Home Education Central Bank Digital Currencies (CBDCs): A Beginner’s Guide

Central Bank Digital Currencies (CBDCs): A Beginner’s Guide

Alisha Bains
Last Updated June 27, 2023 8:26 AM

Key Takeaways

  • CBDCs are digital currencies issued and managed by central banks.
  • CBDCs aim to combine the benefits of digital currencies with the stability and security of traditional fiat money.
  • CBDCs can offer advantages such as increased financial inclusion, lower transaction costs, improved payment system efficiency, and reduced risk of counterfeiting.
  • CBDCs also raise concerns about cybersecurity risks, privacy issues, potential impacts on financial stability, and legal and regulatory challenges.

Central Bank Digital Currencies (CBDCs) are a significant interest in the world of finance and technology. CBDCs, which are digital currencies issued by central banks, are predicted to completely alter the way individuals engage with and transact with money. If you’re new to the concept of CBDCs, this beginner’s guide will provide you with the necessary information to get started.

What are CBDCs

CBDCs are electronic renditions of fiat money that are created and supported by the central bank of a nation. CBDCs seek to maintain the stability and security of conventional fiat currencies while delivering the advantages of digital currencies, such as speedier and less expensive transactions. Retail transactions, interbank settlements, and overseas remittances are just a few of the uses for CBDCs.

CBDCs are created and managed by central banks, which are in charge of managing the traditional money supply, preserving price stability, and ensuring financial stability, in contrast to cryptocurrencies like Bitcoin (BTC). Several approaches, such as account-based, token-based, or hybrid models, can be used to issue CBDCs.

Central banks all around the world are paying more and more attention to CBDCs, and many nations are now examining the advantages and disadvantages of issuing their own CBDCs. Some nations, including Sweden and China , have already started their CBDC pilot programmes, while others are still in the research and development stage. 

Moreover, in October 2020, the Central Bank of the Bahamas launched the Sand Dollar , its digital currency. In this beginner’s guide, we will examine the fundamentals of central bank digital currencies and how to begin using them.

Different forms of CBDCs

Various forms of CBDCs include:

Account-based CBDCs

In this arrangement, consumers have accounts with the central bank through which they may access their money, and the CBDC is issued and stored in a centralized database. Each user’s account is linked to a unique identity, and transactions are logged and updated in real-time. The Digital Currency Electronic Payment (DCEP) system in China is based on a model that is comparable to conventional banking systems.

Token-based CBDCs

With this approach, the CBDC is issued and stored as a digital token using a digital wallet. Through a peer-to-peer network, users can transfer these tokens to other users, and each token has a certain value. The Bahamas’ Sand Dollar functions on a similar principle as cryptocurrencies.

Hybrid CBDCs

This model combines elements of both account-based and token-based models. The CBDC is created and kept in a centralized database, but users can access their money as tokens through a digital wallet. This concept combines the convenience of a token-based system with the security of an account-based system. The e-krona project  in Sweden makes use of this paradigm.

Why are central bank digital currencies being developed

CBDCs are being developed for a variety of reasons, as explained below:

  • To be more efficient, secure, and cost-effective, the current payment system has to be modernized.
  • CBDCs can help central banks stop illegal activities like money laundering and terrorism financing as well as better control and monitor the money supply.
  • CBDCs can provide faster and cheaper cross-border payments, reduce the risks associated with using cash, and promote financial inclusion by offering unbanked populations a digital payment option.
  • Private cryptocurrencies, which are unbacked by any central bank or government and can be extremely volatile and security-risky, can be replaced by CBDCs.
  • Central banks may maintain their position as the industry standard while providing a safe and dependable alternative to cryptocurrencies by developing their own digital currency.

How do CBDCs work

Central bank digital currencies aim to provide a secure, transparent, and efficient means of payment and may offer additional benefits such as reducing transaction costs, increasing financial inclusion, and improving monetary policy. Here are the general steps of how a CBDC works:

  • Issuance: A new digital currency is created and issued by the central bank.
  • Distribution: The digital currency is provided to authorized institutions, such as banks or payment processors, who can then distribute it to individuals and businesses.
  • Transaction: The CBDC can be used for transactions, including the purchase of goods and services, just like real money or other digital payment systems.
  • Validation: The transaction is verified and recorded on a distributed ledger, which maintains a secure and public record of all transactions.
  • Storage: The CBDC can be held in digital wallets or other secure storage options, much like individuals save physical cash or other digital currencies.

The operation of CBDCs may differ depending on the precise model employed. To illustrate, account-based models may call for people and businesses to keep an account with a financial institution, whereas token-based models may involve the direct transfer of digital currency between participants. Hybrid models can combine both approaches.

What are the benefits and risks of CBDCs

The financial system may benefit from CBDCs in a number of ways, including financial inclusion, lower transaction costs, improved efficiency, and better transparency. 

  • Financial inclusion: By giving unbanked communities access to banking services, CBDCs help increase financial inclusion.
  • Reduced transaction costs: By using CBDCs instead of conventional payment methods like credit cards, bank transfers, and remittances, transaction costs for traditional payment methods can be reduced.
  • Efficiency gains: CBDCs can improve the effectiveness of payment systems by accelerating transaction processing and reducing settlement delays.
  • Reduced risk of counterfeiting: Since digital currencies are more difficult to counterfeit than paper money, CBDCs can lower the danger of counterfeiting.

Despite the above pros, CBDCs also pose some risks and difficulties, such as cybersecurity dangers, privacy issues, and the possibility of disintermediation by the banking sector.

  • Risks associated with cyber security: CBDCs are vulnerable to cyber attacks that could lead to the theft of money or other sensitive information.
  • Privacy concerns: CBDCs may put specific people’s privacy at risk because the central bank may trace and monitor transactions.
  • Financial Stability: The adoption of CBDCs may have an impact on financial stability because they have the potential to replace current banking institutions.
  • Legal and regulatory issues: There are concerns regarding how CBDCs will be governed, taxed, and supervised because the legal and regulatory framework is still being constructed.
  • Threat to decentralized currencies: The decentralized crypto community is concerned about CBDCs because they see them as potential threats to the decentralization and privacy ideals that underlie cryptocurrency. 

The future of CBDCs

Although the creation and implementation of central bank digital currencies are still in their infancy, it is already clear that they have the power to fundamentally alter the way we see money and the financial system. As more central banks worldwide explore the possibility of creating their own digital currencies, we should expect a number of changes and advances in the way that money is used and exchanged.

Greater financial inclusion, lower transaction costs, and the provision of safer and more efficient payment systems are some of the potential advantages of CBDCs. They might also make it easier for central banks to control inflation and economic growth by streamlining the monetary policy process.

However, the value of sand dollar balances climbed by less than $300,000 from January 2021 to June 2022, while the value of notes increased by $42 million, emphasizing the limited use  of the sand dollar as a form of money. In contrast, the dollar value of coins in circulation has increased more noticeably.

The architecture of CBDCs, including whether to adopt an account-based, token-based, or hybrid model, as well as the underlying technology and infrastructure needed to support CBDC transactions, must therefore be taken into account by governments. 

The introduction of CBDCs also presents a number of other difficulties, including establishing reliable cybersecurity defenses, safeguarding user privacy, and addressing potential effects on monetary stability and the current financial system. Before CBDCs are extensively used, these difficulties must be rectified.

FAQs:

How do CBDCs differ from cryptocurrencies?
CBDCs are centralized and backed by the government, in contrast to decentralized cryptocurrencies like Bitcoin.

What are the advantages of CBDCs?
CBDCs provide advantages like increased financial inclusion, decreased transaction costs, increased payment system efficiency, decreased risk of counterfeiting, and possibly improved monetary policy.

What are the different forms of CBDCs? 

CBDCs can be implemented in various forms, including account-based models where users have accounts with the central bank, token-based models where digital tokens are transferred between users, and hybrid models that combine elements of both.

What are the risks surrounding CBDCs?
Cybersecurity risks and privacy concerns resulting from transaction tracking and monitoring, potential effects on financial stability, and unresolved legal and regulatory issues are all raised by CBDCs.

What is the current status of CBDC development?
Till now, only the Bahamas has implemented CBDC (the Sand Dollar). Many nations, including Sweden and China, have already started CBDC pilot programmes, and still other nations are looking into the possibility of creating their own CBDCs.