May 22, 2024
MC Academy

What Are Central Bank Digital Currencies (CBDCs) and How Do They Differ from Cryptocurrencies?

Digital currencies are becoming increasingly popular and influential in the global financial landscape. While cryptocurrencies such as Bitcoin, Ethereum, and Dogecoin have attracted millions of users and investors, central banks are also exploring the potential of issuing their own digital currencies, known as central bank digital currencies (CBDCs), and they have some similarities and differences with cryptocurrencies. This detailed article explains what CBDCs are, how they work, and how they compare with cryptocurrencies.

What Are CBDCs?

A CBDC is a digital form of a country’s fiat currency, issued and regulated by the central bank. Unlike physical cash or bank deposits, a CBDC exists only in electronic form and can be transferred and stored digitally. A CBDC is also backed by the full faith and credit of the issuing government, meaning its value is fixed and equivalent to the fiat currency.

CBDCs are not a new concept, as some central banks have been using digital money for interbank transactions for decades. However, the recent interest in CBDCs is driven by several factors, such as:

  • The decline in the use of cash and the rise of digital payments, especially during the COVID-19 pandemic.
  • The innovation and adoption of blockchain technology and cryptocurrencies offer faster, cheaper, and more transparent transactions.
  • The need to improve financial inclusion, stability, and efficiency, as well as to combat money laundering, tax evasion, and cybercrime.
  • The strategic and geopolitical implications of having a digital currency that can compete with other major currencies or challenge the dominance of the US dollar.

As of mid 2023, according to the Bank for International Settlements (BIS), 86% of the world’s central banks are actively researching or experimenting with CBDCs. Some of them have already launched or piloted CBDCs, such as:

  • The Bahamas: The Sand Dollar, which was launched in October 2020 as the world’s first fully deployed CBDC.
  • China: The Digital Yuan, or e-CNY, which has been tested in several cities since 2020 and is expected to be widely used in the 2022 Winter Olympics.
  • Nigeria: The eNaira, which was launched in October 2021 as Africa’s first CBDC.
  • Sweden: The e-krona, which has been developed by the Riksbank since 2017, is currently undergoing a pilot project.

Other countries considering or developing CBDCs include Canada, Japan, South Korea, Singapore, Switzerland, France, Germany, the UK, the US, India, Russia, Brazil, and many more.

How Do CBDCs Work?

The design and implementation of CBDCs may vary depending on the objectives and preferences of each central bank. However, some common features and challenges can be identified:

  • Technology: CBDCs can use different technologies to record and verify transactions. Some may use blockchain or distributed ledger technology (DLT), a system of decentralized nodes that store and validate data without relying on a central authority. This can enhance security, transparency, and efficiency. However, some central banks may prefer to use centralized or hybrid systems to retain more control and flexibility over the network.
  • Access: CBDCs can be classified into two types based on who can access them: wholesale CBDCs and retail CBDCs. Wholesale CBDCs are restricted to financial institutions that deal with the central bank, such as commercial banks or clearing houses. They are used for large-value interbank payments or settlements. Retail CBDCs are available to the general public for everyday transactions. They can be accessed through digital wallets or accounts provided by the central bank or authorized intermediaries.
  • Distribution: CBDCs can be distributed through different channels depending on the degree of involvement of the central bank or other entities. One option is direct distribution, where the central bank issues CBDCs directly to users through its own platform. This can simplify the process and reduce intermediation costs. However, this may also pose operational risks for the central bank and disrupt the existing financial system. Another option is indirect distribution, where the central bank issues CBDCs to commercial banks or other intermediaries, who then distribute them to users through their own platforms. This can leverage the existing infrastructure and expertise of the private sector. However, this may also introduce counterparty risks and regulatory challenges.
  • Design: CBDCs can have different design features that affect their functionality and impact. For example:
  • Interest: CBDCs can be interest-bearing or non-interest-bearing. Interest-bearing CBDCs can pay or charge interest to users depending on the central bank’s monetary policy. This can provide an additional tool for managing inflation and stimulating or dampening economic activity. However, this may also create complexity and uncertainty for users and affect their saving and spending behavior.
  • Anonymity: CBDCs can be anonymous or non-anonymous. Anonymous CBDCs can protect the privacy and identity of users, similar to cash. However, this may also facilitate illicit activities and hinder law enforcement. Non-anonymous CBDCs can enable the traceability and verification of transactions, similar to bank accounts. However, this may also raise concerns about data protection and surveillance.
  • Limits: CBDCs can have limits or no limits on the amount, frequency, or location of transactions. Limits can help prevent excessive hoarding or speculation of CBDCs, as well as mitigate cross-border spillovers or capital flight. However, limits may also restrict the convenience and utility of CBDCs for users and hamper financial inclusion or innovation.

How Do CBDCs Differ from Cryptocurrencies?

Cryptocurrencies are digital currencies that are not issued or controlled by any central authority. They are based on blockchain or DLT, which enables peer-to-peer transactions without intermediaries. Some of the most popular cryptocurrencies are Bitcoin, Ethereum, and Dogecoin.

CBDCs and cryptocurrencies have some similarities, such as:

  • They are both paperless and can be transferred and stored digitally.
  • They both use cryptography to secure and validate transactions.
  • They both have the potential to improve the speed, cost, and transparency of payments.

However, CBDCs and cryptocurrencies also have some significant differences, such as:

  • Issuance: CBDCs are issued and regulated by the central bank, which determines their supply and value according to the monetary policy of the country. Cryptocurrencies are created and governed by algorithms or protocols, which determine their supply and value according to predetermined rules or market forces.
  • Backing: CBDCs are backed by the full faith and credit of the issuing government, meaning they are legal tender and have a stable value equivalent to the fiat currency. Cryptocurrencies are not backed by any real-world assets or guarantees, which means that they are not legal tender and have a volatile value that depends on supply and demand.
  • Access: CBDCs are accessible to anyone with a digital wallet or account provided by the central bank or authorized intermediaries. Cryptocurrencies are accessible to anyone with a digital wallet or account provided by various platforms or services that operate independently from the central bank or government.
  • Privacy: CBDCs may offer different levels of anonymity depending on the design choices of the central bank. However, they are likely to enable some degree of traceability and verification of transactions for regulatory or security purposes. Cryptocurrencies may offer different levels of anonymity depending on the type of blockchain or DLT they use. However, they are generally more difficult to track or monitor by authorities or third parties.
  • Regulation: CBDCs are subject to the laws and regulations of the issuing country, which may vary depending on the jurisdiction. Cryptocurrencies are subject to limited or inconsistent laws and regulations across countries, which may create legal uncertainty or risks for users.

Conclusion

CBDCs are a new form of digital currency issued and regulated by the central banks. They have some similarities and differences with cryptocurrencies, a form of digital currency not issued or controlled by any central authority. Both types of digital currency have advantages and disadvantages for users, businesses, governments, and society. The future of digital currencies depends on how they evolve and interact with each other, as well as with the existing financial system.

Image by Unknown User licensed under CC BY

Related posts

How to Convert USD to Bitcoin: A Comprehensive Guide

Staff

What is Ethereum in Crypto? A Beginner’s Guide to ETH

Staff

How to Find the Best Free NFT Giveaways?

Staff

This website uses cookies to improve your experience. We'll assume you're ok with this, but you can opt-out if you wish. Accept Read More

Please enter CoinGecko Free Api Key to get this plugin works.
Index