Central Bank Digital Currency (CBDC): what is it and how it works

Sushree Behera

29 March 2023

Central Bank Digital Currencies (CBDCs) are the latest buzzwords in the financial world. With countries like China and Jamaica already exploring CBDCs, and others like The United States planning to do the same, it is becoming increasingly important to ask – what exactly is a CBDC, and how does it work?

In this article, we will discuss the concept of CBDCs and answer these questions.

Table of Contents

Central Bank Digital Currency (CBDC): what is it

A Central Bank Digital Currency, or CBDC, is a form of a digital currency issued by a central bank and meant to be used as a form of payment. It can take the form of either tokens or an account-based system and allows users to transfer value without the need for a third-party intermediary.

Much like cash or other forms of digital currency, CBDCs can be used to make payments and store value. The primary difference between CBDCs and other digital currencies is that central banks issue them instead of private companies, making them more secure, transparent, and widely accepted.

Types of CBDCs

There are four types of CBDCs:

wholesale CBDCs: wholesale CBDCs are intended for use by financial institutions;

retail CBDCs: retail CBDCs are intended for general public use. They are again divided into two types;

token-based retail CBDCs: token-based retail CBDCs take the form of digital tokens and allow users to store and transfer value;

account-based retail CBDCs: account-based retail CBDCs, on the other hand, are based on existing bank accounts and use a system of “smart contracts” to enable more efficient payments.

Why are central banks interested in exploring the potential of CBDCs

Central banks globally are investigating the possibilities of CBDCs for numerous reasons. One of the primary motivations is to facilitate more efficient payments between individuals and businesses and international payments.

In addition, Central Bank Digital Currencies (CBDCs) could offer access to financial services for those who may not have access to banking systems. This would help promote financial inclusion. Furthermore, CBDCs are seen as more secure than other forms of digital currency, making them well-suited for use in a world increasingly reliant on technology.

Countries that have already launched CBDCs

Below listed are the countries that have launched Central Bank Digital Currencies:

The Bahamas

The nation has introduced a digital currency called the Sand Dollar, which is a digital representation of the Bahamian dollar and will be managed by the Central Bank of The Bahamas.

Eastern Caribbean Currency Union

The ECCU has also launched its digital currency called the DCash. It is a fully digitized version of the Eastern Caribbean Dollar and is already used for currency union transactions.

Nigeria

Nigeria has launched its own CBDC called the Naira, which is a digital representation of the Nigerian Naira. It is designed to facilitate faster and more secure payments within Nigeria.

Countries testing CBDCs in pilot projects

Below listed are the countries that are currently testing CBDCs in pilot projects.

Jamaica

Jamaica is in the process of testing a CBDC called the Jamaica dollar. This digital currency is designed to help reduce the cost of transactions and enhance financial inclusion.

Sweden

The Swedish central bank, Riksbank, has launched a pilot project called E-krona. The project aims to examine how digital currency can be used to securely and efficiently facilitate payments.

Ukraine

Ukraine is also exploring the possibility of CBDCs with its E-hryvnia project. The project aims to examine the potential of digital currencies in facilitating financial transactions in Ukraine.

China

China is one of the leading countries when it comes to CBDCs. The nation has been experimenting with its own digital currency since 2014 and is currently in the process of testing it out.

Countries developing Central Bank Digital Currencies (CBDCs)

Below listed are the countries that are developing Central Bank Digital Currencies.

The US

The Federal Reserve is currently exploring the idea of launching a digital currency of its own. It recently announced that it had formed an inter-agency task force to explore the potential of CBDCs.

India

The Reserve Bank of India is also looking into launching its own digital currency. A Working Group is currently examining the potential of CBDCs in India.

Eurozone

The European Central Bank is looking into the possibility of introducing a digital currency for the Eurozone. It recently announced that it has set up a task force to study the potential of launching a CBDC in the Eurozone.

The benefits of CBDCs

The benefits are:

faster payments: CBDCs are digital currencies, and as such, they have the potential to facilitate faster payments than traditional payment systems;

increased financial inclusion: CBDCs could potentially increase financial inclusion by reducing the cost of transactions and making them more accessible to people without access to traditional banking services;

improved security: CBDCs leverage the security and encryption features of blockchain technology. By utilizing this innovative technology, CBDCs are able to provide a secure platform for digital transactions. This could potentially reduce the risk of fraud or cyber-attacks on financial transactions.

The drawbacks of CBDCs

The current cons of CBDCs are:

Lack of regulatory clarity: Central banks are actively researching and determining the best approach to regulate CBDCs as well as the appropriate legal framework to implement. This could lead to an increase in regulatory uncertainty;

Increased privacy risks: The ability to track and trace payments using CBDCs could expose users to privacy risks, as it would make financial transactions more transparent;

Potential for financial instability: Central banks are still in the process of understanding how CBDCs could affect financial markets’ stability, making it difficult to predict the impact they could have on the global economy.

The future of CBDCs

Central banks issue digital versions of fiat currencies known as Central Bank Digital Currencies (CBDCs). CBDCs can revolutionize payments and financial services, facilitating faster and more secure transactions than traditional payment systems.

Before we can achieve wide-scale adoption, we must still address regulatory clarity and privacy considerations. As a result, central banks must conduct further research and testing before deploying CBDCs.

Overall, we need to do much work before we can widely adopt CBDCs, but we cannot ignore their potential benefits. CBDCs, if implemented correctly, could transform payments and financial services in unprecedented ways.