What Is a Central Bank Digital Currency (CBDC)?

The practicality of Bitcoin as a universal means of transaction for daily expenses, such as purchasing coffee or paying taxes, remains questionable. Despite its status as a digital form of money, Bitcoin may not be the optimal choice for these purposes. However, another category of digital assets, known as central bank digital currencies (CBDC), is expected to fill this void.

While some countries are in the preliminary stages of considering an entirely digital currency, others have already begun testing the viability of implementing CBDCs. But what sets them apart from other digital assets? Let us delve into the intricacies to gain a comprehensive understanding.

Introduction

Traditional finance's mechanisms for transferring money have lagged behind the rapid pace of global advancements. Despite the simplicity of moving bits from one location to another, the process of sending money can be burdensome, costly, and time-consuming.

Many governments are creating a new digital currency to tackle these problems. These emerging digital currencies, known as Central Bank Digital Currencies, are poised to revolutionize payment systems, enhancing efficiency and reducing costs for all parties involved. CBDCs can be envisioned as digital representations of fiat money, underpinned by a novel technological layer inspired by the transformative potential of blockchain.

Forecasts indicate that many countries will embrace these digital currencies within the next decade. But how do these currencies operate? Let us delve into their inner workings.

What Is a Central Bank Digital Currency?

Central bank digital currency represents a manifestation of traditional fiat currency, legally recognized and regulated by the government. The design approach for CBDCs may diverge significantly depending on the issuing nation. Some implementations may leverage blockchain or distributed ledger technologies (DLT), while others might rely on a centralized database. In the case of blockchain-based CBDCs, a token serves as the representation of the digital fiat currency.

While Central Bank digital currencies draw inspiration from cryptocurrencies like Bitcoin, they differ significantly. CBDCs are issued by governmental bodies and hold legal tender status, while cryptocurrencies operate without centralized control or national affiliation. The borderless nature of cryptocurrencies contrasts with the national scope of CBDCs.

Numerous central banks are actively exploring or experimenting with CBDCs as proof-of-concept. China, for instance, has been developing the DC/EP (Digital Currency/Electronic Payments) project since 2014 and has successfully conducted trials of the digital yuan across multiple cities. In October 2020, the European Central Bank (ECB) released a report outlining the potential merits of a digital euro and proposed its implementation.

Unraveling the Concept of Central Bank Digital Currencies 

Understanding the technological landscape of Central Bank Digital Currencies entails recognizing their fundamental nature as government-run or government-approved databases. Consequently, these databases operate as permission systems, granting transactional authority exclusively to approved entities.

The centralized entity governing the database wields power to regulate transactional flow, reverse transactions, enforce fund freezing, and blacklist specific addresses. While numerous CBDCs are expected to utilize their dedicated blockchains, some may opt for issuance on public blockchains. This approach facilitates the settlement of permission assets atop a permissionless foundational layer. Such a hybrid model offers the advantages of both worlds: the permission layer controls central banks, while the permissionless coating ensures robust security measures.

Nevertheless, this hybrid model is unlikely to become the prevailing norm. Currently, no public blockchain possesses the requisite technological capabilities or has sufficiently withstood the test of time to be entrusted with such a critical task.

Moreover, outlining a comprehensive blueprint for CBDC functionality proves challenging due to the varying approaches adopted by different countries. Each nation will likely customize the technology to meet its unique requirements and preferences.

Advantages of Central Bank Digital Currencies 

While the concept of "banking the unbanked" has often been associated with cryptocurrencies, CBDCs hold a superior potential to achieve this objective compared to decentralized counterparts like Bitcoin. By ensuring convenient access to low-cost bank accounts for all law-abiding citizens, CBDCs can significantly enhance financial inclusion.

Revamping the monetary system brings forth technological advancements. Although a considerable portion of fiat money is essentially digital figures in databases, the underlying infrastructure remains outdated. While sending an email on a Sunday afternoon seamlessly takes a few seconds, the current convoluted financial system prolongs the money transfer process, sometimes spanning multiple days.

The COVID-19 pandemic has underscored the need for swift action by central banks. CBDCs can potentially enable central banks and financial institutions to implement changes in monetary policy with unprecedented directness. This transformative capability can overhaul the functioning of central banking itself. Implementing CBDCs simplifies illicit activity tracking for governments and central banks, offering enhanced control and surveillance measures.

Comparing Central Bank Digital Currencies to Stablecoins

CBDCs and stablecoins may appear remarkably similar, functioning as digital tokens representing fiat currency. However, their underlying mechanisms diverge significantly. Stablecoins primarily emerge through the issuance of private entities, serving as representations of fiat money or alternative assets. While they can be exchanged for their corresponding value, they do not hold the intrinsic nature of fiat currency. In stark contrast, CBDCs are exclusively government-issued and inherently embody the essence of fiat money.

Comparing Central Bank Digital Currencies to Cryptocurrencies

CBDCs and cryptocurrencies diverge significantly in their nature and functionalities. CBDCs, issued by central banks and recognized as legal tender by governments, resemble traditional banknotes. They serve as a unit of account, means of payment, and store of value.

In contrast, genuine cryptocurrencies like Bitcoin operate under distinct principles. They are not issued by governments and transcend national borders. Cryptocurrencies embrace the characteristics of being permissionless, trustless, and resistant to censorship. Moreover, their networks lack centralized control, preventing anyone from blacklisting transaction addresses.

Determining the superior option depends on the specific use case. The capacity for Alice to conduct direct, intermediary-free transactions with Bob using Bitcoin illustrates its powerful concept. Nonetheless, there are inherent risks, such as the potential loss of a significant amount of funds or accidental transfers to incorrect addresses.

Occasionally, reversing transactions or blacklist addresses can prove advantageous for certain entities. In other scenarios, harnessing the advantages of decentralized networks like Bitcoin holds greater value for the broader world.

Conclusion

In essence, central bank digital currencies represent the digitized manifestation of fiat money. Numerous CBDC implementations are expected to leverage blockchain technology, facilitating streamlined and frictionless digital transactions for all individuals.