Understanding Central Bank Digital Currencies (CBDCs): A Comprehensive Guide

What Is a Central Bank Digital Currency (CBDC)?

Central bank digital currencies (CBDCs) are digital forms of a country’s fiat currency issued and regulated by its central bank, and are fixed in value by the government. Unlike cryptocurrencies, which are decentralized and volatile, CBDCs aim to provide stability and are government-backed. With the rise of innovative technologies like cryptocurrency and blockchain, the idea of cashless societies has gained traction. As a result, various nations are actively developing or have already transitioned to using CBDCs. Understanding this shift is crucial as these digital currencies promise expanded financial accessibility, lower transaction costs, and enhanced monetary policy implementation.

Exploring the Basics of Central Bank Digital Currencies

Fiat money is a government-issued currency not backed by a physical commodity like gold. It is legal tender used for buying goods and services.

Traditionally, fiat money takes the form of banknotes and coins, but now technology lets us also use digital transactions.

Physical currency is still widely exchanged and accepted. However, some developed countries have experienced a drop in its use, and that trend accelerated during the pandemic.

The introduction and evolution of cryptocurrency and blockchain technology have spurred additional interest in cashless societies and digital currencies.

Key Objectives of CBDCs

In the U.S. and many other countries, many individuals don’t have access to financial services. In the U.S. alone, 6% of adults had no bank account in 2023. In many other countries, the numbers are much higher. With that in mind, the main purposes of CBDCs are:

• To provide businesses and consumers conducting financial transactions with privacy, transferability, convenience, accessibility, and financial security.
• Decrease the cost of maintenance that a complex financial system requires, reduce cross-border transaction costs, and provide those who currently use alternative money-transfer methods with lower-cost options.
• Reduce the risks of using digital currencies, or cryptocurrencies, in their current form. Cryptocurrencies are highly volatile, with their value constantly fluctuating. This volatility could cause severe financial stress in many households and affect the overall stability of an economy. CBDCs, backed by a government and controlled by a central bank, would give households, consumers, and businesses a secure means of exchanging digital currency.

Understanding Different Types of CBDCs

There are two types of CBDCs: wholesale and retail. Financial institutions are the primary users of wholesale CBDCs, whereas consumers and businesses use retail CBDCs.

The Role of Wholesale CBDCs in Banking

Wholesale CBDCs function similarly to holding reserves in a central bank. The central bank grants an institution an account in which to deposit funds or to use to settle interbank transfers. Central banks can then use monetary policy tools, such as reserve requirements or interest on reserve balances, to set interest rates and influence lending.

How Retail CBDCs Impact Consumers and Businesses

Retail CBDCs are government-backed digital currencies for consumers and businesses. They reduce the risk of losing assets if a private digital currency issuer fails.

There are two types of retail CBDCs. They differ in how individual users access and use their currency:

• Token-based retail CBDCs are accessible with private keys, public keys, or both. This method of validation allows users to execute transactions anonymously.
• Account-based retail CBDCs require digital identification to access an account.

Challenges and Considerations for CBDCs

The Federal Reserve has identified issues addressed by CBDCs, as well as matters that must be addressed before a CBDC can be designed and implemented.

Issues Addressed by CBDCs

• Eliminate the third-party risk of events like bank failures or bank runs. Any residual risk that remains in the system rests with the central bank.
• Can lower high cross-border transaction costs by reducing the complex distribution systems and increasing jurisdictional cooperation between governments.
• Could support and protect U.S. dollar dominance; the U.S. dollar is still the most-used currency in the world.
• Remove the cost of implementing a financial structure within a country to bring financial access to the unbanked population.
• Can establish a direct connection between consumers and central banks, thus eliminating the need for expensive infrastructure.

Issues Created by CBDCs

• If the U.S. financial structure drastically changes, it’s unknown how it would affect household expenses, investments, banking reserves, interest rates, the financial services sector, or the economy.
• A switch to a CBDC could have an unknown effect on a financial system’s stability. For example, there may not be enough central bank liquidity to facilitate withdrawals during a financial crisis.
• Central banks implement monetary policy to influence inflation, interest rates, lending, and spending, which in turn affects employment rates. Central banks must ensure that they have the tools needed to impact the economy positively.
• Privacy is one of the most significant drivers behind cryptocurrency. CBDCs would require an appropriate amount of intrusion by authorities to monitor for financial crimes; monitoring is also important because it supports efforts to combat money laundering and the financing of terrorism.
• Cryptocurrencies have been the target of hackers and thieves. A central bank-issued digital currency would likely attract the same crowd of thieves. Therefore, efforts to prevent system penetration and theft of assets and information would need to be robust.

Comparing CBDCs with Cryptocurrencies

The cryptocurrency ecosystem provides a glimpse of an alternative currency system in which cumbersome regulations don’t dictate the terms of each transaction. Such transactions are hard to duplicate or counterfeit and are secured by consensus mechanisms that prevent tampering.

Additionally, cryptocurrencies are unregulated and decentralized. Their value is dictated by investor sentiments, usage, and user interest. They are volatile assets more suited for speculation, which makes them unlikely candidates for use in a financial system that requires stability. CBDCs mirror the value of fiat currency and are designed for stability and safety.

Global Adoption and Development of CBDCs

Many countries’ central banks have started pilot programs to test the viability of CBDCs in their economies.

As of March 2024, three countries had a functioning CBDC: the Bahamas, Jamaica, and Nigeria. The Eastern Caribbean Currency Union halted its CBDC for technical reasons and started a new pilot program.

There are 36 CBDC pilots in operation and 8 of the G20 have programs in development. The BRICS countries—Brazil, Russia, India, China, and South Africa—are exploring a CBDC.

One example of a failed CBDC attempt is the United Kingdom’s Britcoin, which existed between 2011 and 2019.

According to the Federal Reserve, the U.S. is one of those countries that is exploring whether a CBDC “could improve on an already safe and efficient U.S. domestic payments system.”

The Bottom Line

Many countries are researching or developing central bank digital currencies, and three have implemented them. A CBDC’s main purpose is to provide businesses and consumers with privacy, transferability, convenience, accessibility, and financial security.

Many individuals throughout the world have no access to bank accounts, so a CBDC would give them a way to be paid, hold their money, and pay bills. CBDCs could also decrease the maintenance a complex financial system requires, reduce cross-border transaction costs, and give people who use alternative money-transfer methods lower-cost options.

The comments, opinions, and analyses expressed on Investopedia are for informational purposes online. Read our warranty and liability disclaimer for more info.