What Is a Central Bank Digital Currency? A Brief Guide to CBDCs

With cryptocurrencies exposing the inefficiencies of traditional payment systems, central banks have started exploring the concept of central bank-issued digital currencies.

Read on as we discuss how CBDCs differ from cryptocurrencies, their opportunities and risks, and the controversy behind them.

This is partner content sourced from Laura Shin’s Unchained and published by CoinDesk.

What Is a Central Bank Digital Currency?

A central bank digital currency (CBDC) is a blockchain-based digital form of fiat currency issued and managed by a central bank.

As CBDCs are essentially a blockchain-powered version of a country’s national currency, CBDCs are automatically considered legal tend and can be used for payments. The primary idea behind CBDCs is to offer a government-sanctioned digital payment system that addresses payment inefficiencies within a country.

How Is CBDC Different Than Cryptocurrency?

CBDCs only draw inspiration from cryptocurrencies, but they are significantly different from them. Cryptocurrencies’ key feature is the decentralized aspect. Decentralized digital currencies such as Bitcoin are borderless, permissionless, and censorship-resistant. Peer-to-peer transactions take place on public blockchains, and no one can tell a user what they can or can’t do with their digital money.

For CBDCs, the central bank controls the digital currency and oversees transactions, potentially allowing it to take actions such as freezing funds, blacklisting digital wallet addresses, and directly incentivizing individuals to spend their money (as opposed to saving it), especially if the CBDC is programmable.

Given that most CBDCs are in the conceptual stages, we’ll have to wait and see how they will actually operate (especially beyond national borders), and the level of control central banks will have.

Types of CBDCs

There are two main types of CBDCs: wholesale and retail.

The classification depends on the intended users: one is for financial institutions, and the other is for the general public.

Wholesale CBDCs target financial institutions, which can utilize them for inter-bank transactions.

The intended users of retail CBDCs are the public for everyday transactions, such as buying goods and services and sending money. Ideally, retail CBDCs will complement traditional bank accounts and cash. However, it is still too early in the concept and implementation stage to determine the impact on traditional financial systems.

Opportunities & Risks of CBDCs

CBDCs can potentially change the financial landscape. However, it’s still early to tell whether the net change will be positive or negative for society. Here’s a look at the opportunities and risks they offer.

Pros

• Third-Party Risk Elimination: The system relies on the central bank’s stability, unlike in traditional finance, where commercial banks are the counterparties.
• Cost Reduction: Central banks will deal directly with the public, removing the current expensive banking infrastructure. This has the potential to drive down transaction costs.
• Financial Inclusivity: CBDCs could potentially present a financial structure that eases access to financial services.

Cons

• Complete Lack of Privacy: CBDCs will require a healthy dose of personal information. The issuing central banks are responsible for fraud monitoring and ascertaining the legality of transactions. The government would have access to financial information without going through third parties to access it.
• Government Control of Consumer Behavior: CBDCs run the risk of being tools the government uses to encourage certain practices in line with its policies. For example, a government could program its CBDC only to be used to purchase certain goods and services but not others.
• Centralization Risk: With CBDCs, central banks would likely be the sole entirety in control of the digital currency, creating a single point of failure hackers could exploit, which could have crippling effects on the economy if a hack occurs.

Why Are CBDCs Considered Controversial?

A key issue with traditional finance is the control third parties like banks have over transactions. CBDCs would take further control and give the government direct access to everyone’s financial information.

Moreover, if a CBDC is programmable, it would allow the government to actively incentivize or disincentivize certain behaviors by its population. For example, it could directly prevent citizens from purchasing things like alcohol or cigarettes, if the government would want to actively discourage consumption. Clearly, there is potential for abuse of such access and control.

In a world where people decry the lack of privacy from government intrusion and surveillance, CBDCs would only serve to compound the problem.