What is a CBDC?

Central Bank Digital Currencies are a form of emerging digital currency that will change the way that we use money. In this article, we’ll break down for you the what, why and how of CBDCs. 

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What is a CBDC?

Global economies are looking toward the future of money, and many are taking the first steps of gradually shifting away from paper cash to digital payment currencies. It’s not that cash payments will become obsolete anytime soon, but in the coming decade physical cash won’t be nearly as popular as digital currencies which are both safe, quick, and easy to use. 

Meanwhile, the world of cryptocurrency is steadily on the rise and more people than ever are responding to the global shift towards digital exchanges by investing into digital coins such as Bitcoin and Ethereum. To many, these digital forms of payment are a sign of what’s to come –– the money of the future.

But while many are profiting off the monetary changes, the growth in popularity of digital currencies is a source of concern for central banks everywhere. While financial institutions still need to provide the public with access to stable forms of currency, they can’t continue to do it with outdated technology. 

With stablecoins like the Diem currency on the rise, the market for quick, cheap, and easy financial services is becoming more and more competitive. With the impending adoption of digital currencies by the public, banks see the writing on the wall and are looking to innovate alongside emerging financial technologies.

That’s where CBDCs or Central Bank Digital Currencies come in. CBDCs are a form of digital currency which has developed as a direct response to recent changes in the way that we use money to buy, sell, and exchange goods. It’s essentially the next logical step in the evolution of money, keeping in mind the financial technology available today.

If you’re unclear about how a CBDC works and how its emergence fits into the larger global financial landscape, don’t sweat it. In this article, we’ll break down for you the what, why and how of Central Bank Digital Currencies. 

A Quick Overview of CBDCs

A CBDC is a form of digital currency that is used to both exchange money and store value. In order not to confuse CBDCs with other forms of digital currencies like Bitcoin it’s important to understand that a CBDC is a centralized currency. That means, unlike other cryptocurrencies, a CBDC is under the liability of a single entity –– a country’s central bank. 

CBDCs are a form of cryptocurrency which is a direct representation of a country’s physical fiat currency. This could be the US Dollar, the European Euro, or even the Chinese Yen. This makes it a form of digital currency that’s public rather than private.

The easiest way to understand what a CBDC is to compare it to a traditional banknote. The key difference is that banknotes are physical representations of currency, whereas CBDCs are entirely digital. 

CBDCs are actually much more similar to banknotes than they are to other digital forms of money, such as settlement accounts or reserve balances. Like banknotes, CBDC tokens each have an identifiable serial number which makes them easily traceable. 

The Role of Central Banks

A central bank is a country’s primary bank that is in charge of providing financial services to governmental entities as well as commercial banks. The main purpose of a central bank is to issue money, allowing individuals and businesses to conduct exchanges and store value. Today, central banks provide physical money in the form of cash and digital money in the form of reserves or settlement balances. CBDCs are the third remaining option.

Central banks are vital to global financial stability. They provide the safest form of currency to the public. We’ve seen that whenever the citizens of a country stop trusting their central bank, financial stability disintegrates. 

With CBDCs, central banks are trying not only to stay the most relevant financial institutions but also to keep providing much-needed stability in the form of currency that can keep its value. 

How Does a CBDC Work?

The problem with talking about CBDCs is that there aren’t any tried-and-true models yet –– much of what exists is studies, preliminary experiments and theoretical guidelines.

That being said, CBDCs which are already being developed are using some variation of blockchain technology. A blockchain is a secure way to encrypt financial information so that several entities have access to the data regarding a transaction. This method protects monetary transactions from fraud, by making sure that there is always a consensus regarding the particulars of the transaction. 

The kind of blockchain that CBDCs are likely to turn to is called Distributed Ledger Technology (DLT). This technology is sometimes called a permissioned blockchain because it uses the same principles as Bitcoin’s blockchain, but with a central entity issuing ‘permissions.’ In the case of CBDCs, central banks will manage all records of CBDC transactions. 

DLT has some significant benefits. Like a decentralized blockchain, it provides safety by making sure that several financial entities store the details of a transaction. The fact that it is centralized ensures that the central banks retain control over any exchanges of CBDC. 

Will CBDCs Replace Cash Money? 

All official reports stress the fact that CBDCs don’t aim to replace cold hard cash long-term. When CBDCs are released, central banks won’t stop providing cash to citizens of their respective countries. Cash has too many benefits to be discarded so easily.

The goal of a CBDC is to coexist with existing traditional forms of fiat currencies. It will be used in the same way too –– as an instrument that individuals and businesses can use to make financial transactions. If anything, CBDCs are more likely to replace existing cryptocurrencies than they are to replace cash.

The Risks and Benefits of CBDCs

As the global economies look to the future, many are taking steps to shift away from paper cash and gradually towards digital currencies. The fact is, in the coming decade physical cash won’t be nearly as popular as digital currencies which are quick, safe and easy to use. 

With cryptocurrencies on the rise, more people than ever are investing in digital coins such as Ethereum and Bitcoin. To many, these digital forms of payment are the money of the future –– and they might not be that far off. While the growth of CBDCs has been much slower than that of non-governmental cryptocurrencies, CBDCs are well on their way to a bright future. 

The reason why your government’s central bank hasn’t released a CBDC yet is that it’s most likely still examining the potential risks and benefits of such a payment method. Although CBDCs will make it much easier to make digital payments, there are a couple of things that could make them unsafe.

According to recent research, 80% of central banks worldwide are currently conducting research on CBDCs. Over 50% of them have already started with preliminary experiments and pilot programs to continue their exploration of such a digital payment method. Just recently the chairman of the United States Federal Reserve revealed that creating a U.S. CBDC would be one of the agency’s top priorities in the coming years.

The Benefits of CBDCs

1. Simplified Financial Transactions

While there are many benefits to CBDCs, the primary benefit is that it will make digital payments much easier. Cryptocurrencies like Bitcoin are already doing that, but they’re not overseen by any government body. CBDCs have the potential to combine the financial security provided by a central bank with the effectiveness and ease-of-use of a digital currency. 

2. Improved International Payments

Another major benefit of CBDCs is that they could improve cross-border payments. The fact is, international transactions as we know them today are not very effective. They rely heavily on traditional banking institutions, which must verify transactions and communicate with one another whenever money crosses borders. If central banks manage to work together on creating compatible CBDCs, moving money across borders will be faster and more efficient. 

3. Further Financial Inclusion

Finally, one of the main goals of CBDCs is to improve financial inclusion. CBDCs could provide a stable, reliable digital currency to people who are currently relying on cash alone. This is particularly relevant in developing countries. Of course, for CBDCs to improve financial inclusion, countries will need to work on digital inclusion first. This involves focusing on computer literacy and providing an effective data network. 

Read Also: What Is a Stablecoin?

The Risks of CBDCs

1. The Risk of Fraud

One of the primary concerns regarding CBDCs is that they could be susceptible to fraud. Today, cash money is very safe which has helped to prevent large-scale fraud from happening for a long time. By contrast, while digital currencies offer more financial protections and transparency, they are still more susceptible to fraud. 

A major attack on CBDCs could affect an incredible number of people — potentially destabilizing the monetary supply of an entire country. To make CBDCs safer, central banks are working on developing built-in safeguards and innovative ways to use a secure blockchain. 

2. Threats to Data Privacy

The other risk of CBDCs concerns privacy. With cash, it’s easy for individuals to make anonymous monetary transactions. This isn’t necessarily something that governments want, but most citizens highly value their privacy. 

With CBDCs, it’s likely that transactions won’t be anonymous and that governments will have greater access to people’s financial transactions and history. This poses serious threats of government surveillance and loss of data privacy protections. The answer to this problem will have to come from the legislation surrounding CBDCs as they are developed. 

Conclusion

What’s important to understand about CBDC is that they need to be compatible with one another in order for cross-border monetary transactions to work. This means that central banks will need to work together in parallel to designing their own, country-specific digital currencies. 

So while we’re yet to see a large-scale CBDC available anytime soon, it’s likely that the first to launch will create a domino effect, with other central banks quickly following suit.  Although CBDCs aren’t fully developed yet, they’re already a very relevant concept. Central banks all around the world are currently doing research and trying to develop their own CBDCs. 

It’s still too early to tell what CBDCs will look like in different countries, and just how different from existing cryptocurrencies they will end up being. All we know is that they’ll be an important part of our financial futures as central banks strive to provide monetary stability and safety in a new digital era.

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