Central banks exploring digital currencies to provide stability amid current crypto craze?
Central bank digital currencies are a new form of electronic money which, unlike well-known cryptocurrencies, are issued by the central banks of certain countries.
These digital currencies issued by the central bank are simply digital tokens, similar to cryptocurrency, pegged to the value of a country’s currency. But they are not a form of cryptocurrency.
CBDCs are not cryptocurrencies
Although the idea for CBDCs came from cryptocurrencies, they are two very different types of digital currencies. The main difference between CBDCs and cryptocurrency is centralization.
Centralization is simply the control of an activity under a single authority. A cryptocurrency is a decentralized digital currency, which means that no central party controls it.
CBDCs are most similar to stablecoins, which are cryptocurrencies pegged to fiat money and attempt to retain the same value. The main difference is that governments around the world issue CBDCs.
So what is the difference between cryptocurrencies and CBDCs?
Cryptocurrency transactions are processed and recorded on a blockchain, which is a public, distributed ledger. As the name suggests, a central bank digital currency is controlled by a central bank.
The CBDC is managed on a digital ledger (which may or may not be blockchain), accelerating and increasing the security of payments between banks, institutions and individuals.
Cryptocurrency also offers much greater privacy than CBDCs. Transactions are sent and received via wallet addresses, and it is possible to maintain a degree of anonymity.
Some types of cryptocurrency are even considered untraceable. With a CBDC, the central bank will have a record of users and their transactions.
More than 80 countries and more..
More than 80 countries around the world are researching or developing CBDCs, and they are at various stages of the process.
In 2020, a group of seven central banks, including the United States, Europe, Japan, Switzerland, Canada, Sweden and England, have indicated their intention to assess the feasibility of implementing publicly accessible CBDCs.
Other countries are considering or beginning to implement CBDCs, including China and Russia, as well as a host of smaller countries, including South Africa, Uruguay, Barbados, Switzerland, Thailand and Iran.
Clearly, the CBDCs’ motivation is compelling. Late last year, the UAE Central Bank became the latest monetary regulator to express interest in issuing a central bank digital currency (CBDC).
Why do we need CBDC?
The two main drivers of CBDCs are the challenge posed to national currencies by cryptocurrencies and the uncertainty about the future stability of currencies in the world at large.
In effect, the US dollar has lost its exclusive position as the benchmark for other currencies and for the conduct of international trade.
Public reasoning is often more reserved. Centralized monitoring of currency movements could put an end to many transparency-related frauds. Identifiable digital currency is also difficult to steal.
Moreover, a currency that can circulate without sorting through banks and clearing houses involves much lower costs, especially for businesses that perform thousands of transactions per day.
Since CBDCs could affect the crypto market, it is important to understand them if you are investing in cryptocurrency.
How does a CBDC work?
So, a central bank digital currency (CBDC) is essentially an electronic form of cash that can be traded much like you trade traditional “currency”. We already exchange digital money daily, whether through bank transfers, digital wallets or card payments, but there is a difference.
Most digital payments are essentially checks – instructions for a bank to pay “real” money from your account. As such, multiple players are involved in executing transactions, making payments, and administering millions of individual accounts.
A CBDC, on the other hand, evolved from decentralized digital currencies like Bitcoin and Ethereum and is more like cash by cutting out the middlemen – it apparently travels directly from person to person or from customer to a supplier like a coin.
Cryptocurrencies and CBDCs rely on networked electronic resources to create, track, and validate transactions. In the case of most cryptos, like Bitcoin, these resources are distributed and anonymized.
In the case of the CBDC, a central database ultimately controlled by a central bank issues the currency and provides each e-money with a unique serial number to identify it. Usually, central banks will also peg e-money to their existing national currency.
Since national currencies today are “fiat”, CBDCs are also referred to as digital fiat currencies. Fiat currency is a type of currency that is not backed by any commodity like gold or silver, and usually declared by government decree to be legal tender.
How can I benefit from CBDCs?
Central bank money is the most secure form of money available. A CBDC could also lead to much faster, cheaper transactions, which benefits everyone involved.
In countries that create retail CBDCs, consumers can access central bank funds directly. Many countries have large unbanked populations, and CBDCs could help solve this problem.
In terms of benefits, a CBDC can be categorized into two – a “retail” CBDC, which would be used as a digital extension of money by all people and businesses, and a “wholesale” CBDC, which could only be used by authorized institutions as a settlement asset in the interbank market.
Retail CBDCs are issued to the general public. Under this model, consumers can own a CBDC in a wallet or account and use it for payments. This type of CBDC would serve as a public digital banking option that anyone can use.
Key points to remember
A CBDC is basically legal tender issued by a bank in a digital format and it is no different than cash other than they are in a digital or virtual form. It is not intended to replace hard cash, but co-exists as an additional method of payment.
The idea of central bank digital currencies stems from cryptocurrencies and blockchain technology. CBDCs are government-backed and recognized as legal tender where they are set up.
Thus, a central bank digital currency is the digital form of a country’s fiat currency. A CBDC is issued and regulated by a country’s monetary authority or central bank.
CBDCs promote financial inclusion and simplify the implementation of monetary and fiscal policy. As a form of centralized currency, they may not anonymize transactions like some cryptocurrencies do.
Many countries are studying how CBDCs will affect their economies, existing financial networks, and stability.