The adoption of cryptocurrency is increasing globally despite the fact that many governments have turned their back against it.

Central bank digital currency (CBDC) has been introduced by the governments of some of these countries. Some of the central banks that have launched their CBDCs include the Central Bank of the Bahamas (Sand Dollar) and the Central Bank of Nigeria (eNaira). Others include the bank of Jamaica (JamDex), the Eastern Caribbean Central Bank (DCash), and so on.

CBDCs are seen as less risky alternatives to cryptocurrencies which are highly volatile. CBDCs however have things in common with cryptocurrencies; they are digital currencies and not like physical currency.

In this post, we’ll learn about the Central bank’s digital currency (CBDC), how they work, and its benefits.

What is a Central Bank Digital Currency (CBDC)?

Central bank digital currencies are digital tokens, similar to cryptocurrency, issued by a central bank. They are pegged to the value of that country’s fiat currency.

For example, the eNaira is a Central Bank of Nigeria-issued digital currency that provides a unique form of money denominated in Naira.

Many countries are developing CBDCs, and some have even implemented them. Recently, the Russian government announced that it’ll launch its own digital currency (ruble) in 2024.

A CBDC is a high-security digital instrument; like banknotes, it is a means of payment, a unit of account, and a store of value. And like paper currency, each unit is uniquely identifiable to prevent counterfeiting.

In this case, digital fiat currency is part of the base money supply, together with other forms of the currency.

How Does CBDC Works?

CBDCs are fiat currencies issued by the central bank of a nation digitally. It is considered a form of legal tender that can be used to exchange goods and services.

The distrust in financial institutions especially in regions like Africa has made many turn to cryptocurrencies. Crypto, which is run on blockchain technology is decentralized and unregulated. They cannot be duplicated or counterfeit. CBDC is therefore alternative to this system although blockchain technology might not be employed here.

Some nations of the world that have labeled crypto ‘illegal’ due to the risk attached to it have made moves to launch their own digital currencies.

Related- Will Cryptocurrency Ever Replace Fiat Currency?

When, and if, they are implemented, these currencies would have the full faith and backing of the government that issued them, just like fiat money.

Types of Central Bank Digital Currencies (CBDCs)

There are two types of Central bank digital currencies. They are the wholesale and the retail CBDCs. They are discussed below.

1. Wholesale CBDCs

The wholesale CBDCs are primarily used by financial institutions and not individuals.

The wholesale CBDCs work like holding reserves in a central bank. In this case, the central bank grants an institution an account to deposit funds or use to settle interbank transfers.

They can then use monetary policy tools such as reserve requirements or interest on reserve balances to influence lending and set interest rates.

2. Retail CBDCs

Retail CBDCs are used by consumers and businesses, much like physical forms of currency.

The retail CBDCs are of two types. They differ in how individual users access and use their currency. There are token-based retail CBDCs that are accessible with private/public keys. This method of validation allows users to execute transactions anonymously.

The other type is the account-based retail CBDCs that require digital identification to access an account.

What are the Benefits of CBDCs?

Central bank digital currencies are still in their developmental stage. As many nations are planning to launch their own CBDCs, there are many advantages that could be derived when implemented. Here are the benefits and impacts of the CBDCs.

1. Technology Efficiency

CDBCs will benefit from digital technology, thereby making money transfers and payments to be made in real-time, directly from the payer to the payee.

The technology efficiency will help reduce or eliminate transaction fees that come with using payment systems like MasterCard, Visa, etc.

Just as with cryptocurrencies, transactions with government-issued digital fiat currencies would be faster.

2. Prevent Illegal Activity

A CBDC makes it feasible for a central bank to keep track of the exact location of every unit of the currency.

This tracking can be extended to cash by requiring that the banknote serial numbers used in each transaction be reported to the central bank. The tracking makes it difficult to avoid/evade tax as well as helps to combat cybercrime.

3. Proof of Transaction

A digital record exists to prove that money changed hands between two parties. This avoids problems inherent to cash such as short-changing, cash theft, and conflicting testimonies.

4. Safety

Digital payment instruments boost confidence in privately controlled money systems and increase trust in the entire national payment system. This will also boost competition in payment systems.

This is achievable via secure and standard interoperable digital payment instrument issued and governed by a Central Bank.

There is also financial safety as CBDC would limit the practice of fractional reserve banking and potentially render deposit guarantee scheme less needed.

5. Protection of Money as Public Utility

Cryptocurrencies are enjoying massive adoption recently. Bitcoin was created as an alternative to traditional currency and has enjoyed success in achieving that.

CBDCs would therefore provide a modern alternative to physical cash – whose abolition is currently being envisaged.

Any Risk with CBDCs?

Despite having potential advantages, there are also risks associated with central bank digital currencies. One of the disadvantages is that depositors would shift out of the banking system.

As they are not run on blockchain technology, they are therefore centralized. This means that the controllers of the issuance of CBDCs can add or remove money from anyone’s account with a flip of a switch. This is one advantage cryptocurrencies have over CBDCs.

The Bottom Line

A CBDC is issued and regulated by a nation’s monetary authority or central bank. It is the digital form of a country’s national currency. Many nations are developing their own CBDCs which promote financial inclusion and simplify the implementation of monetary and fiscal policy.