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Central Bank Digital Currencies (CBDCs): A detailed guide on how they work?

  • mm
    by Rahul A R on Wed Jul 27

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). With the help of blockchain technology, these currencies are poised to modernize retail payment systems. 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.

  • What are Central Bank Digital Currencies (CBDCs)?
  • Central Bank Digital Currencies vs. Cryptocurrencies
  • What is the need for Central Bank Digital Currencies?
  • Types of CBDCs
  • Future of CBDCs

What are Central Bank Digital Currencies (CBDCs)?

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 potentially increase payment efficiency with new payment technologies, typically the blockchain. Central Bank Digital Currency is relatively a new idea for economies, and countries are still in the development stage with their digital currencies, such as the digital dollar of the US.

China, with its digital yuan, and South Korea, are two front runners who are 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 did not gain enough traction as very few citizens used it, and it had to be backed by Venezuela’s oil reserves for stability.

Related article: What to know before implementing blockchain in your business

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 vs. Cryptocurrencies

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.

Public blockchains like Bitcoin and Ethereum are known for their decentralism, i.e., they are not controlled by any entity. This characteristic cannot be claimed for government-issued digital currencies.

Learn More: How to choose the right blockchain for your project?

Cryptocurrencies like bitcoin have a limited supply (21 million for bitcoin), and no one, not even the developers, can force a change in the protocols as the coin is controlled by millions of users worldwide. On the contrary, the governments control Central Bank Digital Currencies. The country’s central bank decides if the supply should be increased or decreased, and the interest rates depend on the country’s economy. Thus, Central Bank Digital Currencies are not cryptocurrencies since a central authority governs them.

What is the need for Central Bank Digital Currencies?

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. The banks’ authority to determine monetary policies is undermined by initiatives such as Libra Association’s to peg its stablecoin to fiat currencies, including the US dollar, Euro, and the British Pound.

In addition to addressing problems due to the influx of autonomous cryptocurrencies, CBDCs are also considered necessary by central banks to modernize retail payments into a transparent system and prevent black market trade.

During the months of the peak global pandemic, the Bank of International Settlements (BIS) researchers said that countries might be forced to shift to mobile and contactless money options due to 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 a credit card, 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, Central Bank Digital Currencies 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.

Types of CBDCs

Retail vs. Wholesale CBDC Model

Central Bank Digital Currencies can be categorized as wholesale and retail based on who gets to access the digital currencies. In the wholesale model, a limited group of commercial banks and financial institutions have access to government-issued digital currencies. In the retail model, the currencies are made for corporations, businesses, or all consumers across the economy. 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. 

Related article: What is DeFi 2.0, and why does it matter?

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.

Token vs. Account-based CBDCs

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, and the transaction is recorded as an update of the balance. 

Related Article: How to launch a DeFi project in 2022 (DeFi tokens, DeFi coins)?

The token-based format is similar to cryptocurrencies, and the ownership is linked to proof. Digital signatures can be verified using cryptography to carry out and validate transactions. Therefore, a central bank currency transaction is recorded as a transfer of ownership of a specific unit or token. Like tokenized units such as cryptocurrencies and stablecoins, token-based central bank currencies can be programmed. 

Direct, Indirect, and Hybrid Models

  • Direct Model

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 simple 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.

  • Indirect Model

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.”

  • Hybrid Model

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. 

Related article: Blockchain as a Service (BaaS): How to choose the right provider?

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.

Future of CBDCs

CBDCs can bring an entirely new infrastructure for money by helping central banks who want to fulfill their goal of widening modern payment solutions. The Central Bank Digital Currency will connect the general public, corporations, and financial institutions to the current blockchain innovations and non-payment areas such as 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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Rahul A R

Rahul A R is a technologist and full-stack developer who specializes in Blockchain technologies and Cryptocurrencies. Though he’s ... Read more

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