Central bank digital currencies are a lot different from the cryptocurrencies that you are familiar with.
What Is a Central Bank?
Central banks are able to influence monetary policy through means such as easing or tightening money supply, and thereby influencing interest rates through the cost and availability of credit. Central banks also hold the country’s foreign exchange reserves, which is used to back liabilities or intervene in times of financial crisis.
The most influential central banks in the world are the Federal Reserve of the United States, also known as the Fed, the European Central Bank and the People’s Bank of China. These countries have the largest economies in the world, and their actions greatly shape global monetary policy.
What Is Fiat Currency?
Money supply is pivotal for central banks as part of their influence over monetary policy, as it allows them to control liquidity and interest rates. Money supply can be classified into four categories, denoted by “Ms”, namely M1 to M4. M1 consists of physical cash and ready-to-use electronic money, while M4 encompasses all money, in cash and bank accounts.
New Digital Currency or a Form of Cryptocurrency?
It’s not correct to say that CBDCs are the same as cryptocurrencies — in fact, a lot of the properties of virtual currencies are the direct opposite of everything that most cryptocurrencies stand for.
In simplest terms, this means that CBDCs are backed by governments — which is not something that you’d see in a cryptocurrency project.
While Bitcoin intends to create a new financial system from the outside, crypto’s emergence and growing popularity has — perhaps inevitably — spurred on significant innovation within the citadel of traditional finance itself, stemming from the idea of virtual currency.
This is most strikingly shown in the phenomenal growth of interest in central bank digital currencies, or CBDCs for short.
Are All Central Bank Digital Currencies Alike?
There are two main categories of CBDCs.
The first is a “wholesale” variant, which is limited for use by financial institutions for wholesale settlements — i.e., for interbank payments or securities settlements.
The second is a “retail CBDC” for the general public.
Retail CBDCs are further split into two main types: “general purpose,” “account-based” or “token-based.” Retail CBDCs would in theory extend access to digital central bank money to the general public. They could therefore have much wider reaching implications for banks and the financial system as a whole than their wholesale counterparts.
Depending on their design, retail CBDCs could alter the existing operational roles taken by central banks and private institutions within the financial system.
A bottom line for these virtual currencies is that whatever design they take, their ultimate issuer and redeemer is the central bank: different designs would, however, affect the nature of claims on an intermediary (where relevant) and the records that are kept by the central bank.
This means that no matter how a CBDC looks, the responsibility for its structure and maintenance is with the central bank.
In an indirect, two-tier CBDC system, the structure of claims would be similar to the existing financial system. Commercial institutions would be mandated to fully back a CBDC-like liability to the consumer with their own CBDC deposits at the central bank.
However, changes to this intermediated model could bring new regulatory and supervisory possibilities for central banks, though this would require a massive extension of their existing operations. For this reason, analysts have also researched hybrid architectures that would combine direct and indirect claims on the central bank.
CBDCs in the World’s Largest Economies – What’s Happening?
With cryptocurrency market capitalization reaching almost $2 trillion as of August 2021, governments and national institutions are increasing their scrutiny and regulatory oversight on the crypto industry, as is the case with the recently passed US infrastructure bill. On the other hand, these same countries are also actively engaging in CBDC research and development, partly to keep up with blockchain technology advancements, partly to maintain the status quo. This is being played out in the world’s two largest economies – the United States and China.
China’s Digital Currency – the “E-yuan”
China’s Digital Currency Electronic Payment (DCEP) system has been in development since 2014. The digital yuan is, however, not a blockchain project that relies on a decentralized ledger. Instead, it relies upon a centralized database that records and tracks all transactions on the network, as well as controlling access to the network. The e-yuan is backed 1:1 by the physical yuan. China has already rolled out testing of the DCEP and many expect it to be the first country to fully implement a CBDC.
US Digital Currency – the “Fedcoin”
What’s Stopping Central Banks From Releasing CBDCs Right Now?
Analysts have emphasized that for retail virtual currencies to really take off, they would need to provide cash-like safety and convenience for peer-to-peer (and even cross-border) payments. They would also need to take into account provisions for “privacy by default” and universal accessibility.
However, based on the results of existing proofs-of-concepts by central banks, blockchain technologies are currently unlikely to be implemented for a direct CBDC architecture because of the sheer volume of data throughput that would be required.
However, blockchain architectures have been explored for hybrid or indirect CBDC models, as well as for wholesale CBDCs, given that the number of transactions in many wholesale payment systems is similar to that already handled by existing blockchain platforms.