What Is a Central Bank Digital Currency (CBDC)?

A central bank digital currency (CBDC) is the virtual format of a fiat currency for a particular nation or region. It is an electronic record or digital token of the official currency and is issued and is regulated by its monetary authority.

The main advantages of CBDCs are that they can simplify the implementation of monetary and fiscal policy and promote financial inclusion in an economy by bringing the unbanked into the financial system. The main disadvantages of CBDCs are that they are a centralized form of currency and can erode the privacy of citizens.

Key Takeaways

  • A central bank digital currency (CBDC) is an electronic record or digital token of the official currency of a country.
  • The introduction of cryptocurrencies paved the way for central bank digital currencies.
  • The main advantages of CBDCs are that they promote financial inclusion and simplify the implementation of monetary and fiscal policy.
  • The main disadvantages of CBDCs are that they are a centralized form of currency and can erode the privacy of citizens.
  • Many countries around the world are exploring the introduction and use of CBDCs in their economy.

Understanding Central Bank Digital Currencies

In some respects, the idea for central bank digital currencies owes its origins to the introduction of cryptocurrencies into mainstream society. The invention of a secure and immutable ledger able to track transactions and enable seamless and direct transfers, without intermediaries and between recipients simplifies the implementation of monetary policy in an economy.

The cryptocurrency ecosystem also provides a glimpse of an alternate currency system in which cumbersome regulation does not dictate the terms of each transaction. Facebook, Inc.'s (FB) proposed cryptocurrency Libra was an example of such a system, one that existed beyond borders and was not regulated by a single regime.

Though the current cryptocurrency ecosystem does not pose a threat to the existing financial infrastructure, it has the potential to disrupt and simplify the existing system. Some commentators have construed the moves by central banks to design and develop their own digital currencies as a measure to pre-empt such an eventuality.

As of July 2021, 81 countries around the world were pursuing CBDC development. Their reasons for pursuing this venture varied. For example, Sweden's Riksbank is planning an electronic version of its official currency krona, called e-krona, to facilitate the development of an alternate payment system after a decline in the use of cash in the country. Within the United States, a possible introduction of CBDCs in the monetary system is being considered to improve the domestic payments system.

CBDCs are another liability of the central bank issuing them. They are not interchangeable with the national currency,—fiat or otherwise—of a country or region.

The attraction of CBDCs for a developing country like India is different. A significant population of the country remains unbanked. Setting up a physical infrastructure of banks and network connections to bring this population into the financial ecosystem is costly. A CBDC can promote financial inclusion in the country's economy.

Whatever the motivation, the general consensus is that a CBDC will act as a general representation of a country's fiat currency. Like fiat currencies, it will function as a unit of account, store of value, and medium of exchange for daily transactions. And, like fiat currencies, CBDCs will be backed by suitable monetary reserves like gold or foreign currency.

CBDC aims to bring in the best of both worlds—the convenience and security of digital cryptocurrencies, and the regulated, reserve-backed money circulation of the traditional banking system. The particular central bank or other competent monetary authority of the country will be solely liable for the CBDC's operations.

Types of CBDCs

Depending on the actors involved in the transaction, there are two types of CBDCs.

Wholesale CBDCs

Wholesale CBDCs can settle transactions between existing financial transactions. They use the existing tier of banking and financial institutions to conduct transactions. An example of wholesale CBDC transactions is one that involves the transfer of assets or money between two banks, subject to certain conditions. The current process for such transfers, also known as interbank payments, involves considerable counterparty risk. In a real-time gross settlement (RTGS) payment system, the risk can be magnified.

But a digital currency's ledger-based system enables the setting of conditions. Thus, a transfer will not occur if these conditions are not satisfied. Wholesale CBDCs can also expedite and automate the process for cross-border transfers. Current real-time settlement systems mostly work in single jurisdictions or with a single currency. The distributed ledger technology (DLT) available in wholesale CBDCs can extend the concept to cross-border transfers and expedite the process to transfer money across borders.

Retail CBDCs

Wholesale CBDCs improve upon a system of transfers between banks. Retail CBDCs involve the transfer of central government-backed digital currency directly to consumers. In doing so, they eliminate the intermediary risk or the risk that banking institutions might become illiquid and sink depositor funds.

Depending on the type of access they provide, two variants of retail CBDCs are possible:

  • Value- or cash-based access: In a value- or cash-based access system, CBDCs are passed onto the recipient through a digital wallet that is pseudonymous. The wallet will be identifiable on a public blockchain and, much like cash transactions, it will be difficult to identify parties in such transactions. According to a 2017 paper by Sweden's Riksbank, the development of a value- or cash-based access system is easier and quicker compared to token-based access.
  • Token- or account-based access: This type of access is similar to the access provided by a bank account. Thus, an intermediary will be responsible for verifying the identity of the recipient and monitoring illicit activity and payments between accounts. It provides for more privacy. Personal transaction data is shielded from commercial parties and public authorities through a private authentication process.

The two types of CBDCs are not mutually exclusive. It is possible to develop a combination of both and have them function in the same economy.

Advantages of CBDCs

The advantages of CBDCs are as follows:

  • CBDCs simplify the implementation of monetary policy by making it easier to propagate money through the economy. The current tiered system relies on intermediaries, such as commercial and retail banks, to distribute money between themselves and throughout an economy. CBDCs automate the process between banks through wholesale CBDCs and establish a direct connection between consumers and central banks through retail CBDCs.    
  • A well-designed CBDC system has the potential to revolutionize the remittance industry by making it easy and simple to transfer money across borders using the rails of technology.
  • Disbursement of money through intermediaries introduces third-party risk to the process. What if the bank runs out of cash deposits? What if there is a bank run due to a rumor or an external event? Such events have the potential to upset the delicate balance of a monetary system. A CBDC eliminates third-party risk. Any residual risk that remains in the system rests with the central bank.
  • It is possible to calibrate privacy features in a CBDC system. A value-based retail CBDC functions like cash and preserves privacy by making transactions pseudonymous. On the other hand, account-based access to CBDCs functions like a regular bank account and can be equipped with privacy features.  
  • One of the roadblocks to financial inclusion for large parts of the unbanked population, especially in developing and poor countries, is the cost associated with developing the banking infrastructure needed to provide them with access to the financial system. CBDCs can establish a direct connection between consumers and central banks, thus eliminating the need for expensive infrastructure.
  • CBDCs can simplify government functions. Just as they can promote financial inclusion by simplifying the process to disburse money, CBDCs can also minimize effort and processes for other government functions, such as distribution of benefits or calculation and collection of taxes. The COVID-19 pandemic, when the U.S. government sent out stimulus checks to its citizens, is an example of the ease with which such transfers can be made and tracked.
  • CBDCs can prevent illicit activity because they exist in a digital format and do not require serial numbers for tracking. Cryptography and a public ledger make it easy for a central bank to track money throughout its jurisdiction, thereby preventing illicit activity and illegal transactions using CBDCs.

Disadvantages of CBDCs

  • CBDCs do not solve the problem of centralization. A central authority, in this case a reserve bank, is still responsible for and invested with the authority to conduct transactions. Therefore, they still control data and the levers of transactions between citizens and banks.
  • CBDCs have the potential to erode privacy. A centralized authority is responsible for collecting and disseminating digital identification to conduct transactions in such a system. In effect, the government (or third-party provider) would become privy to all monetary transactions for a person. Such a system could open up a Pandora's box of privacy issues, similar to the ones that plague tech behemoths and providers of services on the Internet. For example, identification information could be hacked or misused by criminals, or central banks could misuse their power and disallow transactions between citizens.
  • The legal and regulatory issues pertaining to CBDCs are a black hole. What will be the role of such currencies in an economy, and who will regulate them? Considering their benefits in cross-border transfers, should they be regulated across borders? Experiments in CBDCs are ongoing, and this could translate to a long time frame.
  • The portability of CBDC systems means that a strong CBDC issued by a foreign country could end up substituting the local currency of a weaker country. For example, a digital U.S. dollar could substitute the local currency of a smaller country or a failing state. One example is that of Ecuador. The country replaced its official currency, the sucre, with the U.S. dollar in 2000 after high inflation in its local currency forced citizens to convert their money to U.S. dollars. More recently, opposition to Facebook's Libra has centered around the fact that it could similarly replace the currency of weaker countries.

Examples of CBDCs

To date, no country has officially launched a central-bank-backed digital currency. Many central banks have launched pilot programs and research projects aimed at determining the viability and usability of a CBDC in their economy. China is the furthest along this route, having already laid down the groundwork and initiated a pilot project for the introduction of a digital yuan.

On May 20, 2021, Federal Reserve Board Chair Jerome H. Powell announced that the U.S. Fed plans to publish a paper later that year that will explore the implications of issuing a U.S. central bank digital currency to complement the research already underway.

Sweden's Riksbank has been exploring the issuance of a digital currency in its economy since 2017 and has published a series of papers exploring the topic. The Bank of England (BoE) is among the pioneers to initiate the CBDC proposal. Following that, central banks of other nations, like China's People's Bank of China (PBOC), Bank of Canada (BOC), and the central banks of Uruguay, Thailand, Venezuela, Sweden, and Singapore, among others, are looking into the possibility of introducing a central-bank-issued digital currency.

Russia has been moving forward with its creation of the CryptoRuble, announced by Vladimir Putin in 2017. There is speculation that one of the main reasons for Putin's interest in blockchain is that transactions are encrypted, making it easier to discreetly send money without worrying about sanctions placed on the country by the international community.

This theory gained traction after The Financial Times reported in January 2018 that one of Putin's economic advisors, Sergei Glazyev, said during a government meeting that, "[The CryptoRuble] suits us very well for sensitive activity on behalf of the state. We can settle accounts with our counterparties all over the world with no regard for sanctions." Glazyev himself was placed under sanctions by President Obama that prevented him from trading in or traveling to America in 2014.

Venezuela has been purported to be working on a CBDC called the petro since 2017, which would be backed by physical stocks of crude oil. The Venezuelan government also announced petro gold in 2018, allegedly pegged to the value of oil, gold, and other precious metals.