Drixx Academy/Introduction to Central Bank Digital Currencies (CBDCs) /

Introduction to Central Bank Digital Currencies (CBDCs)

Edwin Munyui
Head of Content
May 4, 2021

Drixx - Introduction to Central Bank Digital Currencies (CBDCs) - BTC - ETH

Central Bank Digital Currencies (CBDCs) are making headlines within the crypto market and larger financial ecosystem. This concept of a futuristic digital monetary structure is currently a topic of discussion by most central banks worldwide. Countries like China, the Bahamas islands, and Cambodia appear to have taken the lead - each has pioneered its own CBDC, although they are at different stages of implementation.

Going by the traction, CBDCs are likely to influence the future of monetary policy - one of the main reasons central authorities are now focusing on research and development. This upcoming class of digital assets is quite different from the likes of Bitcoin and other decentralized cryptocurrencies. CBDCs are centralized digital assets controlled by monetary authorities such as the People’s Bank of China, which is currently in charge of the country’s ‘digital yuan’.

To better understand CBDCs, let’s first look at the dynamics of monetary policy in traditional finance. This fundamental pillar of today’s markets is run by central authorities such as the Federal Reserve and European Central Bank (ECB). Their role is to ensure that the demand and supply of money are balanced at all times - this is implemented through monetary policy tools like printing new money or reducing the existing supply.

In digital ecosystems, it is impossible to maintain this balance by altering the supply of fiat money in circulation. Central Banks and associated stakeholders have come up with CBDCs to replace fiat money. In doing so, monetary authorities can also shift to digital payment ecosystems and implement policies effectively. Notably, the growth of CBDCs has mainly been influenced by the mainstream adoption of cryptocurrencies in both retail and institutional markets.

How Do CBDCs Work?

In contrast to decentralized crypto assets, CBDCs are issued by central authorities - making them centralized as a single entity controls them. Currently, the developments in this arena are still murky, given that most jurisdictions are in the research phase. However, some running concepts paint a picture of how CBDCs might work in the near future.

Most CBDCs borrow their fundamental architecture from blockchain, which means they use distributed ledger technology (DLT). In simple terms, DLTs are a shared recording system that keeps several copies of transactions or data added to the ledger. Anyone who is permissioned to access this ledger can see the recordings in real-time and validate that they are true. Once recorded, it becomes almost impossible to alter the information without raising the alarm amongst the network participants.

With such fundamentals, CBDCs have emerged as the best monetary tool for digital asset oversight - at least for now. Central authorities that have embarked on research and development are looking at the possibilities of integrating CBDCs with the digital payments industry. So far, there are two popular design frameworks which include a wholesale or retail CBDC.

Wholesale CBDC

The wholesale CBDC design is based on collaboration with financial institutions such as banks, given their role in fractional reserve banking. This model is a good fit for financial institutions that hold reserves with monetary authorities. Ideally, a wholesale CBDC would be the product of a central bank, but the tokens are distributed through accounts held with financial intermediaries.

Let’s take the example of existing monetary policy structures, where central authorities alter fiat money in circulation. This is typically done through banks or direct monetary policy tools. In the former, central banks can alter circulation by increasing/decreasing the reserve requirements or buying/selling market instruments like bonds.

A wholesale CBDC takes quite a different approach - banks play the role of intermediaries by providing accounts and facilitating the payments/transaction processes. However, the token is distributed by the central bank to account holders who can, in turn, send or receive the CBDCs. That way, value can be transferred from the central banks to all actors in the economy - an efficient approach to digital monetary policy.

The wholesale CBDC design is much easier to integrate with existing financial ecosystems. Furthermore, their involvement solves underlying issues such as liquidity, cost of building new systems, and settlement efficiency. While that’s on the upside, this approach has also raised questions regarding the role of financial institutions in monetary policy - a wholesale system would mean that they are actively involved in the process. Ultimately, it poses a challenge in striking a balance between the regulators and financial intermediaries.

Retail CBDC

The retail CBDC model is designed to issue these centralized digital assets to the general public. In short, the regulators directly control its creation and distribution as well. Retail CBDC proposals base the fundamental infrastructure on distributed ledger technology (DLTs), whose features include 24/7 availability, traceability, anonymity, and interest rates feasibility. The last feature is essential as it is part of the monetary policy tools used by central banks - regulators can alter the interest rate to affect the value of a retail CBDC at any point in time.

Some of the fundamental principles of a retail CBDC are pretty similar to those of fiat money. This type of CBDC will need to earn the status of legal tender such that the stakeholders of a particular economy recognize it as a means of payment and store of value. That said, the ratio of retail CBDCs should be 1:1 against the pegged fiat currency - stakeholders can seamlessly convert these digital assets to cash or commercial bank money.

One of the main advantages of a retail CBDC is that they eliminate the need to have a bank account. Instead, financial institutions are tasked with the role of building CBDC compatible infrastructure to facilitate market operations. On the downside, it is more costly and time-consuming to make retail CBDCs compared to their wholesale counterparts. The latter enjoys an upper hand since it uses existing financial systems for implementation.

The Current State of CBDCs

As mentioned earlier, the state of CBDC implementation varies across different monetary authorities globally. The PWC 2021 CBDC global index notes that over 60 central banks have already begun research or developing a local CBDC.

This latest survey places Bahamas as the leading jurisdiction in implementing a CBDC for its retail economy. The tiny Caribbean island launched its CBDC ‘Sand Dollar’ in October 2020 - a digital version of its currency. This digital asset is issued through authorized financial intermediaries, which means that Bahamians can access it through digital wallets or physical payment cards. That being the case, the daily records can be used for other financial operations, such as the approval of micro-loans.

The Bahamas was followed closely by Cambodia and Mainland China. Both countries have been actively implementing CBDC pilots - Cambodia officially launched its central bank-backed digital currency ‘Bakong’ in October 2020. Meanwhile, China’s digital yuan is still in its pilot phase, having been rolled out in multiple cities. It has also been tested to make official payments as China prepares for an official launch soon. Other countries that have already rolled out CBDC pilots include Sweden, which pioneered ‘e-krona’ through Riksbank, the country’s central bank.

While the featured examples are making progress, some developed economies are lagging in the research phase. The United States is one example, although the idea of a digital dollar was floated as early as China’s digital yuan became apparent. This leading economy is yet to give a clear direction on CBDCs - it is only recently that the U.S senate introduced an innovation bill that will support the development of digital ecosystems.

In Europe, the research phase is a bit advanced, with the region now looking into the possibility of a digital Euro. Some of the advancements made include a patent filing to preserve the name ‘digital euro’ and a recently concluded public consultation process. As per the current roadmap, this CBDC will take another 2-4 years before it is officially rolled out, depending on whether the research phase supports its feasibility. European nations that have already volunteered to take part in a pilot phase include Italy and France.

CBDC Value Proposition

CBDCs offer a wide range of opportunities for Central Banks to keep up with the emerging digital economy. For starters, CBDCs will be considered legal tender, which means they can be accepted as a form of digital payment by all individuals and enterprises within a particular jurisdiction. This is a big part of monetary policy functions carried out by central banks - so far, they are a possible fit for digital monetary policy implementation.

A CBDC will also increase the efficiency and safety of digital payment systems. This type of digital currency is much quicker to settle than fiat currencies, which has to pass through a financial intermediary. With CBDCs, payments between counterparties can be made in a few clicks, regardless of their location. In addition, they can solve the inefficiencies in cross-border transactions. This is already in action through an interbank CBDC project by Thailand and Hong Kong.

Disclaimer: The information presented here is for educational purposes only and should not be construed as investment advice. Cryptocurrency trading involves high risk. Drixx will always strive to do it’s best in educating customers and providing high quality products but will not be held responsible for their trading and investment decisions, losses or profits.