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What Is a Central Bank Digital Currency (CBDC) and How Does It Work?

Why it matters to you:
This article in its way touches a very sensitive topic: the global future of cryptocurrencies. Different governments consider crypto industry to be a threat to their national currencies, and work on various solutions, including CBDCs. People should be aware of the concepts that are disrupting the current fundamentals. The global financial system is changing and these developments can influence personal wealth of lots of people around the world.
What Is a Central Bank Digital Currency (CBDC)?Goals and objectives of CBDC explained by officialsCBDCs around the world: the progress

Central Bank Digital Currencies (CBDCs) have emerged as a critical component in transforming the global financial system. As the world becomes increasingly digitized, central banks are exploring the implementation of digital currencies to enhance the efficiency and accessibility of monetary transactions. However, a lot of crypto experts call this phenomenon “digital prison” and they indeed have a point. 

What Is a Central Bank Digital Currency (CBDC)?

CBDC in banking represent a form of digital or virtual currency issued and regulated by a country's central bank. Unlike traditional cryptocurrencies, CBDCs are backed by the government and possess the stability of fiat currencies. Let's delve deeper into this financial innovation and understand its implications for the contemporary economy.

Evolution from Fiat to Digital. Why did CBDCs emerge at all?

Over the past several years, the opportunities of blockchain and cryptocurrencies have attracted traditional financial institutions and governments almost exponentially. Regulators have moved from theory to practice and began to explore the possibilities of central bank digital currencies; some even began to call it the “third form of money.”

The trajectory of currency evolution has witnessed a remarkable shift from tangible fiat money to digital variants. With the gradual decline in physical cash usage, especially during the unprecedented COVID-19 pandemic, the need for secure, efficient, and accessible digital transactions has become increasingly apparent. This trend has propelled the exploration and development of government-backed digital currencies to ensure the stability and resilience of financial systems. However, governments and banks have turned their attention to CBDCs due to several recent developments that have reshaped the landscape of the financial system. 

First, the dwindling use of physical currency, evidenced by a significant decline in cash transactions across Europe and the striking statistic that only 3% of purchases in Norway involve cash, has prompted central banks to reconsider their roles within the monetary ecosystem.

Second, the increasing interest in privately issued digital assets among the public, with approximately 10% of individuals in the United Kingdom and a similar proportion in six major EU nations owning or having owned digital assets, has posed a challenge to traditional currencies, thereby necessitating a proactive approach from central banks. Moreover, the traditional perception of central banks as pioneers in the payment system has been diminishing, prompting them to seek new avenues for driving public discourse on implementing digital currencies.

Finally, with the global expansion of monetary systems aiming for more decentralized control over interconnected payment networks, central banks view the potential adoption of CBDCs as a crucial cornerstone in developing efficient domestic digital payment systems. While central bank currencies promise several beneficial outcomes, it is imperative to acknowledge that their adoption also entails certain inherent risks, which will be further elaborated upon in the subsequent sections of the article.

Today's trend is not the first precedent in history. Experiments on the digitalization of national currencies were carried out back in the 1990s in Finland and the 2000s in the Czech Republic, but were not successful. Technological breakthroughs and the explosive growth in the popularity of cryptocurrencies provided a second wave of interest. 

The Bank for International Settlements (BIS) was first to describe a central bank digital currency in a 2020 report, calling it somehow different from traditional financial asset balance sheet systems. Another BIS report found that 86% of the world's central banks were interested in the CBDC phenomenon, but only 14% were ready to launch tests. At the beginning of September 2022, the International Monetary Fund (IMF) published its report, which stated that about 100 central banks are already working on digital currencies.

Goals and objectives of CBDC explained by officials

The primary objectives revolve around fostering financial inclusion, ensuring convenient accessibility, and reducing transaction costs. By integrating the digital infrastructure, CBDCs aim to provide businesses and consumers a secure and private medium of financial exchange. 

One of the called advantages is the elimination of third-party risks, leading to reduced transaction costs. Additionally, they have the potential to enhance the efficiency of monetary policy and increase the financial system's stability. Still officials understand that implementing CBDCs also poses challenges, such as potential disruptions to the existing financial structure and concerns regarding user privacy. It is crucial to address these issues while leveraging the advantages of CBDCs for sustainable economic growth, and perhaps these are the reasons behind such a slow-and-steady development around the world. 

By now, CBDCs are typically classified into two categories: wholesale and retail. Wholesale currencies are primarily utilized for interbank transactions and large-scale financial operations. On the other hand, retail ones serve the general public, enabling individuals to conduct everyday transactions. 

Households, consumers, and companies would all have access to a method of exchanging digital money in CBDCs if they were backed by the government and managed by a central bank. Speaking in terms of current crypto market, obvious goals and objectives of CBDCs are nothing more than of already existing stablecoins pegged to already existing national currencies. However, there are nuances, and the devil is in the details. 

CBDCs vs. Cryptocurrencies

Here we come closer to the main controversy, where the “collision course” gets in sight. What does CBDC mean for crypto? While these two types of currencies share similarities in their digital nature, they diverge significantly in control, decentralization, and value stability. CBDCs are centralized and regulated by the respective central authorities, ensuring compliance with monetary policies and regulatory frameworks. In contrast, cryptocurrencies operate in decentralized environments, mostly lacking direct government support and control. 

As per officials, central bank currencies can mitigate the risks associated with decentralized cryptocurrencies while upholding the stability of the financial ecosystem. As they also say, CBDCs would lessen the dangers of utilizing conventional cryptocurrencies. The main thesis of authorities is that value of cryptocurrencies is very volatile and changes often – the economic stability of a nation may be jeopardized if people had to deal with such extreme swings in their finances. In the official statements they say that CBDCs offer greater stability and reliability, distinguishing them from cryptocurrencies' volatile nature.

The following can be read between the lines: the authorities understand that, despite its young age, the crypto market provides a lot of benefits for consumers, which national currencies and traditional finance (TradFi) can’t. The more people get to know the benefits of decentralized nature of cryptocurrencies, the less they turn back to TradFi. People tend to understand that central bank digital currency is not the new form of money it tries to look like. It’s the same old TradFi with new features, but the core principles remain the same. 

Moreover, the implementation of such system puts people and entities under total control of regulator. Central bank of any country will know every transaction, and probably will be able to block or freeze any account or operation in an instant. Neither retail users nor commercial banks like this idea, and by now it is the main area of conflict and debate. 

eNaira CBDC in Nigeria

Not more than 0.5% of operations were done with it since its inception

Still, Bitcoin and other cryptos still have the aura of the “people’s money”. The clear example took place in Nigeria. People were not happy with the introduction of eNaira CBDC and chose to avoid it: not more than 0.5% of operations were done with eNaira since its inception.  Meanwhile, according to Le Journal de l'Afrique, more than 34 million of Nigerians possess and utilize Bitcoin and Ethereum for their purposes. 

Symbiosis of CBDCs and traditional payment players. Can they pressure the crypto market? 

Mastercard, the global payments processing giant, has also ventured into the realm of CBDCs with an innovative tokenization experiment that has the potential to reshape the landscape of digital currencies. Mastercard's pilot program, conducted in collaboration with various central banks and financial institutions, aims to assess the viability of integrating CBDCs into existing payment systems. This strategic initiative could pave the way for more efficient international transactions, reduced costs, and faster settlement times. However, the move also prompts contemplation on the crucial issues of data privacy, regulatory compliance, and the need for consumer education. 

This pilot program represents a significant milestone in the digital currency evolution as well as a possible pressure on crypto players involved in developing similar solutions – such as Ripple, for example. The potential benefits of Mastercard solution, including enhanced payment efficiency, improved financial inclusion, and global adoption, are substantial despite the potential hurdles. As the financial landscape continues to evolve, integrating CBDCs into existing payment systems can revolutionize transactions. Institutions and authorities are more likely to trust legacy players, such as Mastercard, when it comes to building fundamental systems, and these developments might impose a pressure on crypto market as well. 

CBDCs around the world: the progress

The future of CBDCs seems promising at first sight, with numerous countries actively exploring their implementation. CBDCs have the theoretical potential to revolutionize the way transactions are conducted, leading to enhanced financial inclusivity and economic stability. Many national central banks are conducting trials and studies to assess whether or not a CBDC would be useful for their economy.

According to data from the Atlantic Council, 11 countries have adopted CBDCs, with 53 being in advanced planning stages and 46 researching the topic.

It includes the nations of the Bahamas, Antigua and Barbuda, Saint Kitts and Nevis, Monserrat, Dominica, Saint Lucia, Saint Vincent and the Grenadines, Grenada, and Nigeria. 

The implementation is not limited by country borders though. Notable cross-border programs in the pilot phase include mBridge, a bank-to-bank project including the central banks of China, Thailand, Hong Kong and the United Arab Emirates, as well as the digital euro, which the European Union is currently setting up a legal framework for and the continuation of which will supposedly be decided by the European Central Bank. 

Some jurisdictions, such as France or Australia, are involved in several CBDC projects. For example, the Dunbar cross-border payments pilot CBDC project is being developed by a coalition of South Africa, Singapore, Malaysia and Australia, under the auspices of the BIS, and is already being tested by participants. The key goal of the project is to make international transactions faster and simpler and to eliminate such an intermediary element as correspondent banks from the transfer process. France, in addition to developing a digital euro model, is also actively involved in testing digital currencies for cross-border transfers, in parallel with Singapore and Tunisia.

Also, Iran and Russia have been paving new routes for financial flows since the most severe sanctions were imposed on these states. Disconnection from SWIFT pushed their Central Banks to studying digital assets as an alternative for making cross-border transactions, considering all possible options and boosting the development of digital rial and ruble. It is highly likely that these two CBDCs will become the basis for cross-border payments of these two highly sanctioned countries.

Pilot programs are launched all over the world, including seven G20 economies. A CBDC "could improve on an already safe and efficient U.S. domestic payments system," the Federal Reserve claims, also putting the United States in the list of the nations investigating the possibility of adopting such a system.

Wrapping up

Central bank digital currencies represent a pivotal advancement in the modern financial landscape, potentially offering a secure, accessible, and stable form of digital currency. By addressing the shortcomings of existing cryptocurrencies and prioritizing financial stability, CBDCs can influence and transform current global financial system.  

As central banks worldwide continue to experiment, it is essential to strike a balance between innovation, regulation and privacy to ensure the long-term sustainability and resilience of the financial infrastructure. By now, central bank digital currencies threaten people – they understand the possibility of total control and would like to have alternatives. It means that cryptocurrencies are still here to stay and provide users with all benefits they have. 

Published: Nov 14, 2023
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