Central Bank Digital Currencies (CBDCs)

A central bank issues digital currencies, which are similar to cryptocurrency. A country’s fiat currency determines its value. CBDCs are being developed and implemented in many countries. Because so many countries are experimenting with digital currencies, it’s critical to understand what they mean and what they are for society. Physical commodities such as gold or silver do not back the fiat money. The initial form of fiat money was banknotes and coins.

Nonetheless, technological advancements have enabled governments and financial institutions to supplement physical fiat money with a credit-based model in which balances and transactions are recorded. With the introduction and evolution of cryptocurrency and blockchain technology, there has been a surge in interest in cashless societies and digital currencies. As a result, governments and central banks worldwide are investigating the use of government-backed digital currencies. In case of their implementation, these currencies, like fiat money, will have the full faith and backing of the government that issued them. In the coming paragraphs, we will discuss the following:

• How do Digital Currencies Issued by Central Banks Work?
• Goals of Central Bank Digital Currencies
• How Safe are Central Bank Digital Currencies?
• Risks Associated with CBDC
• Case for CBDC
• Types of CBDCs
• Monetary Policy and CBDC
• Would Society Benefit from CBDCs?
• CBDCs vs. Cryptocurrencies

How do Digital Currencies Issued by Central Banks Work?

According to the Bank of England, people are using less cash and could use a CBDC to pay for things digitally. According to the World Economic Forum’s Central Bank Digital Currency Toolkit, they can keep the digital currency in an account with the central bank or as electronic tokens. The digital tokens are storable on mobile devices, prepaid cards, or other digital wallets. CBDCs also are helpful for businesses and other financial institutions such as high-street banks. According to the ECB, a digital currency would supplement, rather than replace, physical cash.

Goals of Central Bank Digital Currencies

Many people in the United States and elsewhere lack access to affordable financial services. CBDCs’ primary goal is to provide businesses and consumers with privacy, convenience, accessibility, and financial security. CBDCs could also reduce the costs of maintaining a complex economic system, lower cross-border transaction costs, and provide lower-cost options to those using alternative money transfer methods.

How Safe are Central Bank Digital Currencies?

According to the European Central Bank (ECB), central bank cash is “a risk-free form of money guaranteed by the state.” In addition, the ECB expects to introduce a digital euro across its 27 member countries by mid-decade.

CBDCs, according to the Bank of England, lack the volatility of privately issued digital currencies such as Bitcoin, Ether (Ethereum), and XRP because they are the country’s national currency.

According to the Federal Reserve, with no credit or liquidity risk, a CBDC would be the safest digital asset available to the general public.

Risks Associated with CBDC

There are multiple risks that CBDC can pose. One that stands out is the potentially disruptive effect it would have on the structure of the banking industry and financial stability. The issuance of CBDC accounts by the FED would significantly undermine the commercial banking industry’s role as an intermediary within the US economic system. Establishing it would encourage a shift of money from bank deposits to direct central bank deposits, reducing bank deposits as a source of funds for the industry and likely affecting the relative cost of credit across the economy.

Furthermore, it would be the preferred account and currency during increased economic strain and uncertainty. The flow of deposits and other sources of funds into the CBDC could be massive, further disrupting markets and credit flows and complicating financial stability goals. The public frequently embraces the national currency during severe economic stress, while privately issued currency fails. As a result, policymakers should be concerned about the unknown and potential unintended consequences of expanding the Fed’s role in payments because there is a real risk that the cure will be more harmful than the perceived illness.

Case for CBDC

The entire case for CBDC – defined as an asset in electronic form that serves the essential functions of paper currency, with universal access and legal tender – can be traced back to classical economists’ contention that currency is a public good and its provision’s responsibility is on the government (Friedman and Schwartz 1986). 

• CBDC could mitigate the threat to monetary sovereignty posed by stablecoins issued by global digital service providers such as Facebook, which would jeopardize central banks’ ability to conduct monetary policy.
• CBDC would be a safe, dependable currency free of fraud, hacking, money laundering, and financing risks.
• CBDC could mitigate the threat to monetary sovereignty posed by stablecoins issued by global digital service providers such as Facebook, which would jeopardize central banks’ ability to conduct monetary policy.
• CBDC would be a safe and reliable currency, free of fraud, hacking, money laundering, and terrorism financing risks.

Types of CBDCs

CBDCs are of two types: wholesale and retail. Financial institutions are the primary users of wholesale CBDCs. Retail CBDCs, like physical forms of currency, are used by consumers and businesses. 

Wholesale CBDCs  

The central bank opens an account for an institution to deposit funds or use to settle interbank transfers. Central banks can then influence lending and set interest rates using monetary policy tools such as reserve requirements or interest on reserve balances.

CBDCs in Retail

Retail CBDCs are digital currencies backed by the government that consumers and businesses use. In addition, retail CBDCs eliminate intermediary risk, which is the risk that private digital currency issuers will go bankrupt and lose their customers’ assets.

Retail CBDCs have two types and they differ in terms of how individual users gain access to and use their currency.

Private/public keys are required to access token-based retail CBDCs. This validation method allows users to conduct transactions anonymously.

To access an account, account-based retail CBDCs require digital identification.

Monetary Policy and CBDC

According to researchers, interest paid on CBDC could improve the transmission mechanism, particularly the lending channel (Barrdear and Kumhoff 2019, Williamson 2018, IMF 2020, Meaning et al. 2018). It would also simplify and reduce central bank balance sheets, returning us to a bills-only policy. Furthermore, they are using its interest rate as the policy rate, which could allow central banks to shift from the current ‘floor system’ to a ‘corridor system’ (Meaning et al. 2018). Finally, paying CBDC interest can help the lender-of-last-resort function and financial stability.

Would Society Benefit from CBDCs?

According to the ECB, the digital euro would be a “fast, easy, and secure” way for people to make daily payments. In addition, it would provide people with more “payment options” and increase financial inclusion.

According to World Bank data, approximately 1.7 billion adults worldwide lack access to a bank account. As a result, it is a barrier to poverty reduction. According to the Atlantic Council, central bank digital currencies could potentially improve financial inclusion by making money more accessible and safer.

According to the International Monetary Fund, if a natural disaster or the failure of a payment company rendered cash unavailable, a CBDC could provide a backup.

Another motivator is the reduction of financial crime. Cash is essentially untraceable, which facilitates crime. Central bank digital currencies, on the contrary, can improve the transparency of money flows, says the Atlantic Council.

CBDCs vs. Cryptocurrencies

Cryptocurrency ecosystems offer a glimpse of a different currency system in which cumbersome regulations do not dictate the terms of each transaction. They are difficult to duplicate or forge and have protection by consensus mechanisms that prevent tampering. The central bank Although digital currencies are similar to cryptocurrencies, they may not require blockchain technology or consensus mechanisms. 

Cryptocurrencies are also unregulated and decentralized. Investor sentiment, usage, and user interest all influence their value. As a result, they are volatile assets better suited for speculation, making them unsuitable for a financial system that requires stability. CBDCs have a stable and safe design by mirroring the value of fiat currency.

Conclusion

The history of money is taking a new turn. Countries seek to preserve essential aspects of their conventional monetary and financial systems while experimenting with new digital forms of currency. The paper released today shows that for these experiments to succeed, policymakers must deal with many open questions, technical obstacles, and policy tradeoffs. It may not be easy, but intellectuals in Central Banks can achieve it thanks to their trademark resourcefulness and perseverance.