Cryptocurrencies have made huge progress in a short time. But, despite the hopes, cryptocurrencies have not yet changed how we pay for things. One of the reasons is its extreme price volatility. Recently, crypto has inspired the biggest financial institutions, the central banks, to create digital currencies, the Central Bank Digital Currencies (CBDCs). This currency model modernizes retail payment systems through the use of blockchain technology. It also streamlines the connection between the public, corporations, and financial institutions.
Read ahead to find out how CBDCs can transform a country’s economy.
Central Bank Digital Currencies, a.k.a CBDCs, are digital currencies backed and issued by the central bank. Governments worldwide are experimenting with this currency, hoping to increase payment efficiency with new payment technologies, typically the blockchain. CBDC is a relatively new idea for economies and countries looking to develop digital currencies, like the US digital dollar.
China, with its digital yuan, and South Korea, are two front runners already pilot-testing their central bank digital currency with the public. Venezuela ventured into the digital currency department earlier with the launch of the state-owned cryptocurrency “petro.” But, petro needed to gain more traction as very few citizens used it, and it had to be backed by Venezuela’s oil reserves for stability.
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Recently, the US Federal Reserve Bank of Boston has been experimenting with a digital dollar in collaboration with the Massachusetts Institute of Technology (MIT).
Central Bank Digital Currencies are based on distributed ledger technologies, mainly the blockchain, and therefore, they share similarities with cryptocurrencies, but the intentions are very different.
The decentralized capabilities of public blockchains like Bitcoin and Ethereum allow them to function properly without any central authority. As such, government-issued digital currencies cannot replicate this characteristic.
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Cryptocurrencies like bitcoin have only a limited supply (21 million for bitcoin), and no one, not even the developers, can change the protocols as the coin is controlled by millions of users worldwide. On the contrary, the governments control Central Bank Digital Currencies. Every country’s central bank decides whether the supply needs to increase or decrease. But the interest rates depend on the country’s economy. Thus, CBDCs are not cryptocurrencies since a central authority governs them.
A part of the reason is the challenges from private-sector initiatives such as the Libra Association (whose members include Vodafone, Uber, and Visa) of Facebook. Libra Association’s initiatives undermine the banks’ authority to determine monetary policies by pegging its stablecoin to fiat currencies, including the US dollar, Euro, and British Pound.
To address problems arising because of the influx of autonomous cryptocurrencies, CBDCs become essential. Also, it helps to modernize retail payments into a transparent system and prevents black market trade.
During the months of the peak global pandemic, the Bank of International Settlements (BIS) researchers believed that shifting to mobile and contactless money is the best option for most countries. This suggestion was to prevent the possibility of virus transmission through contaminated notes. Proving the prediction, the governor of Chaco province in Argentina planned to phase out cash usage and bring in “digital currency transaction systems.”
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Focusing on the financially excluded population, The Eastern Caribbean Central Bank started the works for DXCD. The main aim of DXCD is to target those who do not have credit cards, create a retail payment system, and enhance e-commerce for merchants at low costs.
Moreover, digital payment methods on the blockchain facilitate cheaper and faster cross-border payments while allowing more token uses, such as in digital exchanges, combining trading and post-trading services. Casting the net wider, the Swiss National Bank and the SIX Digital Exchange explore using central bank money to trade tokenized assets.
In conclusion, CBDCs provide the advantage of tokenized currencies to those who want them while also including those who do not want them by providing simple account services without the need to manage private keys.
A CBDC is categorized based on wholesale and retail, depending on access. Limited commercial banks and financial institutions can access government-issued digital currencies in the wholesale models. Corporations, businesses, and consumers use this currency while it is in retail mode. The retail model includes a variety of payment methods focusing on linking businesses and individuals. The digital currencies will be of low value but in high volumes.
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The wholesale model is more relevant in developed economies with advanced interbank systems and capital markets. The retail central bank currency is relevant for emerging or developing economies with financial inclusion as the intention.
Central Bank Digital Currency can be classified as account-based or token-based in terms of the underlying format. The account-based format resembles the current digital payment systems. The user’s identity determines the ownership of the central bank currencies. Also, here every transaction is recorded as an update of the balance.
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The ownership of this token-based format is connected to proof similar to a cryptocurrency. Digital signatures can be verified using cryptography to carry out and validate transactions. Therefore, a central bank currency transaction is similar to a token ownership transfer. Like cryptocurrencies and stablecoins, token-based central bank currency is fully programmable.
The direct model works the same way as traditional banking. In the direct model, the parties involved in a transaction will hold an account in the central bank. They can make a digital money transfer from one account to another, and the central bank will back the transaction. Then the central bank will issue the currency and decide the permission mechanism to clear the transactions. The central bank then handles requirements such as Know-Your-Customer (KYC) and Anti-Money Laundering compliances.
In an indirect model, a commercial bank or a non-bank financial institution will be in charge of the digital currencies. These non-banks will be responsible for distributing the currency and compliance with KYC and AML requirements. The claim for the digital currency rests with the non-banks/commercial banks, and they issue a stablecoin backed by the reserves of central banks.
The researchers at the International Monetary Fund (IMF) term the digital currencies in the indirect model the “Synthetic CBDCs.”
The hybrid model is the most preferred by a lot of central banks. In the hybrid model, the Central Bank Digital Currency claim rests with the central bank. Still, a regulated private-sector intermediary like fintech or a commercial bank handles the transactions, KYC, and AML requirements.
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The Bank of England is researching hybrid models, and the platform they are working on is called the “platform model.” Only the central bank can create or destroy a token in the platform model, while the interaction with end-users will be handled by “payment interface providers” (PIP). The PIPs get to build customer relationships and also stand out by providing extra services over core payment services.
CBDCs bring a new infrastructure for money by helping central banks fulfill their goal of widening modern payment solutions. The CBDC connects corporations and financial institutions to blockchain innovations and non-payment areas like digital exchanges or liquidity management platforms. They can be extremely powerful in driving purchasing power in countries because of their modernity and ease of usage.
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