Central Bank Digital Currencies(CBDCs) are emerging as a pivotal point that shapes the monetary system.
CBDCs are capturing the attention of economists, policymakers, and financial analysts as they represent a transitionary leap between traditional and digital currency.
Recently, banks around the globe have been exploring the possibility of introducing CBDCs to change consumer financial preferences.
This article focuses on the potential benefits and risks involved in CBDCs, the challenges the governing institutions face, and how CBDCs redefine how we digitally transact currency.
Let’s get started.
What are CBDCs?
Central bank digital currencies, or CBDCs, are a country’s national currency in digital form issued by the central bank. Central banks create and regulate CBDCs to provide secure online transactions for businesses.
Traditionally, fiat money is a government-issued currency not backed by a physical commodity like gold or silver. For example, banknotes like the US dollar, the euro, the rupee, and all other major currencies are legal forms of currency. Fiat money derives its value from demand and supply rather than a commodity.
Like traditional currency, CBDCs are backed by the government and are considered a digital representation of a country’s currency. This means they are legally secure and can be used for various financial transactions like payments and business settlements.
Although the physical currency is widely exchanged, many countries are experiencing a drop in the use of physical currency post-pandemic. That’s why many countries are exploring how CBDCs can benefit financial networks.
Types of CBDCs
CBDCs are categorized into different types. The main types are the Wholesale and Retail CBDCs, and there’s also a hybrid type. Let’s examine all the types and understand their differences.
#1. Wholesale CBDCs
As the name suggests, Wholesale Central Bank Digital Currencies can be utilized by big financial institutions like banks and other financial regulators to settle big payments quicker in an automated way.
Wholesale CBDCs are different from Retail and are not intended for use by the general public. The differentiating characteristics of wholesale CBDCs are that they support high-volume transactions like transactions between banks and settlements in the security market and make cross-border transactions faster.
Currently, payment settlements are supported in a single currency. In Wholesale CBDCs, utilizing advanced blockchain technologies can make payments faster and smoother.
#2. Retail CBDCs
Retail CBDCs are widely popular because they are intended for public use. They are designed to work like digital net banking and phone banking transactions. Users can make day-to-day transactions and settle payments using Retail CBDCs.
Retail CBDCs can be made available to the public through digital wallets, mobile apps, and other online payment systems. This could eliminate the need to carry physical money and reduce its financial costs.
#3. Hybrid CBDCs
Going by the name, Hybrid CBDCs include some features from Retail and some from Wholesale CBDCs. Its usage lies in the intersection of public use and banks. Basically, it’s designed for transactions between banks and the common public.
A hybrid model can address diverse financial needs within the financial ecosystem by combining elements of retail and wholesale CBDCs. However, this also means that hybrid CBDCs will possess the pros and cons of retail and wholesale CBDCs.
Benefits of CBDCs
Central Bank Digital Currencies possess plenty of benefits over physical forms of money. Here are a few benefits:
🔷 Fast: Compared to traditional banking procedures, CBDCs are relatively quicker. Not only does it enhance the speed of transactions, but it is also efficient, handy, and more inclined towards technology.
🔷 Low Risk: CBDC transactions are settled on a central bank ledger; therefore, every transaction is on record, reducing counterparty risks.
🔷 Low Cost: CBDC transactions incur much lower transaction costs than traditional physical settlements for cross-border transactions.
🔷 Innovation: CBDCs introduce a new development horizon for the financial service sector, which can be a starting point for innovations in the digital currency industry.
🔷 Financial inclusion: Providing a digital currency to a broader population, including those without access to traditional banking services, is a way for CBDCs to improve financial inclusion. More people can access formal financial services by reducing their reliance on physical cash.
🔷 Secure: CBDC transactions are secure and transparent compared to traditional methods because there’s a much lesser chance of fraud and illicit activities.
Risks of CBDCs
Although there are many pros of CBDCs, it’s in the evolution phase and has some concerns that need to be addressed. Here are some risks involved:
🔴 Infrastructure cost: CBDC infrastructure management will add costs to the existing financial ecosystem, as it must always be available and resilient.
🔴 Initial Resistance: People are used to physical forms of money and other online money transfer options. Moreover, CBDCs introduce trackability, which makes customers resistant to adopting them.
🔴 Shift charges: From its issuance to its demonetization, CBDC will affect the entire currency lifecycle. Moreover, shifting to CBDCs will involve significant expenditures.
🔴 Cybersecurity: Although there’s a secure layer around digital currencies, they will be exposed to cyberattacks and face challenges. It will be an ongoing effort to tackle and adopt a variety of cybersecurity activities.
🔴 Regulatory changes: Because CBDCs are new, they require new legal and regulatory rules to determine the use and interaction with existing financial systems.
Overall, CBDCs have potential benefits but also need to be assessed to ensure security and stability in the financial system.
How are CBDCs Different from Cryptocurrency?
Unlike cryptocurrencies such as Bitcoin, CBDCs are typically considered legal tender. They are backed by the full faith and credit of the government, making them a digital representation of the traditional currency.
One major difference between CBDCs and cryptocurrencies like Bitcoin is that the latter are decentralized. CBDCs are centralized and regulated by the government, making them digital alternatives to a nation’s currency.
Another differentiating point is the derived value. CBDCs’ value is derived from the physical currency and backed by the issuing government. However, the value is derived from the crypto holder’s trust in the network for cryptocurrencies like Bitcoin. The trust in cryptocurrencies may hold a different value over time, which poses a risk in the long term.
CBDCs in Circulation
China Digital Yuan
Chinese foreign exchange regulator believes that “programmable features” of central bank digital currencies (CBDCs) could improve the effectiveness of monetary policy tools. CBDCs, which are currently positioned as M0 currency, can be programmed to have an expiration date or be restricted for certain uses.
The People’s Bank of China (PBOC) is expected to explore these features to adjust CBDC rates and manage the macro economy. Cross-border payments based on CBDCs can make transactions safer, more convenient, and more inclusive.
The Riksbank initiated the e-krona project in 2017 to analyze the need for an e-krona. The project team collaborated with national and international agents to exchange experiences, analyze technical solutions, and address legal issues.
In 2020, the Riksbank began an e-krona pilot with Accenture to test a possible technical platform for the e-krona. The pilot aimed to learn about the possibilities of the solution and compare it with other technical solutions.
The Riksbank collaborated with payment service providers to ensure public access to the e-krona. The pilot also examined the possibility of making conditional payments in e-krona, involving a fictitious customer and car dealer. The e-krona pilot also participated in a cooperation project with the Bank of Israel, Norges Bank, and the Bank for International Settlements.
The Reserve Bank of India (RBI) has launched two e-rupee pilots, one for wholesale and one for retail. The wholesale pilot, CBDC (W) or e₹-W, was launched in November 2022, focusing on secondary market transactions in government securities. The retail pilot, CBDC (R) or e₹-R, was launched in December 2022, with 13 banks involved. The retail CBDC pilot has been extended to more banks and is now interoperable with UPI QR codes.
RBI Deputy Governor said the focus is now on increasing the volume of e-rupee transactions, aiming to increase transactions from 15,000 to one million.
Recent Updates on CBDCs
As per the recent data, 11 countries have adopted CBDCs whereas 50+ countries are planning to adopt CBDCs in coming years. Besides there are over 46 countries that are avidly researching about adoption of CBDCs.
According to the Central Bank Digital Currency Tracker by the Atlantic Council, countries that have CBDCs in the pilot phase are Thailand, India, South Korea, Russia, UAE, and Sweden.
Is CBDC the same as Cryptocurrency?
The idea for CBDCs has roots in crypto and blockchain technologies. However, CBDCs are regulated by central banks, while Cryptocurrency is decentralized.
Which countries have CDBC?
Many countries worldwide are experimenting with and opting for CBDCs. A few are China, the UK, India, Canada, Brazil, Australia, and New Zealand.
How is CBDC different than online banking?
Unlike online banking, CBDCs are a digital version of central bank money. Online banking allows consumers to access their accounts and conduct transactions electronically.
Central bank digital currencies (CBDCs) are emerging and have the ability to transform digital transactions. Many countries are exploring using CBDCs for commercial and public use.
CBDCs aim to offer a quicker, more secure, and more convenient money transfer. CBDCs can help people around the world hold money and pay bills.
Careful planning and execution of central bank digital currencies has many benefits, including providing a minimal-cost alternative money transfer method.
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