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Introduction to Central Bank Digital Currencies (CBDC)

  • Yashoda Gandhi
  • Apr 30, 2022
Introduction to Central Bank Digital Currencies (CBDC) title banner

CBDC is an abbreviation for Central Bank. The Reserve Bank of India issues digital currency as legal tender (RBI). "CBDC is the same as central bank currency, but it takes a different form than paper" (or polymer). It is sovereign currency in electronic form, and it would appear on a central bank's balance sheet as a liability (currency in circulation). 


The underlying technology, form, and application of a CBDC can be tailored to meet specific needs. CBDCs should be exchangeable for cash, according to the RBI website. In recent years, there has been a surge in interest in central bank digital currencies (CBDCs). 


The Committee on Payments and Market Infrastructures and the Markets Committee recently completed work on CBDCs, analyzing their potential implications for payment systems, monetary policy implementation and transmission, as well as the financial system's structure and stability.


What is CBDC?


A central bank issues digital currencies, which are similar to cryptocurrency. They are based on the value of the country's fiat currency. CBDCs are being developed in many countries, and some have even gone into effect. Because so many countries are experimenting with digital currencies, it's critical to understand what they are and what they mean for society.


CBDC is an abbreviation for Central Bank Digital Currency, which is an electronic form of central bank money that citizens can use to make digital payments and store value. A CBDC provides three main components:


  • A type of digital currency


  • The central bank issued these notes.


  • Universally available


Fiat money is a currency issued by the government that is not backed by a physical commodity such as gold or silver. It is regarded as legal tender and can be used to exchange goods and services.


Fiat money was traditionally issued in the form of banknotes and coins, but advances in technology have enabled governments and financial institutions to supplement physical fiat money with a credit-based model in which balances and transactions are recorded digitally.


Goal of CBDC


Many people in the United States and many other countries do not have access to financial services. In the United States alone, 5% of adults do not have a bank account. An additional 13% of adults in the United States have bank accounts but use costly alternative services such as money orders, payday loans, and check-cashing services.


CBDCs' primary goal is to provide privacy, transferability, convenience, accessibility, and financial security to businesses and consumers. CBDCs could also reduce the maintenance required for a complex financial system, lower cross-border transaction costs, and provide lower-cost options to those who currently use alternative money transfer methods.


Digital currencies issued by central banks would also reduce the risks associated with using digital currencies in their current form. Cryptocurrencies are extremely volatile, with their value fluctuating all the time. 


This volatility may cause severe financial stress in many households and jeopardize an economy's overall stability. CBDCs, which are backed by the government and controlled by a central bank, would provide a stable means of exchanging digital currency for households, consumers, and businesses.


Countries Experimenting CBDC


Here are some countries that are experimenting CBDC :


  1. Sand Dollar in the Bahamas


The Bahamas also started their CBDC project called "Sand Dollar'' in 2019; it will be fully operational in October 2020. The project began in two districts: Exuma and Abaco Islands. 


Each Sand Dollar is a digital variant of the Bahamian dollar, which is kept at a 1:1 peg with the US dollar. The project provides universal access to financial services and regulated payments.


  1. Sovereignty of the Marshall Islands


The Republic of the Marshall Islands announced plans to launch a CBDC called Sovereign in 2018. (SOV). The US dollar is currently legal tender on the island, owing to the island's small population of 58,729 people and the cost of printing cash outweighed the benefits. 


RMI intends to use SOV as an alternative digital currency as legal tender in order to improve the efficiency of RMI's current payment systems.


  1. E-krona in Sweden


The world's oldest bank, Swedish Riksbank, launched its e-krona CBDC project in 2017. A pilot was conducted from 2020 to February 2021 in collaboration with Accenture PLC, and the project was extended until February 2022. 


E-krona intends to provide a strong alternative in the event of a private payment service provider's emergency or turmoil, ensuring the stability of the Swedish payment system.


  1. DXCD in Eastern Caribbean Area


The Eastern Caribbean Central Bank, the monetary authority for the Organization of Eastern Caribbean States members, began work on a CBDC project called DXCD to reach financially excluded segments of the population. Its prototype is being tested in Antigua and Barbuda, Grenada, Saint Lucia, St. Kitts and Nevis, and St. Kitts and Nevis. 


DXCD's main goal is to be a low-cost retail payment system for citizens without credit cards, as well as for merchant and e-commerce payments.


  1. Digital Yuan in China


One of the first central banks to create a CBDC was the People's Bank of China. In 2014, they formed a special task force to research and implement a digital Yuan. When China announced the testing of a CBDC prototype in 2020, it gained traction. 


The first digital Yuan trial will take place in Shenzhen's Luohu district in October 2020. The second pilot programme was held in Suzhou City in early 2021. According to reports, the Chinese digital Yuan will have an impact on China's $27 trillion payment market.


Also Read | What is Digital Money?


Present Status of CBDC in India and its Benefits


Although India is already a leader in digital payments, cash still reigns supreme for small-value transactions. According to the February 2020 RBI bulletin, citing a survey of central banks conducted by the Bank for International Settlements, approximately 80% of the 66 responding central banks have begun projects to investigate the use of CBDC in some form.


These central banks are deliberating and researching the potential economic benefits and implications of CBDC. A high-level inter-ministerial committee appointed by the Finance Ministry recommended the establishment of a CBDC along with changes to the legal framework, including the RBI Act, which currently allows the RBI to regulate the issuance of banknotes.


Benefits of CBDC in India


  1. It would lower the cost of currency management while allowing for real-time payments without the need for interbank settlement. Foreign trade transactions between countries that have implemented a CBDC could be sped up.


  1. Because of India's relatively high currency-to-GDP ratio, CBDC offers another advantage in terms of the extent to which large amounts of cash can be replaced by CBDC. 


  1. Printing, transporting, and storing paper currency can all be significantly reduced.


  1. They may enable the globalization of payment systems to be less expensive and more real-time. It is possible for an Indian exporter to be paid in real time, without the use of a middleman. The risks associated with dollar-rupee transactions, as well as the time zone difference, would virtually vanish.


  1. CBDC adoption may have far-reaching consequences for the banking system. CBDCs have the potential to reduce transaction demand for bank deposits as well as intraday liquidity for transaction settlement.


  1. They may also result in a shift away from bank deposits.



Types of CBDC


Below are types of CBDC with their comparison :


  1. Retail vs Wholesale


To begin, CBDCs will be available in either retail or wholesale form. A retail CBDC would be intended for use by the general public as well as consumers. 


This would provide central banks with the tools to directly interact with consumers, allowing policymakers to implement the most stimulative or restrictive measures and data collection capabilities.


A wholesale CBDC, on the other hand, would be introduced for use by commercial bank interbank market participants as well as other selected institutional and shadow-bank participants. A wholesale CBDC's goal would be to improve the efficiency and ease of transaction in these wholesale markets.


However, in comparison to a retail CBDC, where direct interaction with consumers provides the mechanisms of stimulus and intervention that central banks truly desire, the benefits of a wholesale CBDC appear to be marginal.



  1. Direct vs Indirect


A direct model represents the most likely iteration of the above-mentioned retail CBDC. Simply put, a direct model would allow consumers to open a bank account directly with the Fed and store their Central Bank Digital Currencies there. 


A direct iteration of a CBDC has both significant advantages and disadvantages. The role of commercial banks in a world of direct central bank money is particularly notable and significant.


In an indirect (or two-tier) CBDC model, consumers would be able to hold their CBDCs directly with a commercial bank, similar to how deposits are used today, with commercial banks continuing to act as the intermediary between the central bank and consumers.

Commercial banks would be required and obligated to provide CBDC to consumers on demand, which they would hold in reserve with the central banks.


Indeed, the utility of the two-tier model for central bankers is largely determined by the restrictions and regulations placed on commercial banks' ability to use their CBDC reserves.


While this model would relieve central banks of the significant operational requirements of a direct CBDC model, if the goal of a CBDC is for central banks to bypass the commercial banking sector and provide direct stimulus, a two-tier model may not provide any meaningful additions to how central banks can stimulate.



  1. Token Vs Account based


A token-based CBDC would be analogous to digital cash in the same way that today's currencies are, with the difference being that cash would be entirely digital, rendering a physical counterpart obsolete.


In an account-based CBDC system, ownership of a CBDC is demonstrated by ownership of an individual account that holds the CBDC. One would demonstrate ownership of a CBDC account and all of the currency contained within. An account-based CBDC is perhaps better classified as an identity-based form of money.


One's identity would be embedded in their CBDC account, and thus their identity would be embedded within their money itself. 


Associating an individual's money with their identity is one of the most important and impactful considerations associated with Central Bank Digital Currencies; herein lies the association with money as digital surveillance and the potentially dangerous path this can ultimately lead to for society as a whole.



  1. Infrastructure: Distributed ledger technology vs traditional banking technology


While a CBDC could be introduced using existing banking infrastructure or distributed ledger technology, either type of technological infrastructure is unlikely to have a significant impact on how a CBDC operates. 


While most discussions about CBDCs have focused on distributed ledger and blockchain technology, there are some CBDCs that can be built using traditional centralized transaction technology.


Indeed, while true digital currencies (i.e. cryptocurrencies) are synonymously associated with decentralized distributed ledger technology, a CBDC utilizing a centralized database would still be effectively digital, while retaining characteristics similar to today's monetary payment systems. 


Distributed ledger technology, on the other hand, would be prohibitively expensive and difficult to implement for a CBDC to be used in a direct, retail iteration



Cryptocurrency Vs CBDC


In recent years, both cryptocurrency and Central Bank Digital Currency (CBDC) have captured the world's attention. Cryptocurrency refers to any type of digital or virtual currency that employs encryption to protect transactions.


Cryptocurrencies such as Bitcoin and others are stored on a decentralized blockchain network, where transactions can be conducted, authenticated, and recorded in the public ledger without the interference of a third party.


The first thing to remember about CBDC is that it is not a cryptocurrency, so it is not required to be associated with anything related to the crypto world. A central authority or bank will regulate digital currency (the RBI, for example)


No other government authority has control over digital currencies. Cryptocurrency owners have direct access to their coins. Encryption protects these. CBDC assets will be distributed and stored in a more centralized manner. 


When dealing with CBDC, you do not have the option of remaining anonymous. Because this is a cash substitute, your information will be linked to your CBDC asset. However, unlike crypto transaction details, which are available to the public, the transaction details will be available only to the sender, receiver, and bank.


As a result, cryptocurrency and CBDC are quite dissimilar in some ways. A solid understanding of the two will assist you in better shaping your investment decisions.


Also Read | What is Proof of Work in Crypto?


CBDCs promote financial inclusion and make monetary and fiscal policy implementation easier. Because they are a centralized form of currency, they may not be able to anonymize transactions as some cryptocurrencies do. Many countries are investigating the impact of CBDCs on their economies, existing financial networks, and stability.

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