Unpacking Central Bank Digital Currency and the Future of Monetary Policy
What is CBDC?
Payment-related innovation has always been an integral and fundamental part of central banking. Central Bank Digital Currencies, or CBDCs, illustrate another such potential innovation. A Central Bank Digital Currency is a digital version of a country's national currency issued and backed by the central bank. "Central bank money" is essentially money that is a central bank liability. For example, there are two types central bank money in the US: physical currency issued by the Federal Reserve and a digital balance simply held by commercial banks at the Federal Reserve. Even though money in digital form isn't new to Americans — e.g. online checking accounts, payment apps, etc. — a CBDC differs from regular digital money because it's a liability of the Federal Reserve, and not a commercial bank.
In Europe, having central bank-issued form of digital money would provide an anchor of stability for payment and monetary systems. A digital euro would enhance the euro area's economic sovereignty and promote competition and efficiency within the European payments industry.
CBDCs have been gaining traction in recent years, as many central banks worldwide (more than 100) have been exploring the potential benefits and risks of issuing their own digital currencies. CBDCs have yet to be widely available. However, several countries, including China, the Bahamas, and the European Central Bank, have begun piloting or experimenting with them. The concept of central banks issuing digital forms of currency for public use is a logical extension of the issuance of physical cash. Interestingly enough, banks have already been able to access digital forms of central bank money for years in the wholesale payment system.
What's the difference between wholesale CBDC and retail?
This type of CBDC is intended for use among financial institutions and large corporations and is typically used for interbank settlements and large transactions. Wholesale CBDCs can reduce the costs and risks associated with these types of transactions and improve the efficiency and stability of the financial system.
Retail CBDCs are for the general public and can be used for everyday transactions such as buying goods and services. These kinds of CBDC can increase financial inclusion, especially for the unbanked or underbanked, and can also provide a cash alternative. They also allow for innovation in the payment system and mitigate the risks associated with digital payments.
Retail and wholesale CBDCs can also be linked, with a wholesale version for financial institutions and a retail version for the general public. The central bank could also issue only one of the two types depending on the country's needs and goals.
Both types of CBDCs come in handy when it comes to managing various risks. For instance, a wholesale CBDC can provide a stable and reliable means of settlement, reducing the risk of liquidity shortages and contributing to the strength of the financial system. And as an alternative to cash, retail CBDCs can be considered more secure than said means of payment, as retail CBDCs are less prone to risks such as loss or counterfeiting.
European countries with CBDC
ABN Amro is the first bank in Europe to register a digital bond for a corporate client on the public blockchain. The bank collaborated with Bitbond and Fireblocks to enter the blockchain and develop a digital wallet to store the client’s keys securely. Another example is The Banque de France (Central Bank of France) and the Banque Centrale du Luxembourg (Central Bank of Luxembourg, where the EIB is registered), which have successfully carried out a trial of a wholesale CBDC using distributed ledger technology, or DLT. Both central banks collaborated to support the European Investment Bank (EIB) in its Venus initiative by securely settling a digital asset, a tokenized version of the Euro, referred to as an "experimental" CBDC. This trial involved the EIB issuing a €100 million digital bond using DLT and the two central banks settling it using the tokenized CBDC.
CBDC vs crypto
Cryptocurrency is a digital currency, or decentralized digital asset, that uses cryptography for security, operates independently of a central bank, and isn't backed by any government or central authority. Cryptocurrencies rely on complex mathematical algorithms and decentralized networks to secure transactions and maintain their integrity. Some prime examples include Bitcoin and Ethereum.
In contrast, CBDCs are digital versions of government-backed fiat money, which uses blockchain technology to verify and store transaction data. But the significant difference is that they operate on a centralized network, which is basically a permissioned network. CBDCs and cryptocurrencies share some similarities, such as being digital and used for electronic transactions. Yet, they differ significantly in their issuance, regulation, and underlying assets.
While the best crypto to buy now is popularly Bitcoin, Ethereum, and Tether according to Forbes, CBDC is still mostly a topic of ongoing research and discussion among central banks and governments worldwide. Determining the best versions of this type of currency and how it'll be used by financial institutions is still up for debate. The idea of CBDCs is to have a digital version of a country's currency issued and supported by the central bank. While some experts argue that CBDCs can enhance financial inclusion, improve monetary policy efficiency and increase the financial system's stability, others are concerned about the potential impact on financial stability and increased surveillance. Ultimately, the significance of CBDCs in the future will depend on the outcome of ongoing research and experimentation.
CBDCs have many advantages, such as reducing financial fraud, and cyberattacks, promoting financial inclusion, and lowering transaction costs. They also provide central banks with a better understanding of money flows, helping to detect financial crimes and promote economic stability. Additionally, CBDCs can give central banks new tools for implementing monetary policies.
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Is CBDC the future?
The introduction of a CBDC raises essential questions about the function of central bank money and the way financial intermediation is structured. Historically, central banks have restricted access to digital central bank money to banks and certain institutions, while liquid cash has been widely available to the public. However, as cash usage declines in some areas, it raises the possibility that the public may need more access to central bank money. Given that the current system has generally served the system well, any changes to the economic and financial structure should be handled with great care.
Various innovations are being introduced in the space, especially around the digital asset infrastructure. Some of the most prominent startups active in Europe include Fireblocks, which aims to simplify the complexity of working with digital assets by enabling financial institutions and other market players to create new blockchain-based products and manage daily digital asset operations. Other startups such as Micobo, Cashlink, Bitbond, and Tokeny provide the platforms to create, issue, manage, and trade digital assets on the blockchain.
For CBDCs to be successful, they need to be executed correctly, and if so, they have the potential to revolutionize the banking and payments industry globally. The benefits, such as boosting economies, cutting transaction times and costs, increasing financial inclusion, and simplifying cross-border transactions, have prompted governments and central banks worldwide to investigate its implementation. At the same time, a strong emphasis should be put on educating the public on the differences between CBDCs and cryptocurrencies as we know them, building trust around central bank-backed digital assets, and making them foolproof against crypto market fluctuations.
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