Central Bank Digital Currencies (CBDC) Explained

Introduction

The technology for transferring funds in traditional finance has not truly kept pace with changes occurring in other parts of the world. While moving money from one place to another is more complex than transmitting binary digits, the costs associated with this process are often high, and the time required frequently exceeds expectations.

Many governments are actively developing new forms of digital currency, primarily aimed at improving the efficiency of payment systems and reducing costs for participants. Central Bank Digital Currency (CBDC) can be viewed as a digital form of fiat currency built on a technological foundation inspired by advancements in blockchain.

In the coming decade, many countries are likely to adopt such digital currencies. So, how do they actually work?

What is Central Bank Digital Currency (CBDC)?

Central Bank Digital Currency (CBDC) is a digital form of legal tender, meaning it adheres to government regulations as a currency.

The design of CBDCs varies depending on the issuing country or region. Some models may be based on blockchain or other types of Distributed Ledger Technology (DLT), while others may simply utilize a centralized database. Blockchain-based CBDCs use tokens to represent digital fiat currency.

Although CBDCs are inspired to some extent by cryptocurrencies like Bitcoin, there are significant differences between the two. CBDCs are issued by the state and recognized by the government as legal tender.

In contrast, cryptocurrencies like Bitcoin are borderless and not subject to issuance restrictions by any country or central authority. While CBDCs can be used for cross-border payments, Bitcoin operates without the concept of national boundaries.

Many central banks are considering and actively experimenting with proof-of-concept for CBDCs.

Since 2014, China has been advancing a project known as DC/EP (Digital Currency/Electronic Payment), with pilot programs for the digital yuan launched in several cities. In October 2020, the European Central Bank (ECB) released a report proposing the digital euro and assessing the potential benefits of this digital currency.

Understanding Central Bank Digital Currency (CBDC)

From a technical perspective, CBDC is essentially a database managed and controlled by the government or approved private sector entities. This makes CBDC a permissioned database, allowing only authorized participants to transact within the network.

As a result, the central entity controlling the database can block transactions, reverse them, freeze funds, or blacklist specific addresses.

Many CBDCs may operate on their own blockchains, while others could be issued on public blockchains. This would allow them to place permissioned assets atop a permissionless foundational layer, leveraging the advantages of both: the permissioned layer provides the necessary control for central banks, while the permissionless layer offers enhanced security.

However, this model may not become mainstream. Current public blockchain technologies are not yet mature enough to demonstrate their capability to securely handle such critical tasks.

Moreover, outlining how CBDCs function is not straightforward, as each country or region may adopt different approaches and tailor solutions to specific needs.

Benefits of Central Bank Digital Currency (CBDC)

You may have heard the concept of “banking the unbanked.” While this idea is appealing, CBDCs are more likely to achieve this goal compared to decentralized cryptocurrencies like Bitcoin. Any legal citizen can easily access low-cost bank accounts, thereby enhancing financial inclusion.

Another significant benefit is that CBDCs could bring about a complete reform of the monetary system and technological advancements. Although most fiat currency is merely a string of numbers in a database, the existing infrastructure is quite outdated. Sending an email takes seconds, but due to the complex financial system, transferring funds may take days.

During the economic measures taken to combat the COVID-19 pandemic, we witnessed the need for central banks to respond more swiftly. CBDCs would enable central banks and financial institutions to implement changes in monetary policy in a direct manner, potentially transforming how central banks operate.

Additionally, CBDCs would allow governments and central banks to more easily track illegal activities.

CBDC and Stablecoins

The characteristics mentioned above may sound similar to those of stablecoins. Functionally, both represent digital tokens of fiat currency. However, they are fundamentally different.

Stablecoins are typically issued by private entities and essentially represent fiat currency or other assets. Their value can be redeemed, but they do not constitute legal tender. In contrast, CBDCs are government-issued legal tender.

CBDC and Cryptocurrencies

As previously noted, there are significant differences between CBDCs and cryptocurrencies. CBDCs are issued by central banks and are classified as government fiat. You can think of CBDCs as cash—they serve as a unit of account, a means of payment, and a store of value.

True cryptocurrencies (like Bitcoin) are quite different. They are not government-issued and lack the concept of national borders, embodying characteristics such as permissionless access, trustlessness, and resistance to censorship. Furthermore, their networks are not controlled by central entities. No one can blacklist your Bitcoin address or prohibit you from sending transactions to other Bitcoin addresses.

So, which is better? It depends on the specific use case. Alice can send Bitcoin to Bob without intermediaries or censors, which is a powerful capability. However, this also has its drawbacks. What if a large sum is stolen, or Alice accidentally sends her life savings to the wrong address?

At times, having an entity that can reverse transactions or blacklist addresses can be very useful. Other times, it may be more important to fully leverage the advantages provided by decentralized networks like Bitcoin.

Conclusion

In summary, Central Bank Digital Currency is the digital form of legal tender. Many implementations of CBDCs may utilize blockchain technology and offer users a smoother digital payment experience.

Risk Warning

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