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Tuesday, January 31, 2023

What is Central Bank Digital Currency (CBDC): How Does It Work?


CBDC, or Central Bank Digital Currency, has been in development for some time now. The main reason why private cryptocurrencies have gained popularity is due to the fact that they seek to replace centralized financial institutions with decentralized ones. So, what exactly is CBDC?

Central Bank Digital Currency

What is Central Bank Digital Currency (CBDC)?

Central bank digital currency is a digital token. It is a somewhat alike cryptocurrency and is issued by a central bank. CBDCs have the same value as that country’s fiat currency.  

CBDCs are being developed and deployed in several countries. Because so many countries are looking into digital currencies, it’s critical to grasp what they are and what they signify for the community. Recently, the RBI created CBDC E-Rupee and enlisted at least five banks, including the State Bank of India, ICICI Bank, IDFC First Bank, and HDFC Bank, to collaborate on the central bank digital currency’s retail pilot project (CBDC).

Let’s delve deeper into the concept of CBDC:

What you are using right now to buy goods and services? Cash, right? Well, that’s called Fiat Money. Fiat currency is issued by the government and not backed by a physical commodity like gold or silver. It is regarded as legal tender and was traditionally issued in the form of banknotes and coins, but technological advance has prompted governments and financial institutions to expand physical money with a credit-based prototype in which credits and trades are recorded digitally.

Physical currency is still extensively traded and recognized; but, in certain affluent nations, its use has declined significantly, and this tendency has increased during the COVID pandemic.

The advent and expansion of cryptocurrencies and blockchain technologies have heightened interest in cashless societies and digital currencies. As a result, governments and central banks throughout the world are investigating the use of government-backed digital currencies. When and if they are adopted, these currencies, like fiat money, will have the full trust and support of the government that issued them.

CBDCs are also known as ‘programmable money,’ which means that payment tokens or digital fiat may now be produced with specific design features and properties. In general, policy debates focus on two types of CBDCs: 

‘Wholesale central bank digital currencies, which would facilitate more efficient central bank clearing operations between the central bank and its member banks, and ‘retail central bank digital currencies’, which would be available for use by the general public and would effectively be the equivalent of a banknote, albeit in digital form. For example, the token might pay the token holder interest straight into their wallet, and the design of the tokens, as well as the broader network, is limitless.

Examples of CBDC

Here are some examples of wholesale projects that are ranked based on project maturity. These projects are headed by:

  • Thailand and Hong Kong: Project Inthanon-LionRock
  • Singapore: Project Ubin
  • Canada: Project Jasper
  • UK: Cross-border interbank payment and settlements
  • France: Digital Euro
  • South Africa: Project Khokha
  • Europe: Project Stella
  • UAE: Project Aber
  • Japan: Project Stella

On the other hand, below are retail projects headed by:

  • The Bahamas: Project Sand Dollar
  • Cambodia: Project Bakong
  • Mainland China: e-CNY
  • Ukraine: e-Hryvnia
  • Uruguay: e-Peso
  • Ecuador: Dinero Electronico
  • Eastern Caribbean: DCash
  • Sweden: e-Krona
  • South Korea: e-Won
  • Turkey: Digital Lira

Let’s check the below brief examples of CBDC projects:

The Sand Dollar of the Bahamas

The Sand Dollar project began in the late 1990s, and the CBDC, a digital counterpart of the Bahamian dollar, was unveiled in October 2020. The Sand Dollar initiative aims to overcome the issue of the Bahamas’ 700-plus islands making ATM systems impossible to operate. However, adoption remains low, with approximately $130,000 in sand dollars in circulation compared to $500 million in Bahamian dollars.

E-Rupee

India launched its own CBDC on December 1, 2022. This is the first phase of a pilot project that will cover select locations and banks in a closed user group (CUG) comprising participating customers and merchants, the RBI has said. The pilot will initially cover the four cities of Mumbai, New Delhi, Bengaluru, and Bhubaneswar, where customers and merchants will be able to use the digital rupee (e₹-R), or e-rupee.

Is CBDC a Cryptocurrency? 

If you’re thinking that CBDC or Central Bank Digital Currency is a cryptocurrency, you’re somewhat wrong as they’re only identical but have differences. CBDCs and cryptocurrencies are both examples of digital currency, although they differ significantly. Some of the distinctions are as follows:

  1. CBDC, unlike cryptocurrencies that use blockchain as its underlying technology. It can’t employ distributed and decentralized public ledgers like blockchain for its implementation.
     
  2. CBDCs are centralized and managed by national central banks, whereas cryptocurrencies are unregulated and decentralized. As a result, the issuing authority can monitor and restrict the flow of CBDC.
     
  3. CBDC’s architecture emphasizes its stability, robustness, and low volatility, making it a safer alternative when compared to extremely volatile cryptocurrencies.

Types of CBDCs 

Wholesale CBDCs and retail CBDCs are the two primary categories of CBCDs. The former largely serves the country’s financial institutions, while the latter serves people and companies on a daily basis.

1. Wholesale CBDC

A wholesale CBDC is a CBDC that is sold to financial institutions. Interbank transfers and related wholesale transactions are settled via wholesale CBDCs. Making a cross-border transaction using central bank digital currency is one of the ways they are used in the interbank system. Furthermore, central bank reserves and wholesale CBDCs work in the same way.

2.  Retail CBDCs

Central banks distribute retail CBDCs directly to the people as a form of digital currency. With cash use decreasing in today’s digital economy, a retail CBDC could undoubtedly be an advancement in the digital economy if it were available to everyone. Central banks in countries would be responsible for determining whether CBDC would be available.

Benefits of CBDC 

CBDCs are gaining popularity among international financial institutions as blockchain technology and cryptocurrencies advance. However, the varied CBDC benefits and drawbacks are dependent on how they are implemented in different nations.

Let us examine some of the disadvantages and advantages of central bank digital currency:

Pros of CBDC 

  1. Improve payment efficiency.
  2. Complement existing money and financial services
  3. Discourage criminal activities
  4. Increase your foreign payment possibilities
  5. Reduce net transaction costs, perhaps benefiting lower-income households

Cons of CBDC 

  1. There is a risk of instability if the current financial system is overhauled
  2. It is possible that monetary policy will lose its effectiveness
  3. Difficulties with operational efficiency
  4. There are risks associated with cybersecurity
  5. Transacting anonymously is no longer possible due to the loss of privacy

Conclusion 

With the majority of central banks either in the pilot stage or in the process of building a CBDC, development is expected to accelerate in the coming year. Despite the fact that we have yet to witness a fully successful rollout, the policy objectives underlying many of these experiments are expected to put substantial pressure on the uptake. Given the continued reduction in cash usage, widespread interest in digital assets, and ongoing worries about sovereignty and monetary stability, central banks appear to be highly motivated to continue investigating the possibilities of CBDCs.

FAQ’s on CBDC

Q1. What is a CBDC?

Ans. CBDC is a digital form of central bank money that the general public can use for seamless financial transactions. 

Q2. What does CBDC stand for?

Ans. CBDC stands for Central Bank Digital Currency.

Q3. Can you buy CBDCs?

Ans. Yes, the general public can buy CBDCs under the retail CBDC category. The CBDCs are stored in a wallet or account and can be used for payments.

Q4. What is the difference between CDBC and Cryptocurrency?

Ans. Cryptocurrency ecosystems provide a peek at an alternate financial system in which bulky constraints do not control the parameters of each transaction. They are difficult to copy or forge, and they are protected by consensus processes that prohibit manipulation. Central bank digital currencies are similar to cryptocurrencies in design, although they may not require blockchain technology or consensus procedures.

Q5. How does CDBC differ from decentralized cryptocurrency?

Ans. Cryptocurrencies are decentralized digital assets, whereas CBDCs are digital fiat. Central banks issue CBDC as legal tender on a digital basis, according to the Reserve Bank of India.
 

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