What is a CBDC?
Central bank digital currencies (CBDCs) are digital tokens issued by a central bank. They are designed to replicate cryptocurrency but be pegged to the value of a country’s fiat money. While the value of a cryptoasset (like Bitcoin, Ethereum, or XRP) can fluctuate quickly, a CBDC will always be worth the same as its physical equivalent.
CBDCs can be considered a natural evolution of digital forms of payment. First came real-time gross settlement systems (RTGS), then faster payments systems (FPS). They offer a way for consumers to make digital payments instantly and through the central bank as an intermediary rather than a traditional financial institution.
There are two types of CBDC:
- Wholesale CBDCs
- Used by financial institutions to settle interbank transfers, set interest rates, and influence lending
- Retail CBDCs
- Used by consumers and businesses, acting like issued cash.
Within retail CBDCs there are a further two categories:
- Accessible with private keys, allowing users to transact anonymously
- Require digital identity verification, similar to a traditional online or mobile bank account
What are the benefits of wholesale CBDC?
A wholesale CBDC would replace or supplement reserves at a central bank with a restricted-access digital token. The token would act as a bearer asset, meaning the transaction could occur without intermediaries. This replaces the existing system whereby a central bank debits and credits accounts without transferring actual values.
This change is popular among central banks due to the potential for faster, inexpensive, and safer wholesale transactions. If financial instruments were to be available in a tokenised format, CBDCs would allow an end-to-end settlement in tokens. This would take the form of token-for-token swaps, which provide instant payment.
Similarly, the applications of wholesale CBDCs in cross-border transactions haven’t been overlooked. The European Central Bank has called CBDCs a “holy grail” for cross-border payments.
What are the benefits of a retail CBDC?
While physical currency is still widely used and accepted worldwide, consumer preferences have largely shifted away from it. A CBDC seeks to supplement a nation’s existing cash availability with a digital equivalent.
In both developed and developing nations, financial inclusion is key. Those outside of the traditional financial system – the unbanked and underbanked – often have few ways to interact with the wider economy. Proponents of cryptocurrency have often stated that it offers a way to “bank the underbanked” as users have no need to go through an intermediary that may demand identification, proof of address, or other documents.
CBDCs could be seen as a challenge to that idea, enabling small traders, workers in the gig economy, and others to hold sums of digital money as they would cash in their wallets, and exchange that CBDC in much the same way, without having to deposit or withdraw from a bank.
Another argument for CBDCs focuses on reliability. Traditional banks can – and have – experienced periods of difficulty resulting in an inability to properly serve their customers. This can come from payment outages, lack of funds, or even insolvency. In these situations, a customer has nowhere to turn. A reserve of CBDC allows these customers a backstop to turn to.
What is the future of CBDCs?
At the time of writing, more than 80 countries are investigating the application of CBDCs. These include:
- India launching a digital rupee by the end of 2023
- Sweden developing e-krona as an answer to an increasingly cashless society
- The US piloting a CBDC to improve domestic payments
- The Bank of England launching a retail CBDC pilot in September
It is important to stress that CBDCs are envisioned as a complement to, not competition for, the traditional banking sector. Most believe that this digital money shouldn’t be relied on as a storage of value for central banks. Instead, it should be a vector through which greater financial inclusion can be achieved.
Pismo has investigated what a CBDC-led future may look like. In our in-depth research into the sector, we analysed just how both retail and wholesale CBDCs could sit alongside the existing banking system. Is it harmony or discord, and does it provide true financial inclusion and ease of use?