Most countries now recognize that the digitalization of the financial sector also requires exchangeable money. More than 114 governments are working on their central bank digital currencies to counter Bitcoin and other decentralized solutions. The big difference with classic cryptocurrencies is that these CBDCs (short for central bank digital currency) give the government the question of how to purchase cryptocurrency and a high degree of control over digital money.
The world’s central banks are cautiously approaching the topic of Central Bank Digital Currency (CBDC) to equip the financial system with new possibilities and functions and to create an alternative to private (crypto) currencies. At the same time, the first available CBDC promises significant first-mover advantages to the issuing central bank and thus to the associated country (“first mover advantages”). This creates a conflict: implementation decisions must be well-considered, while simultaneously, a race to be the first central bank to launch a Central Bank Digital Currency emerges.
What are CBDCs?
In contrast to a cryptocurrency, central bank digital currency (CBDC) is digital significant bank money with the same exchange properties as the familiar fiat money. In this context, CBDC forms a third form of central bank money alongside cash (banknotes and coins) and fiat money (reserve). The critical difference between CBDC and cryptocurrencies, mostly issued by private organizations (not banks), lies in their fungibility. While CBDC acts fungible with other central bank monetary liabilities, private cryptocurrencies mostly have a flexible or fixed exchange rate against fiat currency. Further, CBDC is legitimate and significantly less volatile than distributed ledger technology (DLT)-based cryptocurrencies typically are.
CBDCs reduce the cost of raising money, and payment transactions between machines – initiated via intelligent contracts – become legally secure and can be broken down into minor value units (micropayment). Money laundering becomes virtually impossible. Centralized IT solutions already enable transfers here. However, a standardized ecosystem based on DLT offers many advantages. In particular, this allows the execution of step-by-step transactions in which performance and consideration or payment are made simultaneously. Until now, this has not been easy to map digitally and has often required the involvement of trusted third parties as trustees or guarantors.
To be able to define meaningful areas of application, you should know the basic variants of Central Bank Digital Currency:
- Account-based CBDC is when individuals’ accounts are deposited with a central or commercial bank holding the values assigned to customers.
- In contrast, a value- and token-based CBDC creates a value token as a means of payment, which is used in the real economy and can be transferred as an asset on the DLT network.
Here, the critical difference between token-based and account-based systems is the transfer of value between the parties. While account-based CBDCs know concrete account balances that are updated after each transaction, matter- and token-based CBDCs use definite assets that are transferred on the DLT network and can be assigned to precisely one wallet (digital wallet) at any given time. Account balances and the charging and settling in the course of transactions are thereby eliminated.
Central bank digital currencies could become a new legal tender with universal use and peer-to-peer transaction capability. Features of central CBDCs?
- CBDCs would have the same value as equivalent physical currencies, but they could be used in other ways, such as smart cards or cell phones. The appropriate government intervention would be behind it as a guarantor. “CBDC would give the entire population access to secure and stable payment facilities with no transaction fees,” Herborg says.
- From the end consumer’s perspective, CBDC would give everyone the freedom to pay for something directly, anywhere, and in any situation or to transfer money to another person because everyone would have to accept CBDC just like cash. It won’t require a bank account, and transaction costs will be much lower than with current mobile solutions.
- CBDCs can provide affordable and hassle-free payments, from smart cards to intelligent cards or devices, without a third party, such as a merchant card provider. Imagine two people using a small device to transfer money between two payment cards, even in the middle of nowhere, without a middleman.
How exactly will CBDCs work? The technical details are still being worked out, and whether decentralized registry technology or blockchains will be used is unclear. They should also be less energy intensive than Bitcoin.
Where CBDC is already used
Nigeria became the first African country to implement CBDC in October 2021. Maira should help in the long run with financial inclusion and strengthen the country’s economic strength. To this end, the Nigerian central bank issued three billion nairas, and local banks have integrated the corresponding payment infrastructure.
China is at the forefront of CBDC development. The introduction of the electronic yuan as a public payment instrument has yet to be completed, but in 2019, the PRC launched a large-scale pilot project. The People’s Bank of China program has up to 260 million digital wallets. In August 2020, the test project was expanded to 28 major cities.
In May 2022, Jamaica became the first country in the world to introduce a central bank digital currency as a public tender, the digital Jamaican dollar called Jam-Dex. It aims to reduce the cost of storing and handling cash by about $7 million annually.
But the introduction of Central bank digital currencies carries certain risks. If there is a mass withdrawal of bank assets, banks’ liquidity reserves in the form of central bank reserves could be threatened by an outflow of deposits from the banking system to the central bank (abandonment of intermediation in the banking sector). In the worst case, bank insolvency could loom. In extreme cases, banks can become pure intermediaries and no longer create money through lending. However, an inevitable shift of customers from bank money to CBDC is necessary so that CBDC can eventually be used for transactions. In this respect, it should be ensured that disintermediation could be better when banks face financial difficulties.
Therefore, many countries are wary of innovation changes and are in no hurry to introduce electronic money. The system has to go through a test regime and take into account all the risks.
The interest and projects around CBDC are a prominent example and proof that distributed ledger technology is no longer in its infancy but has become a technology to be taken seriously. Those who are now looking at the potential and ecosystem of decentralized systems and multiparty solutions such as DLT can proactively discover value-creation opportunities and partnerships with technology and business partners. Enterprises, banks, and financial institutions must prepare for the advent of DLT and the resulting business transformation to create a competitive advantage and avoid falling into a reactive cryptocurrency market position.