Cody McGrath 
Central bank digital currencies, or CBDCs, are virtual currencies backed and issued by a central bank. As cryptocurrencies and stablecoins become more popular, central banks around the world have realized that they must provide an alternative to physical money or risk losing the future of money.
Thousands of digital currencies, often known as cryptocurrencies, have been created.
Cryptocurrencies can be centralized, but the government doesn’t issue them – think of the Diem project launched by Facebook.
However, Bitcoin and its competitors are examples of decentralized cryptocurrencies.
Cryptocurrencies are based on distributed ledger technology (DLT), which means that the accuracy of a transaction is constantly validated by devices around the world rather than a single central hub.
The CBDC is managed on a digital ledger (which may or may not be a blockchain), streamlining and securing payments between banks, institutions, and individuals.
Digital currencies issued by central banks are currently one of the most revolutionary innovations in the global financial ecosystem.
There have been many questions in the financial world about Crypto vs. CBDC. Let’s look at different concepts surrounding CBDCs and a comparison between cryptocurrencies and central bank digital currencies.
What is the purpose of CBDCs?
Cryptocurrencies have been heralded for their ability to usher in a new era of global financial inclusion and simplified financial services infrastructure.
However, its importance derives from its status as a store of value rather than a medium of exchange.
This gap is gradually closing as monetary authorities and commercial corporations issue stabilized cryptocurrencies and CBDCs as viable conventional payment options.
However, the core concept of a digital currency (replacing the need for paper notes and coins with computer-based money-like assets) has been around for more than a quarter-century. Central bodies were the first to issue digital currencies such as DigiCash in 1989 and E-Gold in 1996.
However, the introduction of Bitcoin in 2009 significantly changed this model in two ways: it established a decentralized (blockchain-based) ledger for executing transactions and keeping records, and it created a (now widely used) currency, which is independent of any authority.
The growing importance of digital money during the COVID-19 pandemic, the shift to digital payments, ambitions to use foreign CBDCs in cross-border remittances, and concerns about financial exclusion are drawing the attention of CBDCs.
As a result, competition to provide the first real version of digital money is intensifying among the world’s leading central banks.
For example, China is experimenting with a digital renminbi that will allow users to make payments using their cell phones.
Likewise, Europe announced the creation of a digital euro as part of the five-year plan. The pandemic has accelerated the transition to contactless transactions, emphasizing the importance of everyone having access to secure, fast, and affordable payments.
The Federal Reserve is also accelerating its research and public engagement on central bank digital currencies in light of technology platforms integrating private digital money into the US payments system and foreign agencies exploring the potential of CBDCs in cross-border payments.
According to various public statements, CBDCs appear to be more than just a digital native replica of traditional banknotes and coins.
Some governments see CBDCs as programmable money—monetary and social policy vehicles that can limit their use to basic needs, specific areas, or defined time periods—solving the challenge of broader financial inclusion.
CBDC can take many forms, each with different implications for payment systems, monetary policy transmission, and the structure and stability of the financial system.
Key features of CBDCs
A CBDC must have an instrument, system, and institutional features.
Instrument features:
- Convertible: CBDCs should be of the same value as a country’s local currency
- Accepted and available: A CBDC should allow people to make online and offline payments
- Low cost: CBDCs should be of low or no cost to users
System features:
- Secure: Cyberattacks, hacking, and other threats should be extremely difficult or impossible to penetrate a CBDC’s security
- Instant: Users of CBDCs should enjoy instant or near-instant final settlements
- Uptime: A CBDC must never experience downtime or disruptions in operations
- Scalable: CBDCs must make provisions for large future transaction volumes
Institutional Features
- Robust legal framework: A Central Bank’s issuance of a CBDC should be based on unambiguous authority
- Standards: A CBDC will have to meet the necessary regulatory requirements
The money flower concept
The money flower refers to the taxonomy of money in the form of a Venn diagram.
It focuses on the interactions of four main components:
- Issuer (central bank)
- Form (digital or physical)
- Accessibility (general or restricted)
- Technology (token or account-based)
Money is usually based on one of two technologies: tokens or accounts of value. Cash and many digital currencies are token-based, while reserve account balances and most types of commercial bank money are account-based.
The type of verification required when exchanging tokens versus account-based cash is a key differentiator.
The ability of the payee to verify the legitimacy of the object of payment is crucial for token-based money (or payment systems). In contrast, account money systems rely heavily on account holder ID authentication.
At the center of the money flower is digital central bank money. CBDCs are classified into three types according to taxonomy (the dark gray shaded area). Token and account-based forms are available.
The two token-based variants differ in who has access, determined by the future use of the CBDC. A is a payment instrument commonly used mainly for retail transactions, but it can also be used for other purposes.
The other is a restricted-access digital settlement token for wholesale payment and settlement activities. They are called general-purpose tokens and wholesale-only tokens, as explained in the following sections.
Types of CBDCs
The development of a general-purpose or wholesale CBDC can support payment, clearing, and settlement systems in a number of ways.
General-purpose CBDCs
The term “general purpose CBDC” refers to a CBDC that is distributed to the general population. Anonymity, traceability, 24/365 availability, and the feasibility of an interest application are elements of the DLT-based retail CBDC.
This idea is gaining traction with central banks in emerging markets as they spearhead the fast-growing fintech sector, looking to promote financial inclusion by accelerating the transition to a paperless society and reducing the cost of printing and handling currency.
Wholesale CBDCs
A wholesale CBDC is intended for banks holding reserve deposits with a central bank. It could be used to increase the efficiency of securities payments and settlements and reduce counterparty credit and liquidity risks.
With a restricted-access digital token, a value-based wholesale CBDC would replace or supplement central bank reserves.
A token would be a bearer credit, meaning that the sender would transfer the value directly to the recipient throughout the transaction without an intermediary.
That would be a marked departure from the current regime, under which the central bank debits and credits people’s accounts without actually moving any money.
Wholesale CBDC is the most popular concept among central banks due to its potential to improve existing wholesale financial systems faster, cheaper, and more securely.
Therefore, in the previous discussion, we covered the different types of central bank digital currencies (CBDC). The infographics below explain the distinction between retail and wholesale CBDCs.
Which countries have a CBDC?
Prior to COVID-19, central bank digital currencies were primarily a theoretical exercise. However, with the need to introduce massive monetary and fiscal stimulus around the world, as well as the rise of cryptocurrencies, central banks quickly realized that they cannot afford to miss out on the development of money.
According to the Atlantic Council, 81 countries (representing over 90% of global GDP) have considered establishing a CBDC. As of May 2020, only 35 countries were exploring a CBDC.
China is ahead of the game, allowing foreign visitors to use the digital yuan to submit passport information to the People’s Bank of China for the upcoming Winter Olympics.
The United States Federal Reserve is the furthest away from the other major central banks, the European Central Bank, the Bank of Japan, and the Bank of England.
A digital currency has already been fully introduced in five countries. The first CBDC to become widely available was the Bahamas sand dollar.
Fourteen nations, including major economies such as Sweden and South Korea, are currently testing (i.e. piloting) CBDCs for full adoption.
CBDC vs Cryptocurrency
Digital currencies issued by central banks are often confused with other types of cryptocurrencies.
As mentioned earlier, with central bank digital currencies, central banks are at the heart of all transactions.
However, cryptocurrencies like Bitcoin are digital tokens created using cryptographic methods by a distributed network or blockchain.
Cryptocurrencies use permissionless (public) blockchains, while CBDCs use authorized (private) blockchains.
Anyone can participate and participate in the essential operations of the blockchain network on a public blockchain.
The ongoing operations on the public blockchain network can be read, written, and audited by anyone, which helps a public blockchain preserve its autonomous nature.
A private blockchain, on the other hand, is a distributed ledger that acts as a closed and secure database based on cryptographic concepts and is not decentralized.
Restrictions on CBDC networks are set by a central bank. Authority is assigned to the user base in cryptographic networks, who make decisions when they reach consensus.
So while cryptocurrencies are decentralized, CBDCs are centralized. In addition, cryptocurrencies offer anonymity; CBDCs allow central banks to see who owns what.
CBDCs are more likely to run on different technology platforms than cryptocurrencies, which are generally built using blockchain.
CBDCs are also not stablecoins, i.e. currencies pegged to a fiat currency like the US dollar. A CBDC would not be pegged to a fiat currency; Rather, it would be the fiat currency itself. For example, a CBDC dollar bill would be identical to a dollar bill.
CBDCs can only be used for payment, and any storage or investment is strictly prohibited. However, cryptocurrencies can be used for both financial transactions and speculative purposes.
Compared to cryptocurrencies, a CBDC would be less concerned about data and privacy. The cryptocurrency industry is undoubtedly autonomous with a peer-to-peer paradigm while certain restrictions bind central banks.
Users can choose how much and what type of data they want to disclose since cryptocurrencies are peer-to-peer. On the contrary, CBDC transactions will automatically send large amounts of data to tax and regulatory authorities.
How are CBDCs different from Bitcoin?
Bitcoin may have been the first cryptocurrency to gain widespread adoption, and it certainly dominates blockchain and cryptocurrency discussions, but it’s just one of the thousands of crypto assets available.
Bitcoin’s appeal, usefulness, and principles have not been weakened or diminished by the emergence of different cryptocurrency variants.
Instead, the growth of stablecoins, CBDCs, and other blockchain and cryptocurrency-related applications has improved the overall health of the ecosystem.
The Bitcoin ecosystem offers a glimpse into an alternative financial system where transaction terms are not dictated by onerous regulations.
Bitcoin, founded in 2009, is one of the most popular cryptocurrencies in the world. Bitcoin does not represent tangible currencies that change hands.
Transactions are traded and recorded in an encrypted public ledger that anyone can access.
All transactions can be validated through the mining process. Banks or governments do not support Bitcoin.
CBDCs should be used as a replacement for fiat currencies. The idea is to offer consumers the ease and security of digital circulation, as well as the regulated and reserve-backed circulation of the traditional banking system.
They are intended to serve as a store of value, a unit of account, and a medium of exchange in everyday transactions.
CBDCs as fiat currency is backed by the full confidence of the issuing government. The central banks or monetary authorities are fully responsible for their operations.
Advantages and disadvantages of central bank digital currencies
Advantages
- CBDCs facilitate the implementation of monetary policy and government functions. They use wholesale CBDCs to automate the process between banks and retail or general-purpose CBDCs to connect customers and central banks directly. Other government services, such as benefit distribution and tax calculation and collection, can benefit from these digital currencies by reducing labor and processes.
- The money is paid out through intermediaries, which means that the transaction involves a third-party risk. What happens when the bank’s cash deposits run out? What if a bank run occurs due to a rumor or an external event like a financial crisis? Such events can upset the delicate balance of a monetary system. A CBDC eliminates the risk of a third party as the central bank is responsible for any risks remaining in the system.
- In a CBDC system, privacy characteristics can be calibrated. A value-based retail CBDC works like currency and protects personal information by keeping transactions anonymous. Account-based access to CBDCs, on the other hand, works like a traditional bank account and may include privacy protections.
- CBDCs can prevent illegal activity because they are stored digitally and do not require serial number tracking. A central bank can easily track money across its jurisdiction using cryptography and a public ledger, prohibiting criminal activity and illegal CBDC transactions.
- The cost of creating the banking infrastructure needed to access the financial system is one of the barriers to financial inclusion for large segments of the unbanked population, particularly in developing countries. CBDCs can provide a direct link between customers and central banks, eliminating the need for expensive infrastructure.
Disadvantages
- CBDCs are not always the answer to the centralization problem. The power to conduct transactions is still delegated and conferred to a central authority (ie the central bank). As a result, it still influences data and transaction levers between citizens and banks.
- Since the admin is responsible for collecting and disclosing the digital IDs, users would have to give up some privacy. Each transaction would be visible to the service provider. This can create privacy concerns akin to those of IT giants and internet service providers (ISPs). For example, criminals can hack and misuse information, or central banks can ban citizen-to-citizen transactions.
- CBDCs can help with cross-currency and cross-border payments that are not constrained by working hours or holidays in multiple time zones. Different legal and regulatory frameworks, on the other hand, create a significant barrier to cross-border payments. It would be a challenge to bring these structures together.
- CBDCs can have unintended effects on the forex markets. For example, China’s CBDC will threaten the dollar’s dominance: if the digital yuan becomes the main means of payment in China, global companies will be forced to use it for their business, potentially affecting the dollar’s role.
Conclusion
CBDCs would disrupt the current fractional reserve system and allow commercial banks to create money by lending more than they have in liquid deposits. Deposits are required by banks to make lending and investment decisions.
Traditional banks would have to become “loan fund brokers” and lend long-term funds to fund long-term loans like mortgages if all private bank deposits were transferred to CBDCs.
A tightly knit banking system, overseen primarily by the central bank, would replace fractional reserve banking. That would be tantamount to a financial revolution – with countless benefits. Central banks would be significantly better equipped to avoid bank runs and monitor private banks’ risky lending/lending decisions.
A well-designed CBDC will be a secure and unbiased payment and settlement asset, acting as a common interoperable platform for organizing the new payments ecosystem. It will enable an integrated open finance architecture that welcomes competition and innovation. It will also maintain democratic control over the currency.