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Central Bank Digital Currency (CBDC)

A form of fiat currency issued by central banks

What is Central Bank Digital Currency (CBDC)?

Central Bank Digital Currency (CBDC) is a form of fiat currency issued by the central banks of various countries. A fiat currency is considered any form of currency that is not backed by an underlying physical commodity. This digital fiat currency is issued by central banks in token form or with an electronic record associated with the currency and pegged to the domestic currency of the issuing country or region.

Since this digital currency is issued by central banks, the central banks maintain full authority and regulation over the CBDC. The implementation of a CBDC into the financial system and monetary policy is still in the early stages for many countries; however, over time it may become more widely adopted.

 

Benefits and Drawbacks of a CBDC

CBDC is a new concept that is being introduced with various benefits and some potential drawbacks, some benefits of utilizing a CBDC include:

  • Increase payment efficiency
  • Complement current forms of money and financial services
  • Deter criminal activity
  • Improve international payment options
  • Potentially reduce net transactions costs, benefitting lower-income households

 

Along with the potential benefits, there are various risks and drawbacks of utilizing a CBDC, such as:

  • Overhauling the current financial system could create instability
  • The effectiveness of monetary policy may deteriorate
  • Operational difficulties
  • Cybersecurity risks
  • Privacy as there is a loss of ability to transact anonymously

 

Types of CBDCs

CBDCs can fall into different categories. The two main types of CBDCs are:

 

Central Bank Digital Currency (CBDC)

 

1. Wholesale CBDC

Wholesale CBDCs would primarily be utilized by financial institutions such as banks. The use of CBDCs would allow banks to make payments in a quicker and more automated manner. Cross-border transactions may become faster and more reliable.

In their current form, payment settlement systems work in single jurisdictions or with a single currency. Utilizing blockchain technology could potentially make transactions quicker, smoother, and more reliable.

 

2. Retail CBDC

Retail CBDCs would primarily be utilized by individuals. People could use them essentially as digital cash, with the comfort of knowing that the currency is issued and backed by the country’s central bank.

This innovation could potentially replace the need to carry physical currency and reduce economic rents associated with transacting in the legacy financial system.

 

Government-backed Cryptocurrency/Government Crypto Coin

Similar to cryptocurrencies, CBDCs are built upon blockchain technology that should increase payment efficiency and potentially lower transaction costs. While the use of CBDCs is still in the early stages of development for many central banks across the world, several CBDCs are based upon the same principles and technology as cryptocurrencies such as Bitcoin.

The characteristic of the currency being issued in token form or with electronic records to prove ownership makes it similar to other established cryptocurrencies.

 

Digital Fiat Currency

As mentioned earlier, a fiat currency is any form of currency that is not backed by a commodity such as silver or gold. Essentially all forms of currency at present are fiat currencies such as the US Dollar, Japanese Yen, British Pound, etc. These fiat currencies are able to be printed or held physically in the form of coins or bills for example.

The significant difference between traditional forms of fiat currency and digital fiat currency is that there is no physical form for digital fiat currencies. Both physical and digital fiat currencies are established as forms of money by the government, which oversees the regulation of its currency. However, digital fiat currency provides an electronic record or digital token of the issuing country’s currency.

 

CBDC vs. Cryptocurrency

There are some key differences between CBDC and cryptocurrencies, including:

 

1. Centralization

One of the most prominent differences is that most traditional cryptocurrencies are decentralized, with no managing or controlling authority. CBDCs, on the other hand, are centralized with the issuing government maintaining the ability to manage and control the digital currency, as well as track the flow of funds and even censor certain users from transacting in that digital currency.

For central banks, CBDCs concentrate on planning and decision-making, as well as have a way to maintain taxation.  These central banks could digitally issue and retire money as they see fit, which allows them to control the money supply – a key lever for monetary policy – as well as foreign exchange.

However, with cryptocurrencies, there is no central decision-maker. Bitcoin, as an example, can be transacted anonymously in peer-to-peer exchanges. 

 

2. Underlying value

When it comes to the value of CBDCs vs. cryptocurrencies, there can be more safety behind CBDCs as they are backed by the issuing government. In a stable political and inflationary environment, CBDCs can be reasonably expected to maintain their value over time or at least track the pegged physical currency.

For cryptocurrencies such as Bitcoin, the value of the currency is derived from the holders’ trust in the Bitcoin network and its decentralized nature. This trust may not hold over time, posing a risk concerning the long-term value of Bitcoin.

 

Learn More

Thank you for reading CFI’s guide to Central Bank Digital Currency (CBDC). In order to help you advance your career to your fullest potential, these additional resources will be very helpful:

  • Cryptocurrency Exchanges
  • Digital Wallet
  • Federal Reserve (The Fed)
  • Fiat Money
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