Blockchain technology has transformed the financial landscape by facilitating peer-to-peer transactions, eliminating intermediaries. The emergence of Central Bank Digital Currency (CBDC) has further revolutionised blockchain, reshaping the future of payments for both businesses and individuals. Banks and governments have increasingly turned to digital assets in their operations. The U.S. President's executive order, "Responsible Development of Digital Assets," exemplifies the public recognition of the importance of judiciously advancing such assets.
In this article, we shall delve into the concepts and various aspects of Central Bank Digital Currency (CBDC) to fully grasp fundamental information about this digital currency.
A Central Bank Digital Currency (CBDC) is a digital form of central bank money, serving as legal tender established and backed by a central bank. It signifies a claim against the central bank, not a commercial bank or Payment Service Provider (PSP). Managed on a digital ledger, which may or may not be a blockchain, CBDC expedites and enhances payment security among banks, institutions, and individuals. Recent research by the Bank for International Settlements reveals that over 70% of institutions are actively exploring and developing proofs of concept for CBDCs.
Three defining aspects of a CBDC include being digital assets recorded in a digital ledger (distributed or not), backed by the central bank, and subject to complete control and determination of supply by the central bank.
Fiat money is a government-issued currency or legal tender that can be used to exchange commodities and services. Traditionally, fiat money came as banknotes and coins. However, technological advancements have allowed governments and financial institutions to supplement physical fiat money with a credit-based model that records balances and transactions digitally.
Physical currency is still widely used, but some developed countries have witnessed a drop in its use. That trend further accelerated during the pandemic. With blockchain technology and cryptocurrency's inception and evolution, societies have inclined towards a cashless future.
The primary objective of Central Bank Digital Currencies (CBDCs) is to offer businesses and individuals enhanced privacy, transferability, convenience, accessibility, and financial security. Additionally, CBDCs could cut the maintenance costs of a complex economic system, lower cross-border transaction expenses, and provide more economical options for users of alternative money-transfer methods. Moreover, CBDCs aim to mitigate the risks associated with the current volatility of cryptocurrencies, ensuring a secure and stable means of exchanging digital currency for households, consumers, and businesses.
CBDCs include two types – the wholesale CBDCs and the retail CBDCs. Financial institutions primarily use wholesale CBDCs, while consumers and businesses favour retail CBDCs.
Wholesale Central Bank Digital Currencies (CBDCs) resemble holding reserves within a central bank. An institution is provided with an account by the central bank for depositing funds or facilitating interbank transfers. This allows central banks to employ monetary policy instruments like reserve requirements or interest on reserve balances to impact lending and establish interest rates.
Retail Central Bank Digital Currencies (CBDCs) are government-supported digital currencies that individuals and businesses utilise. They mitigate intermediary risk, where private digital currency issuers may face bankruptcy, risking the loss of customers' assets.
There are two varieties of retail CBDCs, differing in user access and currency utilisation:
The Federal Reserve highlights crucial requirements and considerations for designing and implementing Central Bank Digital Currencies (CBDCs).
Cross-Border Cost Reduction:
By streamlining distribution systems and fostering international cooperation, CBDCs can lower high cross-border transaction costs.
International Dollar Role:
CBDCs can support the dominance of the U.S. dollar, the most widely used global currency.
CBDCs remove the need for a costly financial structure, providing direct access between consumers and central banks, thus enhancing financial inclusion.
Establishing a direct connection between consumers and central banks eliminates the need for expensive infrastructure, expanding access to the public.
Financial Structural Changes:
The impact of drastic changes on household expenses, investments, banking reserves, interest rates, and the financial services sector remains uncertain.
Financial System Stability:
The effects of a CBDC transition on financial system stability are unclear, with potential liquidity challenges during crises.
Monetary Policy Influence:
The unknown effects of CBDCs on central banks' ability to implement effective monetary policy are crucial for influencing inflation, interest rates, and economic indicators.
Several trends likely fuel central banks' interest in Central Bank Digital Currencies (CBDCs):