The arrival of cryptocurrencies established the foundation for the digital currency landscape. Stablecoins have emerged as a popular digital currency alternative in recent years alongside providing the assurance of stability among cryptocurrencies. As a result, it is easier to gain access to the digital currency marketplace with Stablecoin, without volatility exposure found in Ethereum and Bitcoin. Therefore, many central banks are turning their attention to Central Bank Digital Currencies or CBDCs.

Central bank digital currency offers a promising avenue for transforming existing monetary units into their digital variants. Although CBDCs have been gaining prominent recognition in recent times, it is important to understand how central bank digital currency works. The following discussion offers you comprehensive insights into the definition, foundational principles along with motivations and challenges associated with CBDCs.

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The Central Banks and CBDC Equation

Central banks are one of the prominent players in dictating the levels of financial and monetary stability in their respective jurisdictions. In addition, they are also responsible for providing explicit or implicit promotion of wide-ranging access to payments with better efficiency and safety. The facility of central bank money to businesses, the public, and banks is a critical instrument that helps central banks in executing public policy goals.

The central bank money generally serves as the unit of account, store of value for a specific jurisdiction, and means of payment. The common unit of account works as a public commodity for enabling the exchange of goods and services alongside safe and efficient settlement of financial transactions. So, when does the topic of CBDC arrive in the equation?

Have you heard of digital transformation of the economy? The digitalization of economy has been successful in transforming the methods followed by people for payment. On the other hand, the public policy objectives of various central banks are still outdated, although various central banks have gone through innovation and evolution in their approaches for addressing their business objectives.

As a result, central banks have come up with an innovative solution in the form of central bank digital currencies for providing a digital alternative to money. Around 80% of central banks are presently reviewing the prospects associated with CBDC, with half of them already completing conceptual research, experiments, and pilot tests. Blockchain in payments systems can offer the infrastructure needed for CBDC.

Many experts have pointed out the potential of CBDCs for introducing notable financial and economic implications globally. Furthermore, CBDCs can also play a crucial role in redefining the existing payments processes on a local level while addressing continuously fluctuating user requirements on a global scale. Now, it is quite important to start reflecting on what a CBDC actually is!

What are CBDCs?

Central bank digital currencies are simply the digital variants of central bank money. You can leverage CBDCs as a medium of exchange alongside a store of value. In addition, it also presents a mix of new and existing variants of central bank money, thereby creating a challenge for defining CBDCs. Every central bank digital currency unit works as a safe digital instrument, just like a paper-based currency.

For example, U.S.A is creating a CBDC project called digital dollar, which may affect our global monetary system. It comes with a digital dollar wallet that will maintain the flow and help users to store their digital assets. At present, federal banks will regulate the currencies to maintain its value.

Therefore, you can clearly note that the definition of central bank digital currency relates to a wide variety of concepts. So, it is quite difficult to find out a well-articulated definition of central bank digital currency. Users should perceive CBDCs from the perspective of other variants of money, which depend on four crucial properties.

The four properties include accessibility, issuer, technology, and form. Generally, money leverages the tokens of stored value or accounts as underlying technology. While cash and digital currencies such as CBDCs are token-based, the balances in reserve accounts and other variants of commercial bank money are account-related. So, there is no way to compare CBDC with the balances in conventional settlement accounts or traditional reserve.

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Establishing the Foundation of CBDCs

Readers might wonder about the potential reasons for emphasizing central bank digital currencies in the present times. For starters, you can consider the link between digital currencies and blockchain technology as one of the prominent reasons for focusing on CBDCs right now. The concept of central bank digital currency gained recognition around the time of the 2008 financial crisis.

The growth in digital transactions alongside the introduction of cryptocurrencies brought forward many motivations for introducing CBDCs. There are many blockchain solutions for central bank digital currency. Therefore, it is reasonable to understand the context underlying CBDCs to understand the significance of central bank digital currency. However, it is important to reflect on the essential traits of central bank digital currency to understand its benefits.

According to the Bank of England, central bank digital currencies are electronic forms of central bank money and must have the following traits.

  1. Broader flexibility of access in comparison to reserves
  2. Potential for exceptionally higher functionality to support retail transactions in comparison to cash
  3. Capability for bearing interests on the basis of realistic assumptions with rates that are different from the reserve rates
  4. Distinct operational structures for various forms of central bank money, thereby enabling capabilities for addressing another core objective

Why Should You Consider the Adoption of CBDCs?

So, it is clear that central bank digital currencies are capable of providing the required functionalities of central bank money, with security, accessibility, and transparency. Therefore, central banks are considering the use of CBDCs on the basis of these factors. On the other hand, the central banks could also find the following important reasons for issuing their own CBDCs.

Beneficial Aspects

The first and foremost beneficial aspect noted with CBDC alternatives is the facility of public access to legal tender, even after phasing out of cash. Cash, as well as CBDCs, will have legal recognition as a form of payment alongside a representation of a claim on the government or central bank.

The use of cash is reducing substantially due to the flexibility in payments through cards, contactless, and apps. However, it is most unlikely to find that a central bank would exclude cash from payments system, albeit with the exception of situations involve negative externalities related to cash. CBDCs, on the other hand, can help in improved monitoring of financial transactions.

Central bank digital currencies would also help in speeding up towards a cashless society. The exchange of money in digital format without any notes or coins is the basic tenet explaining a cashless society. With the continuously decreasing ATM withdrawals, the modern world is considering new approaches for financial transactions.

On the other hand, cryptocurrency alternatives could be subject to government regulations, thereby losing their credibility in transforming payment systems. However, central bank digital currency comes with the backing of a central bank, thereby offering the assurance of credibility. Many companies using blockchain technology are finding it quite promising for their businesses.

One of the prominent reasons surrounding the adoption of CBDC largely revolves around cross-border payments. Central bank digital currency has the capability for improving the counterparty credit risk in cross-border settlements and interbank payments. Existing cross-border payments depend on RTGS infrastructure for settlement of commercial interbank commitments.

However, the limitations of the existing system for cross-border payments, such as time lags, could expose counterparties to credit and settlement risks. On the contrary, central bank digital currencies can help you with a wide array of benefits, including anonymity, zero counterparty credit risk, and round-the-clock availability. However, it is important to note that jurisdiction-based wholesale CBDCs could not provide advantages over the current governance framework for cross-border payments.

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Can It Improve Payment Systems?

Better efficiency of payment systems is one of the beneficial implications of CBDC, which is responsible for fostering their adoption. It can introduce improved safety and efficiency across retail as well as large-value payment systems. In the case of retail payment systems, CBDCs can work towards improving the efficiency of payments. On the other hand, wholesale and interbank payment systems can leverage CBDCs for longer settlement hours with faster settlement.

Central bank digital currencies can also support the exclusion of low-value coins by delivering electronic change. In April 2017, the Bank of Korea introduced a coinless society trial. The coinless society trial allowed customers to deposit their change on prepaid cards rather than taking small change from the purchase. Therefore, CBDCs can improve cost savings by reducing the production of coins.

Another prominent reason for which central banks are considering the adoption of CBDC refers directly to competitive private e-money providers. Privately issued e-money could overshadow fiat money issued by central banks as the former aims at improving their personal profits.

Governments generally use fiat currency for issuing social welfare, and privately issued e-money could exert monopoly, thereby leading to social welfare costs. Since privately issued e-money could place the recipients of benefits at a disadvantage in comparison to the general public, central bank digital currencies can work as promising alternatives.

Also Read:Wholesale and Retail Central Bank Digital Currency

Design of Central Bank Digital Currency

With so many prominent motivations to introduce CBDCs, it is clearly evident that it will not be long before CBDCs become mainstream elements in payment systems. Therefore, it is reasonable for central banks to consider the various possible design choices for CBDCs. Some of the important factors that might play a crucial role include access privileges, interest-bearing traits, and extent of anonymity.

Furthermore, the design of central bank digital currencies also comes across another setback in the lack of any historical reference. In addition, the distinct political and legal characteristics are helpful in determining the value of government money. At the same time, fiat currency can serve as a final settlement for fees, taxes, private liabilities, and fines. Central bank digital currency could have the same underlying features as other variants of government-issued money. As a result, the CBDC design can enjoy the credibility of government-backed money.

China is launching DCEP project, which is new government-supported digital currency. People are speculating that it’s going to be a revolutionary change in world history and will shake the global economy.

Factors to Consider

Now, what are the factors that must be included in the design of central bank digital currency? A central bank digital currency can support the role of the central bank as a focal counterparty for all payments. However, it has to address the following conditions,

  1. Digital currency is accessible to the public without any limits or restrictions. In addition, the central bank’s digital currency must have legal recognition as a tender in the concerned country.
  2. The central bank must not offer the facility of lending for digital currency holders.
  3. Digital currency can take on different forms on the grounds of existing payment infrastructure technology or emerging crypto technologies.
  4. The central bank could opt for paying an interest rate on liabilities with central bank digital currencies. The interest rate structure would resemble the one followed in other government liabilities. In addition, the interest rate would align with the wider financial stability and monetary policy goals.
  5. Central banks can offer a direct guarantee for at-par conversion rates of CBDC into reserves and cash.

So, what about accessibility channels? CBDC design choices indicate the feasibility of restricting their availability to pre-defined groups of users. The pre-defined users include commercial banks and non-banking financial institutions or NBFIs alongside an economy-wide system. The economy-wide system of implementing CBDCs can ensure improved access for non-financial firms and households.

Are crypto and CBDC different? Here’s a guide to help you understand the differences of Crypto vs CBDC.

Challenges for CBDCs

The introduction of this types of currencies would also encounter many setbacks, especially in terms of monetary policy changes. Any debates surrounding the adoption of CBDCs have focused prominently on achieving financial stability and monetary policy objectives.

Furthermore, the control of non-banking institutions on CBDCs is also one of the prominent confusing elements about CBDCs. For example, CBDCs can result in replacement of bank deposits when non-banking institutions assume them as superior to bank deposits. As a result, the bank deposit base can lower down while banks lose their capability for funding credit operations.

In addition, the transformation in the role of central bank money with central bank digital currencies will also present challenges. The arrival of CBDCs is not only a transformation for central banks but also for the overall financial system.

Conclusion

Now, you can clearly observe the details about central bank digital currencies for your foundation-level understanding of CBDCs. As a new alternative to central bank money, CBDCs could imply a new revolution in the domain of financial transactions. Apart from a move toward cashless transactions, central bank digital currency can also introduce better precedents for security.

On the contrary, it is also important to consider the challenges and risks associated with CBDCs. The proper investigation of rationale surrounding the adoption of CBDCs and associated challenges can help in supporting CBDC adoption. If you want to understand how CBDCs work, then enroll in our new Central Bank Digital Currency Masterclass right now. You can find the course on our 101 Blockchains platform!