Central bank
digital currencies are a digital representation of a country’s fiat
currency. They are effectively a government-issued cryptocurrency
designed to replace the traditional, physical form of fiat currencies.


The
term CBDC is broad because its implementation involves several critical
decisions on the part of an issuing central bank. The primary decision
is whether a CBDC should be a general-purpose in that it’s available to
be used by the general population. If not, then the issuing authority
may decide to make it available for “wholesale” transactions, which
means the CBDC is only used for settlements between banks. Finally, a
CBDC could also only be used among central banks.


In its research paper
covering CBDCs in-depth, the Bank for International Settlements, or
BIS, defines these categories using a Venn diagram called the “money
flower,” shown below. The gray area represents various types of CBDCs,
while Bitcoin (BTC) and other cryptocurrencies are deemed to be private digital tokens.


The money flower: A taxonomy of money


What’s the background of CBDCs?



According
to the BIS, the idea of CBDCs has been around for many years, predating
Bitcoin by over two decades. However, the concept has gained prominence
over recent years. This has been mainly due to advances in the fintech
arena, including developments in blockchain technology, allowing the
issuance of digital tokens that represent a store of value. 


Furthermore,
the move toward CBDCs supports the general trend of a more cashless
society. In countries such as South Korea, China and Sweden, cash is
well on its way to becoming a redundant means of payment.


What are the benefits of CBDCs?



CBDCs
offer many comparable benefits to cryptocurrencies, such as Bitcoin.
Hours of operation for banks limit the availability of transactions,
whereas CBDCs could be available to transact on a 24/7 basis. Banks
could decrease their reliance on clearinghouses, which would save costs.


Like
cryptocurrencies, CBDCs could be available to anyone who has a
smartphone, helping to improve financial inclusion, particularly to
people in rural areas without access to physical banking infrastructure
such as ATMs. Countries such as Kenya have already seen an improvement
in financial inclusion due to the popularity of M-Pesa, a cashless payment app based on SMS.


There
are other benefits in using CBDCs beyond the general advantages of
digital currencies. Central banks spend money to print money, with the
average cost of minting a one-dollar bill racking up around $0.077 per
note. Digital currencies are cheap or sometimes even free to produce
once the underlying code is there.


Central banks could
also implement monetary policy directly using a CBDC. This may mean
paying interest on the token itself rather than on bank deposits. 


Finally,
governments could find it easier to distribute cash to citizens, using
CBDCs. For example, COVID-19 led to a crisis that prompted the United
States government to issue
Economic Impact Payments in the form of checks and debit cards, which
are prone to theft and fraudulent use. With a CBDC, the government could
issue relief funds directly.


What are the risks of CBDCs?



Along
with various benefits, CBDCs also come with some considerable risks on
the part of central banks, governments and individual citizens.


Perhaps the biggest risk is cybersecurity. China’s efforts in testing a CBDC have already been hijacked by scammers,
which is alarming because the full version hasn’t been officially
launched yet. The risks of a network attack or creating new loopholes
for fraud or money laundering are a real concern for any central bank
looking to launch a CBDC. 


On the flip side of this risk
is privacy. The greater visibility a government has into who is using a
CBDC, the more the cybersecurity risks can be reduced. However, if
citizens believe that using a CBDC may mean the government could
overstep the boundaries of privacy rights, it may not gain adoption.


Finally,
while governments could use a CBDC to implement monetary policy, the
new possibilities that this opens could also create some degree of risk.
For example, using a CBDC to charge negative interest rates in a time
of crisis could fundamentally change economic paradigms, making it too
costly for citizens to store their wealth in the new digital cash.


Which central banks are close to issuing their own digital currencies?



Although
many central banks use some form of digital money as reserves or
settlement account balance, no central bank has yet issued any general
CBDC. However, several banks are already in various stages of research
and development, including the five major currencies of the world — the U.S. dollar, the euro, the Japanese yen, the British pound and the Chinese yuan.


In May, a U.S. thinktank published a white paper outlining the aims of the “digital dollar.” Since then, events have been making significant headway. 


The most recent news from Japan
is that the central bank has appointed its leading economist to head up
a team researching a yen-based CBDC, while the Bank of England has appointed Accenture for its own CBDC development. Meanwhile, the European Central Bank appears
to be leaning toward a retail CBDC, and given the fact it would operate
across 19 countries, this makes it the biggest project at the moment. 


However, China has been undoubtedly leading the pack, having hit several headlines for months with plans for its CBDC launch. The latest is that the government is planning to target the financial dominance of domestic payment firms, Alibaba and Tencent.


The Philippines has also confirmed that it has been looking into issuing its own digital currency, while Thailand is already in the test phase.


How the U.S. government is applying a new view of crypto, and how new bills are laying the groundwork



In late July, the U.S. Office of the Comptroller of the Currency issued a memo giving the green light to all federally charted banks to offer cryptocurrency custodial services. This effectively allows hundreds
of OCC-member banks to integrate crypto services. The Federal Deposit
Insurance Corporation insurance for crypto holdings is also now within
the realms of possibility.


Banks now only need to
implement the necessary software, hardware and security policies to be
ready to start processing cryptocurrencies, which could also include a
CBDC.


A week after the memo, Brian Brooks, the acting comptroller of the currency, vocalized his support for a blockchain-based CBDC as an upgrade to the current U.S. banking system. Most recently, Federal Reserve Governor Lael Brainard confirmed that the Boston Federal Reserve Bank will work with the Massachusetts Institute of Technology on CBDC research.


The
COVID-19 relief effort is acting as a catalyst for the introduction of
“digital dollars” as referenced in the Automatic Boost to Communities
Act introduced by the U.S. Congress. This came after the introduction of a bill
in March dubbed the Cryptocurrency Act 2020, which attempts to clarify
the responsibility for regulating digital assets by federal agencies.