Central bank digital currencies (CBDCs) are fiat money to be issued digitally by a country’s central bank or centralized financial authority.
The rise in popularity of decentralized blockchain projects such as Bitcoin, Ethereum, Ripple, and other cryptocurrencies that disrupted conventional financial systems in the process became an enormous challenge that governments cannot choose to ignore. Top financial experts got down to the drawing board and started developing what is to be termed as CBDC.
In the concept, CBDCs, as a digital counterpart of the fiat money, must continue to be centralized or government-controlled. And since Bitcoin and other altcoins are based on blockchain structure, CBDCs are being explored if it can thrive without using the distributed ledger technology (DLT). Though much of the population of countries still put their trust in fiat money, governments cannot afford to lose that trust now that the digital onslaught is inevitable and is even being accelerated by the pandemic. The Bank of International Settlements (BIS), the bank of central banks, revealed in early 2020 that nearly 80% of central banks around the world are actively working on the possibility of CBDCs in their respective countries.
Going beyond mere hypothesis, governments are now racing to release their own CBDC versions. The People’s Bank of China (PBoC) has already released the highly touted digital yuan, and so was the Central Bank of the Bahamas (CBOB) releasing its own digital Sand Dollar.
How CBDCs Work
CBDCs are to be issued by the central bank in digital form and works the same as its counterpart paper money and banknotes. It relies on blockchain infrastructure utilizing the distributed ledger technology instead of paperwork.
Two predominant models constitute CBDCs and they are retail and wholesale. Retail CBDCs are digital cash meant for transactions between the consumer and businesses and for peer-to-peer payments. The wholesale CBDC model is designed for interbank settlements that would facilitate a faster and cheaper way for banks to transact with clients.
Most banks and legacy financial institutions still employ obsolete processes that are already inefficient by today’s standards such as reigning, clearing, settling, and payment procedures. CBDCs can effectively fix these inefficiencies.
Retail CBDC models can empower central banks in totally managing their money supply and directly implement policies like negative interests. Processing fees can be reduced drastically and can instantly be sent anywhere through mobile phones. Wholesale CBDCs, meanwhile, operating on automation can perform optimum interbank settlements while reducing counterparty risks.
A CBDC built on Ethereum can deliver a more efficient, resilient, and transparent service since it can be customized and programmed along with interoperability to adapt to the evolving digital ecosystem.
The high volatility of the decentralized cryptocurrencies is a constraint that CBDCs can take advantage of knowing that a centralized token can be highly competitive to become a digital counterpart of the fiat money. It could still beat the decentralized cryptos to their game since they are backed up by a central bank reserve. Yet, there is still much work to be done as central banks are new to the technology and dabbling on proofs-of-concept only for the first time. Maybe in the near future we will see CBDCs asserting their place in the mainstream finance signaling that power remains in governments and the big banks.