The financial world is changing, and central banks are now putting the Central Bank Digital Currencies (CBDCs) – the digital tokens issued by the central banks that represent the legal tender- to the test. This possible change has a far-reaching impact on people, businesses, and the global economy.
This article discusses the rise of Central Bank Digital Currencies (CBDCs) and analyzes their design, types, pros, and cons.
Understanding CBDCs: A New Form of Money
Although private cryptocurrencies like Bitcoin are decentralized, CBDCs are centralized. They are issued and regulated by the central banks and serve as a digital counterpart of physical money. While the specific design of a CBDC may vary, it typically shares some key characteristics:
Central Bank Issuance
Central banks will have the power to issue and redeem CBDCs. Thus, it guarantees stability and eliminates market volatility that plagues many cryptocurrencies.
Legal Tender
CBDCs, like physical cash, are a form of legal payment in a given jurisdiction. The holder can make payments and clear their debt through the assets.
Digital Form
CBDCs are digital forms of money. It removes the necessity for the physical cash infrastructure. It enhances the performance and efficiency of transactions. After understanding CBDCs, learn the specific design below.
The Specific Design of CBDCs
CBDC design will vary based on a country's priorities and needs. So here are the possible models:
Central Bank Direct Model
In this system, businesses and individuals have CBDCs directly in the central bank accounts. It offers the central bank the highest level of control but might also eliminate the banking system.
Two-Tiered Model
This model forms a two-level system where commercial banks act as the middlemen. The central bank gives CBDCs to commercial banks, which provide them to individuals and businesses. It gives the private sector a role, but central banks control it.
Hybrid Model
This concept merges the characteristics of direct and two-tiered approaches. For example, central banks could give CBDC accounts to people for specific applications, and commercial banks would handle regular transactions.
Offline CBDCs
Some models are looking into offline CBDCs. It could work like cash and wouldn't need the internet. Now you know the possible CBDCs design models, let’s discuss the types.
Types of CBDCs
There are two types of CBDCs: wholesale and retail. Financial institutions primarily use wholesale CBDCs, while businesses and consumers use retail CBDCs.
Wholesale CBDCs
The wholesale CBDC system works like a reserve that a central bank holds. The bank gives an institution a reserved account to deposit money or to use the funds to settle interbank transfers. Hence, the central banks can utilize monetary policy tools, such as interest on reserve balances or reserve requirements, to influence lending and determine interest rates.
Retail CBDCs
Retail CBDCs are government-backed digital currencies that consumers and businesses use. Retail CBDCs eliminate the intermediary risk that a private digital currency issuer might become bankrupt and lose assets.
Retail CBDCs are of two types, Token-based and account-based, and they differ in how individual users access and use them.
Token-based retail CBDCs are accessible with public or private keys or both. This validation method enables users to execute transactions anonymously.
Account-based retail CBDCs demand digital identification to access an account.
You now know the CBDCs types, let’s dive into the motivation for the rise of centralized currencies.
Motivations for the Rise of CBDCs: Why Now?
A few reasons are the need for higher quality in cross-border payments and reduced use of cash.
Evolving Payment Landscape
The rise of cashless payments and an increasing number of digital wallets motivate central banks to develop CBDs. Through the centralized currency, cashless transactions become more secure and efficient. Also, it could potentially reduce over-dependence on private entities.
Financial Inclusion
A considerable number of people are still unbanked globally. They lack access to the regular financial services. However, CBDCs have the potential to achieve financial inclusion by providing a global digital payment system that is accessible to everyone.
Combatting Cash in the Shadow Economy
Cash allows transactions in the shadow economy, making it impossible for the government to collect taxes and keep a check on illicit activities. The CBDCs, with their inherent traceability, can give central banks control over the flow of money and prevent tax evasion.
Maintaining Monetary Policy Control
The emergence of private cryptocurrencies is one reason central banks fear losing their power in monetary policy. At the same time, CBDCs can help central banks control money supply and interest rates in a digitalized financial ecosystem.
Still don’t know the potential benefits of Central Banks Digital Currencies (CBDCs)?
Potential Benefits of CBDCs: A Brighter Financial Future?
CBDCs can be a safe and accessible digital substitute for paper money, cutting transaction costs and reducing reliance on private companies.
Increased Efficiency
CBDCs could be a tool to simplify the financial transaction. It could lower costs for individuals and businesses and ensure quick settlement time.
New Trade Finance Instruments
The programmability of some CBDCs enables the creation of innovative trade finance instruments. Smart contacts in CBDCs make it possible to automate payments once the predefined conditions are met, like presenting custom documents or delivering goods. It reduces the use of conventional letters of credit and other trade finance instruments.
Financial Inclusion
CBDCs could be a digital payment system for the masses, even for the unbanked, who are inaccessible by the traditional payment systems.
Enhanced Security
Central banks can use the latest security features to ensure CBDC transactions are authentic and credible. It reduces the chances of fraud and fake items.
Greater Transparency
The establishment of CBDCs leads to more traceable transactions. Thus, tax collection will be more accessible, preventing financial crimes.
Programmable Money
CBDCs could have specific attributes—an expiry date or a stimulus package targeting a particular group.
After learning the benefits of CBDC for individuals and businesses, learn the drawbacks to stay ahead.
Challenges and Considerations
CBDCs have low transparency and traceability and are largely inaccessible to some people. Other challenges include:
Privacy Concerns
Central banks could monitor CBDC trades. Thus, the privacy issue would arise. Data protection systems should be in place to guarantee that individual privacy is not infringed.
Financial Stability
CBDCs might influence financial stability, but it is not yet known. The large-scale change from the usual banks to digital wallets might be too risky. Central banks should design the CBDCs carefully to minimize the risks.
Harmonization and Interoperability
The real transformative power of CBDCs lies in the fact that different countries' CBDCs have to be interoperable and work seamlessly. It necessitates international cooperation to establish protocols and standards for cross-border transactions.
Cybersecurity Threats
CBDCs are digital and are probably vulnerable to hacking. The CBDC system is secure enough for the CBDC system but also necessary for its safety.
Financial Exclusion
Although CBDCs can be a good tool for financial inclusion, the country should ensure that all its citizens have the same access to technology and infrastructure.
Impact on the Private Sector
The birth of CBDCs may disrupt the role of commercial banks and other financial organizations. Careful consideration is necessary to ensure a competitive and healthy financial ecosystem.
Conclusion
CBDCs can easily create a global market where international trade becomes much faster, cheaper, and more transparent. Nevertheless, the issues associated with harmonization, regulation, and infrastructure development must be addressed to achieve the goal. Currently, the world is testing CBDCs, so experiments are taking place in this era, and changes in the international trade system may result from these digital currencies.
