An Introduction to Central Bank Digital Currencies (CBDCs) Pt.1

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Meteor X

8 min readJan 10, 2023

So, what is a Central Bank Digital Currency (CBDC)?

It is a digital form of money issued and backed by a central bank, such as the Federal Reserve in the United States or the Bank of England in the United Kingdom. CBDCs are intended to function like traditional fiat currencies, but they are digital and can be accessed and transferred using electronic devices, such as smartphones or computers. In simpler words, CBDCs are digital tokens pegged to the value of the country’s fiat currency.

Before we go in-depth with CBDCs, let’s review what is the definition of a fiat currency 💰

Fiat money, or fiat currency, is a government-issued currency that is not backed by a physical commodity. The term “fiat” comes from the Latin word “fiat,” which means “let it be done.” In other words, a fiat currency is one that is accepted as legal tender by the government, but it is not backed by a tangible commodity such as gold or silver. Instead, it is backed by the faith and credit of the government that issues it. Most modern currencies, such as the U.S. dollar, the euro, and the Japanese yen, are fiat currencies.

If I may side-track a bit, non-fiat currencies are also known as “commodity money” and most countries have moved away from using commodity money and have adopted fiat currencies, but some countries do hold significant amounts of gold reserve and link the value of their currency to the gold prices in some way.

For example, The Central Bank of Russia has been increasing its gold reserves in recent years, and gold now makes up a significant portion of Russia’s total foreign currency reserves. Similarly, China is also known to hold a large amount of gold in its reserves and has been increasing its gold purchases in recent years. Other countries like Turkey, Kazakhstan, and India, have also been increasing their gold reserves in recent years.

Give me some stats about CBDCs 👀 :

Source: Atlantic Council’s CBDC Tracker

In May 2020, only 35 countries were considering CBDCs but now up to 114 countries are exploring CBDCs. This represented 95% of the world’s GDP.
11 countries have fully launched a digital currency, including Nigeria, Jamaica, The Bahamas, and other Caribbean countries.
In 2023, over 20 countries are taking significant steps towards piloting CBDCs. China, Australia, Thailand, India, and South Korea are some countries on that list. China’s pilot is expected to reach 260 million people during the pilot phase.
As of December 2022, all G7 countries have now moved into the development stage of a CBDC. The New York Fed’s wholesale CBDC experiment, Project Cedar, is also in the development phase.
18 of the 20 G20 countries are now in the advanced stage of CBDC development.

What are the different types of CBDCs?

Type A: Wholesale CBDCs 🏦

A wholesale CBDC is a digital version of a country’s fiat currency that is primarily used for interbank settlements and large-value transactions between financial institutions, rather than for retail transactions between consumers and merchants.

Wholesale CBDCs are similar to holding reserves in a central bank. The central bank grants an institution an account to deposit funds or use to settle interbank transfers. Central banks can then use monetary policy tools such as reserve requirements or interest on reserve balances to influence lending and set interest rates.

Case study to further explain wholesale CBDC: Project Helvetia

A joint experiment by the Bank for International Settlement’s Innovation Hub, SIX Group AG (Swiss principal stock exchange), and the Swiss National Bank. It also involved 5 commercial banks: Citi, Credit Suisse, Goldman Sachs, HBL (Hypothekarbank Lenzburg), and UBS.
The project consists of two Proofs-of-Concept, both testing the functional feasibility of settling tokenized assets which are settled and traded in the SIX digital exchange (called SDX) in central bank money
Three components were designed to operate the test environment of Project Helvetia:

(1) SDX by SIX Exchange is a permissioned DLT platform which is a licensed financial market infrastructure operating in Switzerland. It hosts multiple nodes:

SNB node: technical issuer of wCBDC
Observer node: collects all relevant data & monitors settlements
Notary node: signs and time-stamps all state changes to the ledger

(2) SIC is the test environment of the Swiss RTGS system where each commercial bank and the Swiss National Bank have a settlement account. For the issuance and redemption of wCBDC, the SNB has a technical account.

(3) Core banking test systems: in SNB’s core banking system new mirror accounts are needed to keep track of wCBDCs. Mirror accounts for reserve balances and wCBDCs in commercial banks’ core banking systems keep track of traditional and tokenized central bank money.

In Proof-of-Concept #1, the cash leg of the transaction is settled with the wholesale central bank digital currency wholesale CBDC issued directly onto the DLT (Distributed Ledger Technology) infrastructure of SDX by the Swiss National Bank

Use Case #1: issuance and redemption of wCBDC

1-to-1 conversion of reserve balances of CHF in the RTGS system to wCBDC in the DLT platform

Use Case #2: settlement of financial transactions on the DLT

the delivery of tokenized assets against payment in wCBDC

Use Case #3: back-office processes

recording of financial transactions involving wCBDC in the traditional core banking system

Use Case #4: central bank control over wCBDC

the ability of the central bank to monitor wCBDC settlement and holdings

In Proof-of-Concept #2, the interoperability between the DLT infrastructure of SDX and the Swiss RTGS (Real-Time Gross Settlement) system, SIC, is established and the cash leg of the transaction is settled in the SIC balances.

This shows how wholesale CBDCs could make central bank money programmable to (1) support automation (2) mitigate risks (3) and be designed with international standards in mind to support interoperability

Okay, sorry…I know I lost you with all the jargon stated above so here is a glossary to help you realllllyyyy understand how central bank reserves and commercial bank settlements work 🤭

*Source: Investopedia

RTGS (Real-Time Gross Settlement): Gross settlement means transactions are handled and settled individually, so multiple transactions aren’t bunched or grouped together. This is the basis of a real-time gross settlement system. An RTGS system is generally used for large-value interbank funds transfers operated and organized by a country’s central bank. These transfers often require immediate and complete clearing. As mentioned above, once transactions are settled, they cannot be reversed.
Bank Reserves: Bank reserves are the cash minimums that financial institutions must have on hand in order to meet central bank requirements. This is real paper money that must be kept by the bank in a vault on-site or held in its account at the central bank. Cash reserve requirements are intended to ensure that every bank can meet any large and unexpected demand for withdrawals. (Also, refer to reserve ratio)
Net Settlement: The opposite of RTGS. Net settlement is a bank’s routine resolution of the day’s transactions at the end of the business day. Since many or most bank transactions are now sent electronically, this is no longer a matter of counting the cash in the drawer. Instead, the bank has to add up all of its electronic credits and debits.
Solvency: Solvency is the ability of a company to meet its long-term debts and financial obligations. Solvency can be an important measure of financial health since it’s one way of demonstrating a company’s ability to manage its operations into the foreseeable future.
Bank Run: A bank run occurs when a large number of customers of a bank or other financial institution withdraw their deposits simultaneously over concerns about the bank’s solvency.
Overnight Rate: The overnight rate is the interest rate at which a depository institution (generally banks) lends or borrows funds from another depository institution in the overnight market. In many countries, the overnight rate is the interest rate the central bank sets to target monetary policy. In most circumstances, the overnight rate is the lowest available interest rate, and as such, it is only available to the most creditworthy institutions.

Type B: Retail CBDCs 💳

Retail CBDCs are government-backed digital currencies used by consumers and businesses. Retail CBDCs eliminate intermediary risk — the risk that private digital currency issuers might become bankrupt and lose customers’ assets. (Did anyone say FTX? 😅)

There are two types of retail CBDCs. They differ in how individual users access and use their currency:3

Token-based retail CBDCs are accessible with private/public keys. This method of validation allows users to execute transactions anonymously.
Account-based retail CBDCs require digital identification to access an account.

What is the difference between a CBDC and stablecoins?

CBDCs and stablecoins are both digital forms of currency, but they have some important differences.

CBDCs are digital versions of fiat currencies that are issued and backed by central banks. They are intended to function like traditional fiat currencies, but they are digital and can be accessed and transferred using electronic devices. CBDCs are issued and backed by central banks, which means that they are considered to be very safe and stable since central banks are responsible for managing the supply of money and ensuring its value.

Stablecoins, on the other hand, are digital assets that are designed to maintain a stable value relative to a specific asset or basket of assets. They are typically pegged to a fiat currency, such as the US dollar, or to a commodity, such as gold. The value of stablecoins is intended to remain stable, even if the value of the underlying asset fluctuates.

Another important difference is that CBDCs are intended to be used as a payment and store of value, while stablecoins are primarily used as a payment and a store of value. CBDCs are intended to be widely accepted and used as a substitute for fiat currencies, while stablecoins are typically used to facilitate transactions and transfers of value between individuals or organizations.

Do CDBCs need to be blockchain-based?

No, Central Bank Digital Currencies (CBDCs) do not necessarily have to be based on blockchain technology. While blockchain is a popular choice for many central banks that are exploring the use of digital currencies, other central banks and organizations are considering alternative technologies, such as Directed Acyclic Graphs (DAGs), Hashgraphs, or even more traditional centralized systems.

The most important consideration for a CBDC is that it should be able to meet the requirements and goals of the central bank. For example, some central banks might prefer a permissioned blockchain as it offers a good balance of security and scalability. Some others might prefer a centralized system as they believe they can provide better control over the monetary policy and prevent potential illicit activities.

It’s also worth mentioning that some central banks are also exploring the possibility of using a hybrid approach, where a private permissioned blockchain could be used to process high-value interbank transactions, while a traditional centralized system would be used for retail transactions.

(To be continued…)

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