CBDCs or Central Bank Digital Currencies is the new buzzword that finds its origins in blockchain technology. Even though they are usually mistaken for crypto, they have a variety of different fundamentals from crypto.
Issued by a central bank, CBDCs are digital tokens that are linked to the value of the country’s fiat currency.
And while many countries are in the process of digitizing their currencies, CBDCs seem to be gaining a lot of popularity.
But what are these CBDCs meant for? How do they work, what are the advantages and disadvantages that come with using CBDCs, and what avenues do they open for regular investors? And Most importantly, how does it differ from cryptocurrencies?
There is a lot to know about CBDCs. Let’s start with learning about what are CBDCs and how they function.
What Are CBDCs (and how do they work)?
Investors can be confused between CBDCs and digital fiat currency. Though the idea of CBDCs came from cryptocurrency. These are two very different types of digital currencies.
The key difference between cryptocurrency and CBDCs is that Crypto does not have any centralization meaning it’s a decentralized currency and no central party controls it. On the other hand, CBDC is an electronic form of central bank money being centralized and monitored by the central bank itself.
Here’s an example.
The US Federal Reserve says the annual global dollar supply amounts to $20 trillion. While only 2 trillion dollars originate in the form of paper cash, the rest of it originates from electronic balance sheets.
But this electronic cash is very different from the CBDCs as well.
Physical cash is created by the central bank or the Reserve Bank in India’s case. This cash is then lent to commercial banks on fractional reserve banking systems. Commercial banks maintain an accounting of assets and liabilities of the physical cash. The reserve bank is the body that sets the rules for commercial banks.
On the other hand, CBDC is quite the opposite. The CBDCs will be issued and directly managed by the reserve bank. The accounting of assets and liabilities will also be the duty of the reserve bank, thus eliminating the middle tier – the commercial banks.
The individual citizens would directly be in contact with the reserve bank, without the need for any intermediary.
In simple words, a CBDC is the digital form of the country’s fiat currency. Unlike cryptocurrencies, these will be issued and regulated by a country’s central bank or monetary authority.
However, an interesting concept. It might destabilize the entire banking system as it will change how currency works in the form of cash flow over a long period.
While no nation has yet fully implemented its CBDC, the Peoples Bank of China is running its pilot, and the Bank of England is exploring the concept.
What are the advantages of CBDCs?
According to the research done by the US Federal Reserve, there are various ways CBDCs are acting in beneficial ways for the economy.
The most critical one is that they eliminate the risks of bank failure or runs. Whatever risk remains is of any issue with the central bank.
- CBDCs can play an active role in minimizing the foreign currency exchange costs in high-value transactions. The reason is more straightforward distribution systems and more jurisdictional control and cooperation between governments.
- It also provides the means to reach the population currently out of the umbrella of the banking system.
- It eliminates the need for expensive infrastructure required for connecting the central bank and consumers. It reduces the dependency on banks and establishes direct contact. Such direct contact can be also helpful in a crisis when the government needs to send relief amounts directly to the citizens.
What are the disadvantages of CBDCs?
According to the same research, below are some of the disadvantages that CBDCs create:
- This disruptive approach to finance can bring drastic changes to the financial structure of the country (the US in this case). How it would affect households, investments, etc, is a subject for further study.
- Less knowledge is present in terms of their effects on the financial system’s stability. For example, how would they be able to maintain the liquidity of the CBDC during mass withdrawals in a financial crisis?
- The monetary policy set by the central bank influences inflation, interest rates, lending, spending, and employment rates. The central bank needs to ensure they have the right tools and knowledge to influence and keep a check on all these crucial aspects of an economy.
- Privacy or say anonymity is an important aspect of cryptocurrencies. But this could lead to financial crimes. Thus implementing CBDC would require enough intrusion by authorities to safeguard citizens and prevent money laundering and terrorism financing.
- Cryptocurrencies being digital assets are often a target of thieves and hackers. A CBDC would be no different. Thus, a step towards central bank digital currency should be well thought of and be taken with adequate preparation.
CBDCs vs Cryptocurrencies
As mentioned already, CBDCs are a digital asset. But how different or similar are they to their popular cousin cryptocurrency?
Suitable for a stable financial system
Volatile in nature, Hence not stable
Unregulated and decentralized
Payments and speculation
Less scalability due to mass monitoring
CBDCs are derived from authorized (private) blockchains and are centralized systems. They’ll be connected to a person’s existing bank account and will be adequately monitored. In CBDC the authority over the network and every other aspect is by a centralized authority, which is the central bank. It can be used for payments and similar transactions.
Central bank digital currency can be used for payments and similar transactions. Also, it stands a better chance at scalability because it’s monitored via a central authority that can take action when in need.
On the other hand, cryptocurrencies are a product of blockchains that are decentralized. Anonymity is a crucial feature of crypto. Here the authority is on the user base, which operates on consensus. It is mass monitored and its value is also fluctuated by investor sentiments, usage, and user interest. Crypto can be used for both payments and speculation.
(Conclusion) How are CBDCs a good inclusion to the economy?
There are many reasons for the government to opt for CBDCs. They provide easy and safer access to money for the population. This will increase efficiency in payments and will also lower transaction costs. This will create a transparent environment for money flow and even lower transaction costs.
To sum up, the seamless flow of money and better fiscal policies are the biggest motivation for countries to add CBDCs to their system. And therefore, a lot of countries are launching their respective CBDC pilots.