Sunday, September 25, 2022

What Is a Central Bank Digital Currency (CBDC)? Understand Its Types, Uses, and More

What Is a Central Bank Digital Currency (CBDC)?

Central Bank Digital Currency (CBDC) is a traditional currency but in digital form. It is issued by the central bank in national units representing a legal tender with the liability of the central bank. Just like fiat money, the supply and value could be influenced by monetary policies and trade surplus, among other factors, which results in inflation and deflation.

Is CBDC Cryptocurrency?

No, it is not cryptocurrency. CBDCs are mainly controlled by a central authority (the central bank) as opposed to decentralized cryptocurrency. In addition, as the authority is held by the central bank the need for a consensus mechanism may not be required.

Are CBDCs Blockchain-based?

They may or may not be powered by blockchain or distributed ledger technology. A study by the Federal Reserve Bank of Boston and Michigan Institute of Technology’s Digital Currency initiative found ledgers hinder the scalability and efficiency of CBDC.

Types of CBDCs

CBDC can be categorized using various parameters: implementation models, underlying formats, and distribution models.

Wholesale vs Retail

In the wholesale model, digital currencies of the central banks are restricted to certain commercial banks and institutions. On the other hand, the retail model gives access to businesses, corporations, and consumers.

Account-based vs Token-based

In an account-based model, the CBDC is linked to the identity, wherein the identity of the payer is verified, and a transaction is a balance update of the payee and payer.

Token-based CBDC ownership is linked to proof wherein the token used for payment is verified.  The proof of ownership can be verified using cryptography as to who the to-be-payer would be, and thereby a transaction means the change of ownership.

Direct/Indirect and Hybrid Models

The direct model is where all participants of a transaction will hold an account in the central bank, and payment will be transferred from one account to another with all claims being backed up by the bank. Know Your Customer (KYC) and Anti-Money Laundering (AML) compliance requirements will be managed by the central bank.

On the other hand, the indirect model is where central banks distribute the digital currency token to commercial banks or non-bank financial institutions, which will then redistribute and handle KYC and AML compliance requirements.

Meanwhile, the hybrid model is where the central bank distributes its digital currency tokens to intermediaries, which will then redistribute. Notably, KYC and AML compliance requirements will be managed by the intermediary. However, in this scenario, the claim remains with the central bank. 

With the digitization of economies, the need for real-time updates on payments and transactions, and the need for efficient carrying out of transactions cross borders have had central banks eyeing to tap CBDCs. According to the International Monetary Fund (IMF), adopting CBDC technology could reduce expenses, facilitate the flow of money, improve financial inclusion and help access money more securely.

Factors That Drive Central Banks to Experiment With CBDC

Support Digitization of Economies

CBDCs could help the central bank’s function of providing legal tender in a digital space. These assets help central banks offer access to digital payments at minimum or zero cost through a general-purpose electronic medium.

Streamline Current Payment Systems

These digital tokens could help central banks compete better with payments, as it involves lower operational costs and reduced risks involved with handling currency.

A CBDC promotes innovation and participation of private players with lower entry barriers or requirements. Furthermore, they help facilitate faster settlement of payments and give more time.

Enhance Monetary and Fiscal Policy

CBDCs improve the distribution of government benefits to individuals and gives more control over transactions for tax control. They enhance financial stability and help manage liquidity squeezes by offering a public alternative to private currencies.

Improving Financial Inclusion

CBDC could act as a tool that improves the competitiveness of local currency in terms of payments and markets trying to reduce their dependency on dollars. Moreover, CBDCs help bring the unbanked population of 2 billion (as of 2020) into the global financial system.

Pros and Cons of Central Bank Digital Currency

Pros of CBDC

Improves the confidentiality of information:

The information of transactions could be monetized by companies. With more and more tech companies with revamped Artificial Intelligence offering financial services, privacy is at stake as Data Protection regulations fail to keep up with the advancement of technology. CBDCs, which are exploitation-proof to information, would be the perfect solution to meet the need of the hour.

Levels the playing field in payment:

Certain players have gained the upper hand in segments like cards and e-payments, which has reinforced their pricing power. The introduction of CBDC would dismantle such sovereignty.

Helps combat illicit activity:

CBDCs could help trace every unit of currency that would come in quite handy in detecting tax evasion and financial crimes.

Cons of CBDC

Might trigger bank runs:

At times when one withdraws a large sum of money and buys CBDCs, it could trigger a run on banks.

Regulations:

The inefficiency of the present legal framework to support the latest forms of money could have legal and financial implications. Also, the reputation of the CBDC-issuing central bank might be at stake.

The Future

Financial institutions will have to put on their thinking caps and consider how their core capabilities will overlap with the capabilities CBDC would demand in the future. This includes examining whether their programs are equipped to offer custody services to digital assets stored on physical devices, finding out whether their programs are cybercrime-proof, etc.

As it is believed that at some point CBDC will approach financial institutions for digital wallet capabilities and transaction processing, financial institutions must update, integrate, or retire their system based on CBDC design and implementation.

Financial institutions too need to vet the skills of their people or recruit employees who have the needed skills to tap into the potential of CBDCs, determine its liquidity management approach, and recognize CBDC customers. 

There are predictions that the future will be a mix of centralized, decentralized, account-based, token-based, stablecoins, and cryptocurrencies along with digital currency and physical currency. However, with most countries looking to go ahead with wholesale CBDC, which involves less risk as opposed to retail, we can only expect CBDC to give a boost to digital currencies.

From public-private partnerships, wherein the central bank uses an intermediary to distribute tokens to the public, to other interesting models that are being tested, which if successful, could involve the private sector to varying degrees. Will CBDC help introduce the future of money? Only time will tell.

What Is a Central Bank Digital Currency (CBDC)?

Central Bank Digital Currency (CBDC) is a traditional currency but in digital form. It is issued by the central bank in national units representing a legal tender with the liability of the central bank. Just like fiat money, the supply and value could be influenced by monetary policies and trade surplus, among other factors, which results in inflation and deflation.

Is CBDC Cryptocurrency?

No, it is not cryptocurrency. CBDCs are mainly controlled by a central authority (the central bank) as opposed to decentralized cryptocurrency. In addition, as the authority is held by the central bank the need for a consensus mechanism may not be required.

Are CBDCs Blockchain-based?

They may or may not be powered by blockchain or distributed ledger technology. A study by the Federal Reserve Bank of Boston and Michigan Institute of Technology’s Digital Currency initiative found ledgers hinder the scalability and efficiency of CBDC.

Types of CBDCs

CBDC can be categorized using various parameters: implementation models, underlying formats, and distribution models.

Wholesale vs Retail

In the wholesale model, digital currencies of the central banks are restricted to certain commercial banks and institutions. On the other hand, the retail model gives access to businesses, corporations, and consumers.

Account-based vs Token-based

In an account-based model, the CBDC is linked to the identity, wherein the identity of the payer is verified, and a transaction is a balance update of the payee and payer.

Token-based CBDC ownership is linked to proof wherein the token used for payment is verified.  The proof of ownership can be verified using cryptography as to who the to-be-payer would be, and thereby a transaction means the change of ownership.

Direct/Indirect and Hybrid Models

The direct model is where all participants of a transaction will hold an account in the central bank, and payment will be transferred from one account to another with all claims being backed up by the bank. Know Your Customer (KYC) and Anti-Money Laundering (AML) compliance requirements will be managed by the central bank.

On the other hand, the indirect model is where central banks distribute the digital currency token to commercial banks or non-bank financial institutions, which will then redistribute and handle KYC and AML compliance requirements.

Meanwhile, the hybrid model is where the central bank distributes its digital currency tokens to intermediaries, which will then redistribute. Notably, KYC and AML compliance requirements will be managed by the intermediary. However, in this scenario, the claim remains with the central bank. 

With the digitization of economies, the need for real-time updates on payments and transactions, and the need for efficient carrying out of transactions cross borders have had central banks eyeing to tap CBDCs. According to the International Monetary Fund (IMF), adopting CBDC technology could reduce expenses, facilitate the flow of money, improve financial inclusion and help access money more securely.

Factors That Drive Central Banks to Experiment With CBDC

Support Digitization of Economies

CBDCs could help the central bank’s function of providing legal tender in a digital space. These assets help central banks offer access to digital payments at minimum or zero cost through a general-purpose electronic medium.

Streamline Current Payment Systems

These digital tokens could help central banks compete better with payments, as it involves lower operational costs and reduced risks involved with handling currency.

A CBDC promotes innovation and participation of private players with lower entry barriers or requirements. Furthermore, they help facilitate faster settlement of payments and give more time.

Enhance Monetary and Fiscal Policy

CBDCs improve the distribution of government benefits to individuals and gives more control over transactions for tax control. They enhance financial stability and help manage liquidity squeezes by offering a public alternative to private currencies.

Improving Financial Inclusion

CBDC could act as a tool that improves the competitiveness of local currency in terms of payments and markets trying to reduce their dependency on dollars. Moreover, CBDCs help bring the unbanked population of 2 billion (as of 2020) into the global financial system.

Pros and Cons of Central Bank Digital Currency

Pros of CBDC

Improves the confidentiality of information:

The information of transactions could be monetized by companies. With more and more tech companies with revamped Artificial Intelligence offering financial services, privacy is at stake as Data Protection regulations fail to keep up with the advancement of technology. CBDCs, which are exploitation-proof to information, would be the perfect solution to meet the need of the hour.

Levels the playing field in payment:

Certain players have gained the upper hand in segments like cards and e-payments, which has reinforced their pricing power. The introduction of CBDC would dismantle such sovereignty.

Helps combat illicit activity:

CBDCs could help trace every unit of currency that would come in quite handy in detecting tax evasion and financial crimes.

Cons of CBDC

Might trigger bank runs:

At times when one withdraws a large sum of money and buys CBDCs, it could trigger a run on banks.

Regulations:

The inefficiency of the present legal framework to support the latest forms of money could have legal and financial implications. Also, the reputation of the CBDC-issuing central bank might be at stake.

The Future

Financial institutions will have to put on their thinking caps and consider how their core capabilities will overlap with the capabilities CBDC would demand in the future. This includes examining whether their programs are equipped to offer custody services to digital assets stored on physical devices, finding out whether their programs are cybercrime-proof, etc.

As it is believed that at some point CBDC will approach financial institutions for digital wallet capabilities and transaction processing, financial institutions must update, integrate, or retire their system based on CBDC design and implementation.

Financial institutions too need to vet the skills of their people or recruit employees who have the needed skills to tap into the potential of CBDCs, determine its liquidity management approach, and recognize CBDC customers. 

There are predictions that the future will be a mix of centralized, decentralized, account-based, token-based, stablecoins, and cryptocurrencies along with digital currency and physical currency. However, with most countries looking to go ahead with wholesale CBDC, which involves less risk as opposed to retail, we can only expect CBDC to give a boost to digital currencies.

From public-private partnerships, wherein the central bank uses an intermediary to distribute tokens to the public, to other interesting models that are being tested, which if successful, could involve the private sector to varying degrees. Will CBDC help introduce the future of money? Only time will tell.

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