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What Are Central Bank Digital Currencies?

What Are Central Bank Digital Currencies (CBDCs)?

Central bank digital currencies (CBDCs) are electronic versions of government-backed currency. Each CBDC is issued by a central bank and linked to its country’s national currency. CBDCs are most similar to stable coins, which are cryptocurrencies pegged to fiat money that attempt to maintain consistent value. The difference is CBDCs are issued by governments worldwide. If you’re planning to invest in cryptocurrencies, it’s vital to understand CBDCs and how they may impact the market. More than 80 countries are researching and developing CBDCs, with projects in various stages of development. Some digital currency initiatives are fully launched, and others are idle or already terminated.

How Does Central Bank Digital Money Work?

With numerous countries working on CBDCs, there will undoubtedly be nuances in how they operate. In principle, CBDCs function in the same way fiat currencies operate. Their government backing gives the central bank authority to issue CBDCs as legal tender, which can be used to pay employees or purchase goods and services. Without CBDCs, you can send money from your bank account to a friend’s account at another bank via electronic transfer. However, when using a CBDC, this transaction would not need to go through multiple banks and only take a few business days. It may all happen in the blink of an eye on a single digital ledger. In addition, you would not need a commercial bank account to transact with CBDC. Unbanked persons would be able to send money digitally using CBDCs.

Types of Digital Currencies Issued by Central Banks

CBDCs can be retail, wholesale, or a hybrid combination. Here’s how they function and what makes them unique.

Retail Central Bank Digital Currencies

CBDCs for sale to the general public are known as retail CBDCs. Consumers can store CBDCs in a digital wallet or account and use it to make payments under this paradigm. This form of CBDC would act as a public digital banking option and would be available to anyone.

Customers who cannot access traditional banking services may find it particularly useful. Because the government backs the funds, there is also no possibility of a bank failure. Several countries have adopted the retail CBDC model. The Bahamas was the first country to make CBDC publicly available using the retail model, promoting the Sand Dollar supposedly as “a safe & easy alternative to cash”. The United States meanwhile is still exploring the possibilities of a CBDC and has published papers, opening them up for public comment.

Wholesale Central Bank Digital Currencies

Financial firms would employ wholesale CBDCs, which would enable banks and other financial institutions to use the CBDC of a central bank to move funds and settle transactions more swiftly. While this form of CBDC would help with domestic payments, it could also be helpful with cross-border payments. Improved security is another advantage of a wholesale CBDC. The digital ledger that these currencies employ to process and record transactions may aid in the prevention of banking fraud. Singapore, Malaysia, and Saudi Arabia are pursuing a wholesale CBDC strategy.

CBDC as Efficient Medium of Exchange

Using a CBDC as a form of payment may benefit a wide range of transactions if it pays interest at the same rate as risk-free assets. People hold bank deposits and other check accounts at financial institutions for various reasons, including how they allow households and businesses to make payments (although they pay little or no interest).

Consumers value these transaction services, but they tend to save money on currency and bank deposits in their portfolios because maintaining money balances has an opportunity cost. The difference between a risk-free asset’s interest rate and cash’s yield is the “cost.” This difference would be driven to zero with an efficient medium of trade.

When interest rates rise, people and businesses seek to move money from non-interest-bearing checkable accounts to risk-free assets. A CBDC would encourage consumers not to shift money to risk-free (but illiquid) assets by providing an interest rate comparable to other risk-free assets in the economy.

A CBDC is a new payment instrument that competes with all forms of inside money, as we’ve seen. If a central bank decides to introduce a CBDC with the above-mentioned qualities, some people and businesses will likely transfer cash from private financial institutions to the central bank account, a process known as disintermediation by economists.

Consider the case where a central bank launches a CBDC overnight and offers to pay 4% annual interest on its account balances to comprehend disintermediation better. Most retail clients’ account balances currently get a negligible, if not zero, interest rate from commercial banks in the United States. Many people and businesses will likely transfer their balances to a CBDC account immediately if commercial banks do not adjust their interest rate strategy in reaction to the creation of a CBDC because commercial banks need deposits to provide loans to families and businesses. A drop in deposits will force them to reduce their lending portfolio, resulting in disintermediation in the banking system.

Several factors determine the precise level of disintermediation. Assume that someone with a $2,000 private bank account wishes to transfer their money to the newly established CBDC. Assume the private bank started with $20,000 in assets, $2,000 in reserves stored in a central bank account, and $18,000 in loans to businesses and individuals. The private bank’s deposits fall by $2,000, as do its reserves with the central bank. Reserves fell by $2,000 on the liabilities side of the central bank’s balance sheet, while the CBDC grew by the same amount.

Put another way, the private bank had 10% of its assets in reserve. The private bank ends up with no resources when one of its depositors transfers $2,000 to the CBDC. It would have to call in $1,800 worth of loans to return to the target portfolio composition while keeping everything else the same. This would only happen if the central bank did not issue new CBDC units with purchasing assets from the private bank.

This example indicates that if a CBDC with a sufficiently attractive interest rate is introduced, the volume of loans generated in the private sector will likely decrease. Suppose consumers and businesses move their funds to a CBDC, and nothing else changes in the economy. Financial system intermediaries must reduce their balance sheets, so establishing a CBDC may drop private-bank loans to households and businesses.

CBDC vs. Cryptocurrency

Cryptocurrency-inspired CBDCs are two entirely different types of digital currencies. The main distinction between CBDCs and cryptocurrency is the degree to which they are centralized. As a decentralized digital currency, a cryptocurrency is independent of any central authority. As the name suggests, a central bank regulates its digital currencies. Transactions are processed and recorded on a public, distributed ledger known as a blockchain.

Compared to CBDCs, cryptocurrency offers much higher levels of privacy. Wallet addresses are used to send and receive transactions. Thus, a degree of anonymity can be preserved. It is even claimed that some cryptocurrencies are untraceable. If a CBDC is used, the central bank will be able to keep track of its users and their transactions.

As the name implies, a central bank’s digital currency is regulated by a central bank.

Disadvantages of CBDCs

Because CBDCs are digital money controlled by a government and/or central bank, it comes with significant downsides.

CBDCs have the disadvantage of further centralizing money and preserving banking institutions’ oligopoly power. CBDCs give central banks near-complete control, unlike cryptocurrencies, which aim to democratize and decentralize finance. Greater central bank surveillance and control come at the cost of privacy and transactional anonymity. Theoretically, every transaction could be monitored, recorded, analyzed, and taxed using central banks’ new digital toolkits. It would also improve control over an ordinary citizen’s access to the financial system, mainly if the citizen engages in behavior that central banks may deem hazardous.

Privacy would also be a consideration, as the central bank would have at least some information about CBDC users and the ability to track every transaction.

CBDCs would also take time to gain traction. In the interim, some people would be unable to use digital currencies due to a lack of necessary resources or accessibility. Others might be wary of digital currencies because they do not trust them.

Modern monetary theory, or MMT, proposes that the government can run a budget deficit and distribute monies directly to citizens to alleviate economic pain during downturns without worrying about the national debt. Inflation is the most apparent hazard in this concept.

The most alarming feature of CBDCs is the potential politicization of MMT for partisan purposes rather than a more independent central bank approach to monetary policy that is separate from fiscal policy.

For so-called “behavior crimes,” social credit scores in China stopped 23 million people from purchasing plane and train tickets in 2018. Consider how central banks could use their greater capacity to control accounts due to the CBDC rollout to create comparable systems to punish businesses or consumers for unsavory behavior.

What would prevent central banks from abusing this power by collaborating with state security or political officials to seize customer monies for otherwise legal purposes? CBDC implementation might easily result in a dystopian, “Black Mirror” style approach to policing society.

Another potential disadvantage to consider is bank runs. Traditional banks may see significant deposit outflows if anyone may open an account with a central bank and deposit CBDCs (perhaps without fees or transfer costs, as in a regular bank).

The Bottom Line

CBDCs are in my opinion, a foregone conclusion, as global digitization necessitates and pushes the central bank towards innovation. The advantages for central banks are clear:

  • Tighter control
  • Complete tracking and monitoring capabilities
  • The ability to quickly execute monetary policy measures
  • The ability to fight fintech and financial institutions’ expanding impact

However, there is a downside to these creative technologies. They rely on faith and trust in a central bank and other government agencies not to abuse their newly acquired power.

Sure, CBDCs have their benefits, but with no governance in place, what will be left to defend the people these institutions are intended to care for and protect from state-sponsored overreach? Despite CBDC benefits and risks, central banks will have no choice but to get involved in the digital world; otherwise, decentralization would upend the structures and institutions they will spend every last fiat note fighting to preserve. Central banks need to jump in with CBDCs to play defense against the rising tide of Bitcoin and cryptocurrencies.

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This content is for educational purposes only. It does not constitute trading advice. Past performance does not indicate future results. Do not invest more than you can afford to lose. The author of this article may hold assets mentioned in the piece.


George Sarantopoulos is the CEO and founder of Access One Solutions, a leading payments provider based in NY. As a serial entrepreneur he is constantly thinking and writing about the future of money, business, politics and his next business.

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