By Larry Wright
Everyone is well aware that banks of any county provide money in the form of banknotes which is the fiat currency of that country. It is the physical money used for daily transactions and for payments by the citizens of that country. Although banks produce electronic money, it is only accessible by banks and some particularized financial institutions. Other people cannot make use of that electronic money for their daily chores. But “CBDC,” which is an abbreviation of “Central Bank Digital Currency,” is the latest kind of currency that the Bank of England issues for demonstration. The governments of several countries are trying out this newest type of currency.
This central bank digital currency is a type of digital currency it would be available for all business and household chores. You can think of CBDC as the virtual form of fiat currency of any country. Like 10 pounds of CBDC would be equivalent to a 10-pound note. It is to be noted that the purpose of CBDC is not to replace the physical currency or bank deposits of any country; instead, it will be issued alongside the fiat currency.
This latest kind of money is not fully established yet. Many countries are on the verge of taking notice of that idea. For example, the United States just started experimenting with this idea by issuing digital dollars. Some other countries also do not want to stay behind and form digital currency types like China-made digital Yuan for its national currency Yuan. South Korea also made some assessments and is now starting to develop its national digital currency. Although a lot of countries have begun to adopt the idea of the digital form of their national currency, CBDC is still not launched on a big scale.
If the CBDC is to be launched on an international level, it will create many new chances for payments and methods of how banks keep prices and keep the complete financial system steady. But along with these benefits, it will also create new challenges, which would have to be handled very carefully.
While many countries are analyzing the idea of CBDC, they have their approach to deploying it. Many types of CBDCs are formed on the basics of the same rules and regulations and Blockchain technology, which was the basis of many cryptocurrencies.
To understand this concept, one should have complete knowledge of Blockchain technology. When payments are made in the form of crypto-based currency around the world, the record of these transactions is held by many entities. The reason is that nobody can temper these transactions’ history, and a single person does not have any hold on these transactions. As the cryptocurrency is not centralized like fiat currency, and it does not have a particular set of rules and regulations, but CBDC is regulated and issued by the government.
Venezuela was the first country to introduce its CBDC influenced by Blockchain technology named “Petro” back in 2018. But, soon after its launch, Petra faced many difficulties, and now only a few citizens of Venezuela utilize this currency. China is one of those countries that are known for the evaluation of CBDCs. Citizens of many cities of China make use of the Government issued digital Yuan. Federal Reverse Bank of Boston U.S is also taking steps to launch a digital Dollar in collaboration with the Massachusetts Institute of Technology (MIT).
With the establishment and growing popularity of cryptocurrency, our methods of making our payments have already changed beyond recognition. And with the launch of CBDC, our ways of using money would be far more different than how we used to do some years ago.
Centralized Bank Digital Currency Taskforce
The central bank of England has made the CBDC task force in collaboration with HM Treasury to survey the possible UK CBDC. The primary goal of this task force is to encourage close collaboration between the authorities of the United Kingdom as they experiment with the various aspects of CBDC.
How does CBDC Work?
The term fiat money is used for the physical currency of any country issued by the government. It can be either in the shape of coins or banknotes. Fiat money is considered a type of legal tender that the people of that country use to make payments or buy products or services for carrying out daily chores. CBDC is backed by the government, just like the official currency.
The purpose of CBDC is to represent fiat money. It will provide the citizens with the safety and convenience of digital currency and the regular, reserve circulation of the conventional banking system. Just like governments support fiat currency, they will also support CBDCs. Monetary authorities and central banks would be responsible for the functioning of CBDC. Some examples of the countries pursuing CBDC evolution are as follows.
- The central bank of Sweden, Riksbank, has started working on the digital version of the krona. Soon after, the country suffered from a decrease in cash.
- The USA is trying to introduce CBDCs for the usage of its civilians.
The underdeveloped countries have their own reasons for launching CBDCs in their countries. For example, in India, a vast number of people are unbanked. If they were to establish a physical infrastructure for bringing the unbanked people into the economic system, it would cost a lot of money. But if they set up a CBDC system, it will increase the financial inclusion of the economy of the country.
Types of Central Bank Digital Currencies
The description of two types of CBDCs: Retail and Wholesale central bank digital currency are as follows.
Wholesale Central Bank Digital Currencies
Wholesale CBDCs use the already existing system of financial institutions and banks to carry and sort out assets transactions. Wholesale CBDCs are precisely like the conventional central bank reserve.
There are two further types of wholesale CBDCs. In the first type, the money transactions are the interbank payments. Meaning the transfer of funds would be between banks only, and this transfer would have to follow certain regulations. The transfer would be carried out with a substantial amount of counterparty risk. This risk can be sorted out in a real-time gross settlement payment system.
The settlement of certain rules and regulations is possible due to digital currencies’ ledger-based technology. For this reason, if the money transaction is not following certain restrictions, the transfer of money cannot happen. Wholesale CBDCs speed up the operation of cross-border transactions and make it automatic. Our present-day real-time settlements mainly work with a single authority and one type of currency. But the distributed ledger technology implied in the wholesale CBDC would expand the idea of cross-border transactions, speeding up the process of sending funds across borders.
Retail Central Bank Digital Currencies
Wholesale CBDCs upgrade the process of interbank transactions of funds, whereas retail CBDCs improve the system of transferring CBDCs straight to the consumers. The retail CBDCs diminish banking organizations’ risks of becoming illiquid or sinking depositor funds.
The two forms of retail central bank digital currencies are as follows. They are distinguished based on the kind of access they provide to the consumers. Remember that it is possible to combine these two types of retail CBDCs, and they both can exist in the economy at the same time.
- Cash-based or Value-based access
The CBDCs are distributed among consumers through digital wallets in this type of access. This wallet can be found on the public Blockchain, and just like with money transactions, it will be hard to recognize parties in cash-based transactions. According to the Swedish national bank Riksbank, the cash-based or value-based access systems can be easily and quickly developed as compared to account-based or token-based access systems.
- Account-based or Token-based access
These access systems are identical to the access given by bank accounts. Therefore, a third party would be responsible for the identity and verification of the recipient. It will also keep a check on any illegal activities and monitor payment transfers between accounts. Because of that, an account-based access system provides more privacy than cash-based access systems. Any data containing records of personal transactions are guarded against commercial personals and public organizations via a unique authentication process.
Common Attributes of CBDC
CBDC is relatively new in the market, so we are pretty unclear about its characteristics. It is not a sure thing that they will ever be launched internationally. Considering all these facts, their attributes are quite vague.
But if we talk generally, CBDCs are like a mixture of the regular physical currency issued by the Government and Bitcoin. Some specific characteristics of CBDC are described below.
Distributed Ledger Technology (DTL)
Our world has now become digital, and how we deal with our currency is also digital. It is safe to say that our currency is already digital because we mostly use credit cards or debit cards for most of our payments. We check our bank credits on our phones. Only a few people keep physical money with themselves. This discussion is to prove that our money is already in the form of digits, so what is CBDC any different from our regular money?
It is true that CBDC is digital money, but the technology behind it is entirely different. CBDC was introduced to restructure money from the grass-root level. The technology under laying CBDC is similar to that of Bitcoin, Distributed Ledger Technology.
Ledgers are a type of storage file for recording the financial records of every person by banks. They keep track of the amount of money and each transaction of their customers.
But keep in mind that only one database system does not store the record of financial transactions of each person. DLT is the collection of multiple copies of these transaction records, which are saved and handled by different financial personals. The central bank of the country manages all these DLTs and shares them with the economic entities in a dispersive fashion.
The above-given explanation is an example of permissioned Blockchain, in which just selected entities can temper with or have access to the Blockchain. Additionally, only central entities can decide which other entities can have access and how much they can retrieve the Blockchain. For example, suppose Peter and Stephen are the financial entities. In that case, only the central entity can decide that Peter has the authority to only look through the Blockchain, and Stephen has the power to change and modify it.
This aspect of Blockchain technology is different from than Blockchain technology of Bitcoin, in which anyone can run the program and take part in dispatching transactions. Bitcoin Blockchain technology has no central entity to control the accessibility factor.
CBDCs are Centralized
We discussed the similarities between DLT and Bitcoin, and other cryptocurrencies, but the goal behind the creation of CBDCs is entirely different. There is a specific reason that CBDC has this underlying permissioned Blockchain.
Bitcoin and many other cryptocurrencies like Ethereum have public Blockchains, which means that they do not have a central entity that has all the authority over the Blockchain. And we all know that how much governments like control over things, and CBDC being a government-issued digital currency does not sit well with this attribute.
For this reason, governments selected DLT to control the following aspects of CBDCs.
- The Supply
Bitcoin is limited to 21 million Bitcoins, and this limit is incorporated inside the protocol. For this reason, this limit is inflexible and cannot be changed by any means possible. But the Government of every country has a central bank, which has the authority to manage the money supply of the whole country. These banks are very influential and can decide when to add up or remove from the money supply, stimulate the country’s economy in difficult times, adjust the rates of interest, and do other duties. In the case of CBDC, the Government would have all these authorities.
- Run by Government
With CBDC, unlike cryptocurrency, there will be a central entity that will have authority over which financial organizations can participate in the management of distributed ledger. That means that the software program of CBDC is completely in contrast with that of the cryptocurrency network in which no one is allowed to manage the program without authorization.
High Efficiency and Lower Costs
Some advocates of the CBDC system profess that because the CBDCs are designed under the hood, using this network can lead to less money transaction costs. It could be possible because, with the CBDC, the financial organizations would be more connected; hence, it would be easy to move funds from one organization to another. Because of that, it would take less money than we need today for money transactions.
Tracking Payments
As we learned earlier in this article, DLTs keep track of every transaction. The Government of some countries wants more surveillance over its citizens. China is one such country, which will definitely want to keep a close eye on the financial information of its citizens for the sake of keeping a tight check on its civilians.
If we talk about other countries, they all have a different point of view in this regard. United States is famous for protecting the privacy of its citizens’ privacy and wants to continue to do so if the nation adopts CBDC. The U.S. Federal Reserve has made several policies in this respect.
Central Bank Digital Currencies vs Cryptocurrency
The idea of cryptocurrency is the foundation for creating central bank digital currencies. Cryptocurrencies are digital currencies based on blockchain technology and decentralized networks. They are secured by cryptography makes them impossible to duplicate or temper. The purpose of the ledger is to track money transactions, and for this reason, the ledger is developed with cutting-edge technology to make it as secure as possible. It is also responsible for a direct and flawless transaction of money without any arbitrator.
When we think about cryptocurrency, another currency system comes to mind in which the transaction does not have any strict rules or regulations. Bitcoin, established in 2009, is the world’s most famous cryptocurrency. The records are stored on an encrypted, public ledger in Bitcoin and other cryptocurrency transactions. Any entity does not control that ledger, and anyone can have access to that ledger. This process makes sure that all transactions are verified. Any bank or government does not back Bitcoin.
It is true that the present-day cryptocurrency system is not a threat to the current economic infrastructure, but it can potentially simplify and derange the system.
According to some experts, the development of central bank digital currencies is a means to prevent this from happening.
Advantages of Central Bank Digital Currencies
- CBDCs can simply the execution process of monetary policy and government procedures.
- With wholesale CBDCs, the transactions between banks will become automatic, and with retail CBDCs, consumers will have a direct connection with central banks.
- Illegal activities can be prevented with CBDCs because it is a digital currency and thus does not need serial numbers for tracking.