Klaus Vedfelt/Getty
A central bank digital currency (CBDC) is a form of electronic money that is issued and controlled by a monetary authority. Unlike cryptocurrencies, which rely on decentralized networks, CBDCs are centralized.
Like the US dollar and other regular currencies, CBDCs derive their value from the trust and faith that individuals have in the governments that issue them. The dollar and other so-called fiat currencies can be used as legal tender because their issuing governments have authorized it.
CBDCs are different from cryptocurrencies like bitcoin and ether since they are centralized, while cryptos rely on decentralized networks. Further, most cryptocurrencies use distributed ledger systems known as blockchains, while CBDCs don't necessarily require this technology.
Although a handful of nations had developed them as of mid-2022, CBDCs remained largely in the research and experimental stages.
CBDCs can be structured in different ways, depending on their intended use. One kind is called a wholesale CBDC, which financial institutions would use to make and settle transactions with each other. Market participants would potentially use wholesale CBDCs to make cross-border transactions, possibly simplifying the process by reducing the number of parties involved.
Another type is called a retail CBDC, which would be available to everyone. In this case, individuals and businesses would have digital fiat currency, which would function as a direct claim on the issuing central bank. This approach would differ from the traditional model, where the digital money held by depositors would represent a claim on an intermediary, like a commercial bank or non-bank payment service provider (PSP).
A third possibility is a hybrid model, in which financial institutions would take responsibility for many crucial functions, for example executing retail transactions, setting depositors up with accounts and enforcing any relevant regulations, while central banks would retain information on the account balances of all the aforementioned account holders.
In this case, the central bank would have the ability to step in and function as an intermediary should a bank or non-bank PSP be unable to make a transaction.
While CBDCs could harness blockchain technology to record transactions, several central banks have emphasized that it may not be necessary for digital fiat currencies to use this technology. Distributed ledgers have their own strengths and weaknesses, which could cause policy makers to look to other options.
Several jurisdictions used CBDCs as of mid-2022, including seven Eastern Caribbean countries, Nigeria, Jamaica and The Bahamas, according to figures provided by The Atlantic Council's CBDC tracker.
Further, over 90 more countries have looked into these digital fiat currencies, additional Atlantic Council data shows. Of these, 15 are conducting pilots, including China, Russia, Saudi Arabia and Sweden.
Central banks are developing these digital fiat currencies to achieve multiple objectives. Researchers and industry participants have noted that they could create a more resilient payment system, make cross-border transfers faster and less expensive, and offer greater inclusion by extending financial services to people who live in remote areas or don't have bank accounts.
Further, CBDCs could give policy makers real-time access to financial transactions. Armed with information on specific sectors and their activity, these government officials could provide more precise policy solutions. They could also use the information to combat financial crime.
"The benefits of a CBDC are certainly potentially valuable to both governments and users," says Budd White, co-founder and chief product officer of crypto regulatory software firm Tacen. "Payments will be seamless and cheap. Users could use their phones for just about any purchase."
Central banks could also possibly use CBDCs to set interest rates on an individual, rather than national level, which would bring a lot of efficiency to national economies, White says.
In addition to the appeal of these benefits, some believe central banks are exploring CBDCs in response to the proliferation of cryptocurrencies. Government-issued digital fiat currencies could potentially compete with cryptocurrencies, which largely rely on decentralized networks and can be challenging to regulate.
"I certainly think central banks see crypto as a threat and, therefore, will hasten the implementation of CBDCs," White says.
CBDCs have several key characteristics that differentiate them from cryptocurrencies. The key distinction is that they are issued by a monetary authority and therefore centralized, while cryptocurrencies are created privately and rely on decentralized networks.
Another major difference is that some cryptocurrencies, such as monero and zcash, are specifically designed to provide users with privacy. Market experts, industry participants, and digital currency enthusiasts have raised concerns about how CBDCs could significantly reduce privacy by recording consumer transactions.
Cryptocurrencies | CBDCs |
|
|
The Federal Reserve has put effort into researching CBDCs, and Fed Chair Jerome Powell has repeatedly spoken on the matter. He emphasized earlier this year that the central bank would not implement a digital dollar "without support from Congress."
The Fed published a discussion paper in January 2022, stressing that the financial institution's "policymakers and staff have studied CBDC closely for several years."
The document looked at various digital assets, including cryptocurrencies and stablecoins. It also discussed the state of the US payment system, including its challenges. It mentioned, for example, that many more than 5% of Americans lack bank accounts.
The report also highlighting the risks, benefits, and uses for CBDCs. When issuing the document, the Fed asked 22 specific questions and gave interested parties an opportunity to provide input. This resulted in more than 2,000 pages of comments.
In June 2022, Powell told lawmakers tha the Fed plans "to work on both the policy side and the technological side in coming years and come to Congress with a recommendation at some point."
While CBDCs could provide consumers and governments with multiple benefits, there also potential drawbacks.
A CBDC would give policy makers greater insight into economic activity. For instance, they could use information about transactions to get a better sense of which specific business sectors would be most in need of government stimulus. They could also use it to prevent financial crime.
However, critics are worried that allowing officials to harness this much data about economic activity would go too far in terms of reducing consumer privacy. Further, any infrastructure put in place for a CBDC would be vulnerable to cybersecurity threats. This would require any key stakeholders to perform substantial due diligence in order to manage such risks.
