What is a central bank digital currency (CBDC)?

Key takeaways

• A CBDC is a digital form of money issued and controlled by central banks in different countries. 
• Central banks want to use CBDCs to modernize financial systems and improve how people transact.
• There are two types of CBDCs, retail and wholesale, each serving different purposes.
• Cryptocurrencies operate on decentralized systems, whereas CBDCs are centralized digital currencies regulated by governments.
• The pros of CBDCs include enhanced financial inclusion and efficiency, while the cons involve privacy concerns, cybersecurity risks and implementation challenges.

Central bank digital currencies (CBDCs) are a new form of digital currency that some governments are considering rolling out to support and supplement their own money and financial systems. 

Similar in their digital nature to cryptocurrencies like Bitcoin (BTC), they operate as a way to transfer value over the internet. But, unlike Bitcoin, which has no central controlling body, CBDCs are made, distributed and monitored by governments and their central banks. 

CBDCs offer benefits such as faster, easier and more modernized payments and increased financial inclusion. But, they also raise potential risks, particularly around privacy and cybersecurity. 

Countries like the Bahamas, China, Jamaica, Nigeria and the United Kingdom are already exploring CBDCs. It’s part of their big plan to modernize money for their citizens, making it important to understand the basics and realize the implications of CBDCs.

This article explains what CBDCs are and what they are not. It also discusses the benefits for governments and people, the challenges they face, and how they might affect the future of finance.

Central bank digital currency, explained

Imagine the Bank of England (BoE) — the UK’s central bank — decided to create another form of money besides notes and coins. The average person would never touch or feel this digital British pound, but it would operate in a similar way as funds on a debit card. This is what a CBDC would look like — and it’s something the Bank of England is looking to do.

While a BoE CBDC would feel similar to digital funds on a debit card for everyday citizens, it has several functions that existing funds, notes and coins do not.

Commercial banks may be able to track your transactions, but they still offer a high level of privacy. Physical cash, be it coins or notes, can be spent however you like, offering even more privacy and protection. However, the digital pound would have a ledger that tracks transactions and individual pounds, making it visible to governments and controlling bodies.

That said, CBDCs are part of the exciting world of financial technology (fintech). They leverage digital innovations like cryptocurrency and blockchain to improve financial services and make transactions faster and more efficient. 

This move isn’t just about convenience; it’s about including people without access to bank accounts in the financial system. CBDCs and their digital wallets can operate entirely on smartphones, meaning people excluded from everyday financial services who can’t get to banks or acquire debit and credit cards can be welcomed into this new, entirely digital system. It could open up new possibilities for how we use and think about money.

Did you know? The Bahamas launched one of the first fully operational retail CBDCs, the Sand Dollar, in 2020.

Why are central banks considering issuing CBDCs? 

Central banks are exploring CBDCs for several reasons. One key motivator is the rise of stablecoins like Tether (USDT) and USD Coin (USDC). Stablecoins are digital currencies tied to stable assets, such as the US dollar, where one digital coin can be redeemed for 1 US dollar.

Another push comes from the rise of cryptocurrencies like Bitcoin. These digital assets operate outside traditional banks, spurring central banks to explore digital currencies they want to regulate and control.

Additionally, CBDCs offer central banks a chance to modernize financial systems using digital technology. By potentially reducing costs and improving transaction security, CBDCs aim to meet the changing demands of users in an increasingly digital world. Central banks also seek to control monetary policy and improve their surveillance capabilities.

CBDCs vs. cryptocurrencies

Many people assume CBDCs are the same as cryptocurrencies, but this is not entirely true. CBDCs are like a controlled or regulated version of Bitcoin, but Bitcoin operates on a decentralized ledger, meaning no single entity can control it. On the flip side, CBDCs are centralized, meaning they’re under the watchful eye of a central authority, such as a country’s central bank. 

Both involve digital money. But, CBDCs offer more oversight and control compared to the decentralized nature of cryptocurrencies. 

CityLibrary vs. CommLibrary Example

To give a real-world example, Imagine a public library system run by the city government called “CityLibrary.” The city government funds and operates all the libraries in this system, which is centrally controlled by the city government. The city decides which books are available, tracks all borrowed books, and can change the rules for borrowing at any time. 

Now imagine a community library system called “CommLibrary” that is set up and maintained by volunteers from the community. There is no single entity in charge; instead, the community collectively manages it. CommLibrary is decentralized. The volunteers decide together which books to add and how to run the library. Any changes to the system require consensus from the community members, and people can take and return books whenever they want and however they want, anonymously. They just need to note the book has been taken out.

Borrowing books from CityLibrary is like using a CBDC, where the central authority controls the system and can monitor all activities closely. Borrowing books from CommLibrary is like using Bitcoin, where the community manages the system, and users have more privacy and control over their own actions.

The table below further summarizes the differences between CBDCs and cryptocurrencies:

How do CBDCs work?

Knowing that CBDCs are more controlled and regulated also gives insight into how they work. They take a very different approach than free-spirited cryptocurrencies like Bitcoin. 

Many central banks even skip using blockchain. Instead, they are opting for a centralized ledger system to manage CBDCs. A centralized ledger is simpler than a blockchain, but it still keeps a record of every transaction made with the assets and also stores more private information about the parties involved. This centralized set-up gives the central bank the power to oversee and regulate transactions involving CBDCs.

Understanding the rollout of a potential digital pound in the UK can help unpack the way CBDCs work:

• Step 1: The BoE creates digital pounds to complement Britain’s physical currency.
• Step 2: The BoE distributes digital pounds to commercial banks and financial institutions.
• Step 3: People and merchants acquire digital pounds through bank accounts or wallets.
• Step 4: People use digital pounds for everyday transactions. For instance, they can use them to buy goods or services in stores or online (as merchants also use this new money system).
• Step 5: Every transaction involving digital pounds is securely logged on the Bank of England’s digital ledger, keeping everything accurate and observable.

Now, whether CBDCs could one day eliminate physical cash entirely is a hot debate in the world of digital currencies.

Will CBDCs replace cash?

The idea that countries, or even the entire world, will only use CBDCs for money in the future seems far-fetched today. But it could happen, depending on how digital currencies develop and whether society accepts them. Similar to the shift from print to digital books, some people still value the feel of physical books. This is true even when digital solutions are more convenient and accessible.

Governments and consumers alike are drawn to CBDCs’ benefits, such as quicker transactions and financial inclusion. But, for CBDCs to really catch on, concerns like privacy and universal access would need to be addressed. Ultimately, whether cash sticks around or CBDCs steal the show will depend on the balance between privacy concerns and modernized money convenience.

Did you know? CBDCs can be designed to work offline, allowing for transactions even without internet connectivity.

Types of CBDCs

CBDCs typically come in two major forms: One designed for citizens to use alongside cash and digital funds, and the other designed to help inter-bank transfers.

• Retail CBDCs: Central banks issue digital currencies directly to the public and companies. Users can use these CBDCs for daily transactions, replacing physical cash.
• Wholesale CBDCs: Financial institutions use wholesale CBDCs for interbank transactions and settlement, aiming to improve efficiency in the financial system.

Let’s understand these two types using an example:

Consider that Bob pays for his coffee at a local cafe with retail CBDCs, exactly like he would with his debit card. Alice, on the other hand, works at a bank. She deals with wholesale CBDCs, bundles large sums of money into CBDCs and uses them for interbank transactions. 

Banks always need to have cash, or digital forms of cash, in reserve, and that is where these wholesale CBDCs come in as significant reserves of currency that banks use to maintain liquidity. Thus, Bob uses his CBDCs for regular purchases, while Alice uses hers to facilitate settling significant bank transactions.

Are CBDCs the same as digital funds?

Similarities have been drawn between digital funds in a bank account and CBDCs because they can work similarly. The difference is that a CBDC is a direct liability of the central bank, much like actual cash, whereas digital funds in bank accounts are a commercial bank liability. 

In other words, CBDCs can provide a more stable and secure type of digital currency because the government backs them. Commercial banks can fail and lose people’s money in their bank accounts, and this is another component of the existing system that central banks aim to change by rolling out CBDCs.

Which countries have implemented CBDCs?

Even with all the technology and experimentation with digital assets, no leading economy has rolled out a full CBDC yet. Yet, several countries are actively testing and developing their own versions.

According to the Atlantic CBDC Tracker, as of July 4, 2024, the status of CBDCs worldwide is as follows:

Take China, for example. It is leading the charge with its digital yuan, which is undergoing extensive trials in various cities across the country but is not yet fully rolled out. Meanwhile, the Bahamas has already launched the Sand dollar, its own version of a CBDC, for everyone from regular consumers to businesses.

Countries, including Sweden, the UK, India and various Caribbean nations, are also exploring the potential of CBDCs by conducting pilot programs. The trials help central banks understand how CBDCs could integrate with the existing financial system — it’s all about figuring out the technical, regulatory and user experience challenges involved.

After all, central banks want consumers to happily accept CBDCs and make sure that people like using them. This will mean striking the right balance between convenience and control, and full adoption will only come if CBDCs provide enough incentives. 

Did you Know? Sweden’s Riksbank is testing an e-krona as part of its efforts to keep up with the declining use of physical cash.

Benefits and drawbacks of CBDCs

Benefits

• Financial inclusion: CBDCs can provide access to financial services for unbanked or underbanked people.
• Payments efficiency: CBDCs can make transactions faster and cheaper, both domestically and internationally (cross-border).
• Monetary policy control: Central banks can use CBDCs to better manage and control the country’s money supply and interest rates, facilitating swift and successful economic adjustments.
• Combating financial crime: CBDCs allow central banks to track transactions to comply with Anti-Money Laundering legislation and combat financial fraud.

Drawbacks

• Privacy concerns: Increased tracking of transactions and surveillance can violate privacy rights.
• Cybersecurity risks: Being digital, CBDCs are vulnerable to cyberattacks.
• Implementation costs: It can be expensive to develop and maintain the CBDC infrastructure.
• Technical challenges: Ensuring the underlying technology used to develop CBDCs is robust and reliable isn’t easy.

Did you know? Some countries, like Denmark, have halted their CBDC projects. They concluded that existing payment systems are efficient enough, and the potential benefits of a CBDC did not outweigh the costs and risks.

The future of CBDCs

CBDCs taking off could mean upgrading the money game to the next level. Their widespread adoption could potentially change how people deal with money, providing advantages like better cross-border transactions and financial inclusion for those without bank accounts. 

But there’s a flip side, too. As CBDCs come into focus, concerns about security, privacy, and the role of conventional financial institutions persist. So, it’s important to stay in the loop with all these latest technological developments and adapt to the shifting digital finance landscape.

Written by Guneet Kaur