Understanding Central Bank Digital Currency (CBDCs)

Central Banking Digital Currencies (CBDCs) are receiving increasing attention, initiating debate, and innovation by both public and private sectors worldwide. While it falls under the broader category of digital currency, CBDCs are a complex innovation. This post will dissect the fundamental aspects of CBDCs, including its stipulations, types of CBDCs, challenges in issuing CBDCs, and a brief examination of some CBDCs that have been piloted.

What are CBDCs

At its core, CBDCs are central-bank issued electronic money.

The exact parameters as to what constitutes a CBDC differ from definition to definition. The Bank for International Settlements (BIS), in its seminal 2018 report on CBDCs, has defined a CBDC as a digital form of central bank money that is different from balances in traditional reserve or settlement accounts that held between banks and central banks. The Bank of England (BoE) has defined CBDCs as an electronic form of central bank money that could be used by households and businesses to make payments and store value.

How they’re different from cash and bank deposits

While CBDCs sound much like bank deposits, they differ from bank deposits, other forms of digital money, and cash.

CBDCs are digital money that is not included in central bank-issued digital money in the form of reserves. Reserves constitute broader money, whereas CBDCs generally replace narrow money, namely cash.

The difference between CBDCs and cash depends on whether the CBDC is being issued to enable retail or wholesale transactions.

Payments are commonly divided into retail and wholesale segments, with retail payments constituting relatively low-value transactions such as cheque and card payments, and wholesale payments constituting high-value transactions such as interbank transfers.

Similarly, retail CBDCs are used as a digital replacement of cash by individuals and entities, and wholesale CBDCs are used by commercial banks and other permitted institutions to settle transactions in the interbank market. Uruguay and Sweden have issued retail CBDCs, China is issuing hybrid CBDC, where both retail and wholesale elements are present.

Where they have been issued

According to data from the BIS, 80% of the world’s central banks are engaging in CBDC-related research, with around 70–80 countries conducting research on CBDCs and some even piloting CBDCs. Uruguay, Sweden, and China, among others, have piloted their CBDCs.

Uruguay’s Banco Central del Uruguay (BDC) was one of the first to successfully pilot their CBDC, the e-Peso, in November 2017 as part of a country-wide financial inclusion program.

Early 2020 saw a renewed interest in CBDCs, with the proposed launch of Facebook’s privately-issued cryptocurrency Libra instigating central banks to look into issuing CBDCs.

Sweden’s Riksbank piloted the e-Krona in February 2020, with Sweden’s predominantly cashless society driving its successful trial. China is the most recent to pilot its CBDC, with the People’s Bank of China launching Digital Currency/Electronic Payment (DC/EP), beginning in April 2020 in select Chinese cities.

Issuing CBDCs is a long-drawn process replete with challenges, as examined below.

Why they’re not easy to design and launch

Central banks are faced with a unique set of challenges in issuing CBDCs, namely, privacy and anonymity of users’ and transactions, regulatory compliances, cybersecurity risks and disintermediation risks.

Privacy of users and anonymity of transactions are significant concerns, with different CBDC designs determining different degrees of privacy and anonymity. A CBDC designed with greater anonymity and privacy would alleviate users’ fears about the safety of CBDC-related transactions but in turn, increase Anti-Money Laundering and Countering Financing of Terrorism (AML/CFT) risks and simplify the violation of AML/CFT regulations.

Cyber-security is another major challenge, with a highly scaled project prone to greater security risks with many points of attack. Disintermediation of existing financial institutions is perhaps the toughest challenge for CBDCs, with financial institutions’ current business models at risk of being disintermediated by the arrival of central bank deposits creating imbalances in bank funding, liquidity, and competition. The aspect of disintermediation will be explored in a future post, and the coming posts will explore China’s digital currency in greater detail.

In conclusion, CBDCs have arisen as central banks adapt to a globally evolving payments landscape. Design choices surrounding CBDCs are pivotal to its impact on technologies and various aspects of domestic and global economies and financial systems, with these implications being steadily unpacked as more countries experiment and launch CBDCs.

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