CBDC – Central Bank Digital Currencies: An Effort by Governments to Digitize Currency

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CBDC – Central Bank Digital Currencies: An Effort by Governments to Digitize Currency

At this point, technology has infiltrated every single facet of our lives. It now has a broad range of use cases across all sectors. It is a far cry from several decades ago when its applications primarily existed in manufacturing, communication, and a few other vital industries.
One of the areas in which technological solutions have been applied extensively in finance. For instance, Artificial Intelligence is being used to develop bots that help stock traders to execute trades in the stock market.

Blockchain technologies also promise to revolutionize modern currency as we know it through decentralized cryptocurrencies. Therefore, we need to understand clearly how technology is transforming various sectors of our economies.
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Central Bank Digital Currencies

The primary role of central banks across the world is to regulate the monetary ecosystem of their native countries. As such, they are responsible for printing and issuing legal currency, regulating its supply, formulating policies, and overseeing other financial institutions.

For a long time, Central banks’ functions as central monetary authorities have been based on fiat currencies. This is because fiat currencies have been the primary medium of exchange and store of value.

However, technological advancements have shifted from this traditional dynamic of the financial ecosystem, and Central banks have had to adapt correspondingly. And one main product of this adjustment by Central banks? Well, central bank digital currencies.

So what are they?

Central bank digital currencies (CBDC) are called digital base money or digital fiat currency. They are essentially digital versions of the legal tender issued by a nation’s Central bank.
The rise of cryptocurrencies has primarily driven governments’ development of CBDCs worldwide. More people continue to embrace cryptocurrencies as a tradable asset and a potentially reliable medium of fulfilling payments.

However, due to their decentralized nature, cryptocurrencies are not regulated by any authorities. This provides users with extensive freedoms, including peer-to-peer transactions and the ability to transfer funds anonymously.

The lack of a central regulatory authority also leaves users vulnerable to cybertheft, extreme volatility, and market crashes that result in massive financial losses. This is why Central banks worldwide are developing CBDCs to provide people with regulated digital payment options to shield and protect them against the dangers of decentralized currencies.

Some of the countries that have made significant strides in developing functional CBDCs or have plans underway to implement them include;

  • China – DC (Digital currency)
  • Sweden – e-krona
  • The Bahamas – Sand Dollar
  • The Eastern Caribbean Currency Union – DXCD
  • The Marshall Islands – SOV (The Sovereign)

 

Types of Central Bank Dgital Currencies

There are two main types of CBDCs;

  • Wholesale CBDCs; These CBDCs are primarily meant to enable institutions to transfer funds between different banks and hold reserve deposits in central banks.
  • Retail CBDCs; Designed to cater to the digital currency needs of consumers and businesses. They are useful in protecting consumers and businesses from losing their assets in the event of the bankruptcy of a private digital currency issuer.

What is the relationship between CBDCs and cryptocurrencies? Are they the same?

Cryptocurrencies are defined as “virtual currencies that exist in digital form.” CBDCs also have a digital element as they are considered the “digital representation” of fiat money issued by governments.

Therefore, it goes without saying that cryptocurrencies and CBDCs share a very fundamental trait—they are both digital-based. But what is the extent of their relationship, and what are the implications of this fundamental similarity?

Succinctly put, cryptocurrencies are not a type of CBDC, and CBDCs are not a type of cryptocurrency. Rather, there is a very stark difference between these two types of currency that is primarily rooted in the nature of their governance.

Cryptocurrencies are digital currencies that exist on a decentralized network called the Blockchain. On the other hand, Central bank digital currencies are digital currencies issued by central banks and backed by fiat currency.

With cryptocurrencies, there is no central monetary authority regulating supply and transactions. Rather, trust is established through consensus mechanisms were the participants on the decentralized network have to approve and validate all transactions.

Transaction data is then recorded on an immutable public ledger that cannot be altered. Additionally, most cryptocurrencies are not backed by other traditional assets like fiat money or gold with the exception of stable coins whose value is pegged to fiat currencies.

In the case of CBDCs, issuance, supply, and circulation are regulated by a central monetary authority, a nation’s Central bank. It is the Central bank that enforces a system of trust between users. Also, unlike cryptocurrencies, CBDCs are backed by fiat money issued by the government.

This is the reason why CBDCs are considered to be more similar to stablecoins than they are to conventional cryptocurrencies. These are the primary differences between cryptocurrencies and CBDCs that are important to understand.

Benefits of Central Banks Digital Currencies

The existence of every innovation is justified by its use cases and how it impacts the predominant way of doing things in its respective industry. As such, several benefits accrue from the use of Central bank digital currencies. They are as follows;

a) Enhanced financial stability

Most digital currencies, like cryptocurrencies, are designed to offer people a reprieve from the limitations of conventional fiat money. However, crypto markets are often characterized by high volatility due to the intensive speculation by investors, which directly affects prices.

This leads to frequent price fluctuations and makes crypto unreliable as a unit of account, medium of payment, and store of value. On the other hand, CBDCs offer a much more stable form of digital currency.
This is mainly because, similar to stablecoins, CBDCs are backed by the fiat currency of their respective countries. Their values do not fluctuate randomly; instead, they imitate the dynamics of the fiat currency. This makes them a more reliable medium of payment and value store than other digital currencies.

b) Lower transaction costs

CBDCs enable people to own deposit accounts directly with Central banks. Resultantly, people can transfer money to each other in a peer-to-peer transaction system that requires no third-party intermediaries like commercial banks.

This makes the cost of completing transactions lower as people do not need to pay transaction fees which third-party intermediaries normally charge. This can go a long way in not only saving people money but also making financial services accessible by people who are usually unable to meet the transactional costs of conventional financial systems.

c) Faster cross-border transactions

International trade has continued to grow at a higher rate yearly due to expansion in production volumes, globalization, and increased bilateral and multilateral cooperation between various world nations.

As a result, the trade volumes across borders have increased. However, the payment systems for facilitating this cross-border trade have, for a long time, remained to be slow, inefficient, and costly.

As a result, payments take too long to be completed and lead to delays in the procurement of other goods hence undermining trade. However, CBDCs offer a practical solution to this challenge. This is because they rely less on third-party payment companies to transfer money.

Rather, they facilitate real-time payments direct from payers to payees. This eliminates the long processes that result from an intricate ecosystem with complex financial structures.

d) Increased safety and protection for consumers

One major concern plaguing cryptocurrencies has been the adverse effects of the lack of regulation in the sector. From fraudulent crypto projects to very high volatility and sudden market crashes, lack of regulation has been cited as among the causes of problems in the crypto ecosystem.

Because they are digital-based, CBDCs retain some of the positive qualities associated with cryptocurrencies while benefiting from the regulatory oversight of Central banks. This helps to ensure that users are not exposed to potentially catastrophic financial situations unnecessarily without a body to protect them.

e) Easier monitoring of financial crimes

Another major challenge associated with conventional fiat money and cryptocurrencies is the difficulty of tracing and stopping criminal activity like money laundering and tax evasion using money trails.

Sophisticated criminals can obscure fiat money trails to avoid detection, while cryptocurrencies facilitate the anonymous transaction of money on the Blockchain. This makes it hard to discover, track, and arrest criminals using their transactions.
However, CBDCs provide a solution to this problem. Since Central banks issue them, these authorities can leverage user data and tracking mechanisms to detect financial crimes and stop them in good time.

Conclusion

Undoubtedly, Central bank digital currencies can bring unique benefits to the financial ecosystem. This is especially so through providing consumers, businesses, and institutions with a safer, stable digital currency regulated by a legal entity.

All that Central banks should do is put in place adequate measures to safeguard privacy, ensure financial stability, and optimize security architecture. Once that is effectively done, CBDCs can be rolled out and adopted widely.

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