What you need to know about Central Bank Digital Currency CBDC

CBDC (Central Bank Digital Currency) is a topic that has been making headlines lately. But what exactly is a CBDC? In simple words, CBDCs are digital versions of traditional paper fiat currency created and regulated by central banks (Dollar, Yuan, Rupee) of respective countries. CBDCs are gaining increasing attention from governments around the world as they have the potential to revolutionize the way regulators can impose monetary policies and encourage or crack down people’s economic activities. In this article, we’ll take a closer look at CBDCs and examine the pros and cons of this emerging technology.

What are CBDCs

Central bank digital currencies (CBDCs) are a virtual form of digital currency that is issued and regulated by a country’s central bank. They are a new form of digital currency that is being explored as a potential alternative to traditional physical currency and electronic payment methods. This means that instead of carrying around cash or using electronic payment methods like credit/debt cards, these digital currencies will allow people and businesses to make and receive payments electronically using a digital wallet version of the currency. CBDCs typically operate on a blockchain system or digital ledger, which allows for secure and transparent transactions.

Central Bank Digital Currency

Around 70 percent of all central banks worldwide are now engaged in some kind of CBDC research. Some countries like China, Nigeria, and the Bahamas have already implemented some form of CBDC in their economy. Some other countries are planning to launch their pilot CBDC programs this year (2023). BRICS nations are also exploring ways to introduce gold and commodities backed CBDC.

US Federal Reserve is currently looking into a potential Central Bank digital currency. In fact, Federal Reserve has already announced FedNow, a 24/7 instant payment network, to be released in July 2023. Most see it as a laying ground for a CBDC. This means that the Federal Reserve would not need to print physical money but would instead issue a cryptographic representation of the currency in electronic form. Unlike proposed commodity-backed or gold backed currencies such as digital Yuan or digital Ruble, American CBDC will be backed by the credit of the US government, just like its traditional physical currency. The value of US Dollar is based on American government’s guarantee to fulfil its enormous debt obligations and the world reserve currency status it enjoy at the moment, rather than any inherent utility or intrinsic worth (like gold). Therefore, American dollar CBDC is essentially the same fiat currency in the digital form.

For countries in debt or unpopular governments, CBDCs could give unprecedented power to control public unrests. We have already seen glimpse of that when Canadian government decides to freeze bank accounts associated to trucker protesters. Recently, the UK has denied bank access to Nigel Farage, one of the leaders of the Brexit movement.

In contrast to CBDCs, electronic payment methods like credit cards and Venmo are not backed by the government. These methods are typically used to make payments between commercial banks or through payment transaction providers.

Central bank digital currencies are also different from cryptocurrencies. Cryptos are community-driven projects and typically not backed by anything but hype. Unlike cryptocurrencies, CBDCs are issued by a central bank and get their value from its gold/commodity backing or trust in the issuing government, limited to citizens of a country. Cryptocurrencies are not limited by any border, so anyone in the world can purchase or sell them. Cryptocurrencies like Bitcoin operate on decentralized networks and are not subject to the same regulations as traditional fiat currencies or CBDCs. Cryptos are useful instruments to circumvent government crackdowns: Canadian Authorities Struggle to Seize Freedom Convoy’s Bitcoin Donations.

Although the name “CBDC” gives the impression that it’s something technical, modern, and digital, it’s not a completely new concept. In fact, people have been using “BDC” (Bank Digital Currency) for decades. This is how the money we use gets transferred throughout the world. In fact, money is created, invented, and sent into circulation by banks through the act of lending or credit creation.

How Do Banks Create Currency?

This is how the fractional reserve banking system works: When you deposit money in a bank, you are actually loaning money to that bank, and the bank can do whatever it wants with your money, including investing in the stock market and loaning it out at a profit. Fractional reserve lending allows banks to keep only a fraction of your deposit in reserve and loan out the rest. For example, with a 10% reserve ratio, if you deposit $100, the bank can legally take $90 and loan it out, leaving $10 in reserve. However, the bank creates IOUs in the form of bank credit numbers to replace the money it takes, which are essentially currency, even though they only exist in computers. This process repeats as the borrowed money gets redeposited and re-lent, creating more bank credit. Under a 10% reserve ratio, an initial deposit of $100 can create up to $1,000 of bank credit. The majority of our currency supply is created by the banking system through this process, with 92-96% of all currency in existence being created by banks rather than the government.

Therefore, most of the money we use was created by banks through lending. The Federal Reserve acknowledges that paper money is only a small part of the money supply, and over 90% is bank digital currency, even though it’s not referred to as such.

Differences Between CBDC and Physical Currency

CBDCs have several distinct features that make them different from physical currency.

Authority of the Federal Reserve/Central Bank

Unlike physical cash, the Central Bank will have the power to make all decisions related to any CBDCs held by people, and they can do so at any time. CBDCs can have hundreds of features that can be turned on or off by the central bank, depending on the desired outcome. For example, a CBDC can be programmed to expire on a set date or not be usable in certain areas or for specific products.

Easy Tracking of Transactions

Another significant difference between CBDCs and paper currency is that CBDCs are easily tracked. While cash transactions are mostly untracked, CBDCs are centralized, programmed, and controlled by their issuers, which enables them to track all user transactions. While this level of control can help authorities monitor for financial crimes such as anti-money laundering, it also poses a threat to personal privacy.

Impact on Monetary Policy

CBDCs have the potential to change how monetary policy is executed. Unlike traditional monetary policy tools such as interest rate adjustments, which take months to show results, CBDCs can increase or decrease the money supply in seconds. This feature can help the Federal Reserve execute any monetary policy that is deemed necessary and appropriate.

Cybersecurity Concerns

As CBDCs are primarily digital, cybersecurity is a significant concern. Unlike physical cash, which can be held in a safe, CBDCs will be stored in digital wallets, which can be vulnerable to cyber-attacks. Using both digital and hardware wallets can help users protect themselves from possible cyber-attacks.

Age of paper fiat money is over. Digital Currency is the future

Types of CBDCs

In broad terms, there are two types of CBDCs: wholesale and retail. To understand the difference between these two types of CBDCs, it’s important to first understand how commercial banks work.

Commercial banks have two types of ledgers: a front-end ledger facing the public, and a back-end ledger used to manage transactions between commercial banks and central banks. The back-end ledger has assets and liabilities like bank reserves, mortgage-backed securities, treasury bonds, and cash. The front-end ledger has assets and liabilities like mortgage loans, car loans, personal loans, and cash.

In the case of Central Bank Digital Currency, they can be broadly categorized into direct CBDC where Individuals have a direct account with the central bank essentially eliminating need for a intermediary and indirect CBDC which are managed through intermediary such as banks. These indirect CBDC can be further categorized into 2 types,

1. Wholesale CBDC, only the back-end ledger and process are replaced with CBDC. These would primarily be utilized by financial institutions.

2. Retail CBDC, both the back-end and front-end ledgers are replaced with CBDC. These are designed to be utilized by individuals.

Why Do Central Banks Want to Use CBDC

Central banks are interested in replacing fiat currency with CBDC for a number of reasons:

Tracking and taxing every transaction:

Converting all cash into CBDC would allow central banks to track and tax every transaction, formalizing the entire economy.

Imposing negative interest rates:

Banning cash would allow central banks to push interest rates into negative territory which can boost economic activity (save less and consume more).

Expiring Currency:

Central banks can implement an expiring currency to incentivize consumption over savings, making sure that people do not hoard currency.

Impose Transaction caps:

CBDC give central authority the power to cap transactions in order to control the flow of currency into an asset class/economic activity.

Impose Transaction taxes:

Transactions can also be taxed at a higher rate to control the flow of currency into certain asset classes. This is useful to discourage certain economic activities.

Keep track of the issued money and control who get to use it:

Anonymity would be completely lost with CBDCs, giving central banks the power to exclude individuals from the financial system, if need.

Implementation of universal basic income:

The programmability of CBDCs would make it easier to implement universal basic income and ensure it is used for its intended purpose. The government could dictate how the currency is used and even enforce substitutions in times of scarcity.

Online Transaction using CBDC

Pros and Cons of CBDCs

Let’s now examine what are the societal advantages and disadvantages of using CBDC for transactions.

Pros of Central Bank Digital Currencies

Convenient electronic payments: CBDCs offer a more efficient and convenient way to conduct transactions compared to traditional payment methods like cash, credit/debit cards, QR codes, and checks. This is because digital payments can be made and received in real time without the need for physical exchange or processing by a third party company. In addition, we can simply make payments using smartphones or other devices, allowing for greater flexibility and accessibility. Overall, transactions are faster and more convenient this way.

Reduce the need for intermediaries: Central bank digital currencies reduce the need for intermediaries such as banks and payment processors that facilitate instant payments. This also speeds up clearing and settlement processes. As a result, transactions could be completed more quickly and at lower costs, especially for online and cross-border payments.

Increased financial inclusion: CBDCs provide alternative means of accessing financial services for those who are unbanked or underbanked, thereby addressing the issue of financial exclusion in society. Individuals who do not have a traditional bank account can simply create digital wallets to store and transfer digital money without using the banking system. This helps to increase individuals’ participation in the modern economy and improve their quality of life.

Safer payments backed by the government: CBDCs are issued and regulated by the central bank. They also have the backing of the government. The involvement of the central bank and government minimizes the financial risks for users.

More stable and secure than cryptocurrencies: CBDCs act as a more stable and secure form of currency than cryptocurrencies, which are subject to volatility and security risks.

Easier tracking and verification: Digital transactions can be easily tracked and verified. Therefore, central bank digital currencies may provide greater transparency and accountability.

Cons of Central Bank Digital Currencies

Privacy concerns: Since central bank digital currencies are issued and operated by the government, the government may have access to the financial data of all people who use CBDC. The government may use this data to track and monitor the financial transactions of individuals.

Government control: These digital currencies can give the government complete control over a person’s financial wellbeing. The government will have the ability to freeze or seize funds at its discretion, which could lead to issues related to financial freedom and autonomy.

Security risks: Like with any digital system, CBDCs too have security threats like cyber-attacks and hacking. These can result in significant financial losses for both individuals and the government.

Accessibility concerns: Digital currencies might not be accessible to everyone, especially those without access to smartphones and other devices. To run a CBDC network the countries’ electricity supply should always be available. This is not something a government can guarantee specially given the recent energy crisis.

Cryptocurrency risks: Although CBDCs may be more stable and secure than cryptocurrencies, people may still use it given cryptos decentralized nature as a way to circumvent government imposed CBDC limitations.

Implementation challenges: Implementing a digital currency at the national level may be a complex and challenging task. It may require significant resources and expertise. This implementation can also disrupt existing financial infrastructure that a country has built for hundred of years.

Conclusion

Central bank digital currencies are simply a digital form of fiat currency issued and regulated by the central bank. Some countries around the world, including the Bahamas, Nigeria, China, and Jamaica, have already introduced some form of CBDC into their financial systems. Some consider them as an efficient way to conduct digital transactions and an alternative to fiat paper currency system. But, like any new technology, they, too, have both pros and cons. Some pros include increased efficiency and financial inclusion, while cons include privacy concerns, security issues, and complete government control over transactions. Policymakers of a country should carefully examine its ability to maintain such complex system before getting into this disruptive technology.

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