bank of England, European Central Bank, and Bank of Canada are underway. Digital dollars and euros might be just around the corner.
The successful implementation of CBDCs in all countries, however, will depend on addressing technical, regulatory, and societal challenges. If executed effectively, CBDCs could change the way we buy, invest, and transact, bringing on a new era of financial software.
