Understanding Central Bank Digital Currency

Nowadays, CBDCs, or central bank digital currencies, are becoming a hot topic in the financial sector, as banks, governments, and other financial institutions are studying the feasibility of introducing a new form of digital money, and its potential impact on the monetary and fiscal policies, as well as on existing financial networks.

But what are CBDCs?

CBDC is a new form of digital money issued by a central bank. They are digital tokens like cryptocurrencies pegged to a country’s fiat currency.

However, because they are issued by a central bank, CBDCs overcome some of the current problems associated with cryptocurrencies: they are extremely volatile, they lack government backing and sometimes they anonymize transactions. If a government decides to issue a digital currency, from that moment on, that currency is recognized as a legal tender, and so it can be used for payment, meaning every business must accept it, and store value.

A new question comes up: Why should a government issue a digital currency when fiat currency already exists?

Maybe it is because of the strong pressure for governments to adopt a CBDC (the market for private e-money is on the rise), maybe it is because governments are aware of the potential inherent to this new type of currency (privacy, transferability, accessibility, efficiency and financial security to both businesses and consumers). The fact is that, currently, many countries are researching ways to transition to digital currencies (some like The Bahamas and Nigeria already launched theirs). And if a country intends to become a cashless society, a digital currency with central bank backing is a credible alternative.

CBDCs decrease the high maintenance costs that complex financial systems require, and so one can expect transaction costs to decrease with this new technology. A CBDC facilitates the quick settlement of retail payments at the wholesale level and has the potential to improve the efficiency of payments made at the point of sale or between two parties (this is especially important to eliminate both the third-party — any residual risk rests with the central bank — and counter-party risks present in most transactions).

Additionally, and as was already discussed, CBDCs, reduce the risk of using cryptocurrencies. In fact, this is one of the biggest advantages that CBDCs offer. They are designed for safety, so their use prevents the extremely volatile cryptocurrencies from causing severe financial distress to households and businesses and from jeopardizing an economy’s overall stability.

Finally, because they can be easily managed, CBDC can support strong and swift implementation of various monetary policies.

These are all good news, and until now it seems that CBDCs are perfect, as they offer plenty of advantages to the economy’s agents. However, that is not the case. In fact, there are some concerns with the implementation of CBDC.

Firstly, one needs to acknowledge that a CBDC is not a cryptocurrency, meaning it will be regulated by a single authority (it will be centralized). Secondly, CBDCs, despite being designed to be similar to cryptocurrencies, do not have to be based on blockchain technology. This means that CBDCs may fall short of capturing the attention of the growing number of cryptocurrency enthusiasts.

Moreover, the effects of switching to CBDC would have on the stability of the financial system and of the economy are unknown (during a financial crisis, for example, there may not be enough central bank liquidity to allow withdrawals). Also important is that CBDCs would necessitate an appropriate level of government intervention to monitor for financial crimes and would also need a proper management infrastructure so that transactions can be first verified and then modified under the jurisdiction’s law.

Overall, due to the significant efforts that central banks and governments are devoting to CBDC, they should become a reality soon.

All of this, however, will be predicated on two aspects: 1) the establishment of a dedicated legal framework that facilitates global governments’ transparency and issuance of a digital form of money; 2) a balanced CBDC ecosystem, involving both the private and public sectors, to ensure that the desired policy outcome is achieved and to enable innovations that meet the always evolving payment needs.