Central Bank Digital Currencies — A Hot Topic (and new reality) for the Post-Pandemic World

This is a three-part series on CBDCs: what they are, how they are used, and why they are useful for cryptocurrency markets. In this first post, I will go over the history of CBDCs and how they compare to traditional fiat currencies, and how they differ from other blockchain-based tokens.

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A CBDC is a digital payment currency that is issued and fully backed by a central bank

It was March 2nd, 2016, and Ben Broadbent, Deputy Governor for Monetary Policy at the Bank of England, gave a speech about Central Banks & Digital Currencies. It was at that speech, when Mr. Broadbent first mentioned the term: Central Bank Digital Currencies (CBDCs). To give the timeline in reference to the price of Bitcoin, it was around $420 that day. At the time of this writing, the price of Bitcoin is north of $13,000.

It has been more than three and a half years now and the term “CBDC” has become ubiquitous. More and more central banks are working on and exploring the possibility of proposing one, and countries like Sweden, Ukraine, China, and Uruguay are in the advanced stages of CBDC exploration. Additionally, the Bahamas could be considered the first country to have actually introduced a CBDC, called the “Sand Dollar” that is fully backed by the Bahamian dollar, which is itself pegged 1:1 to the US Dollar. Let’s see what this real-life experiment brings about!

What is a CBDC?

If you are still reading this, you might have asked yourself — ok, I understood bits and pieces, but what is the definition of a CBDC? It is probably a good idea to go back to the Bank of England and provide the formal description that it proposed. According to the BoE, a CBDC is electronic Central Bank money that:

(i) can be accessed more broadly than reserves,

(ii) potentially has much greater functionality for retail transactions than cash,

(iii) has a separate operational structure to other forms of Central Bank money, allowing it to potentially serve a different core purpose, and

(iv) can be interest bearing, under realistic assumptions paying a rate that would be different to the rate on reserves.

Ok, that really represents the much-needed formality right there, but I will try to wrap it up in one sentence: A CBDC is a digital payment currency that is issued and fully backed by a central bank, used as a medium of exchange and a unit of account, represents a store of value, and is legal tender. Mentioning “legal tender” in its definition is important because this means that it is recognized by law as a means to settle a public or private debt, or to meet a financial obligation of any monetary kind. Distributed Ledger Technology (such as blockchain, and others) can easily support operations around issuing, transacting, and storing CBDCs.

Compare this to traditional paper (fiat) money: whenever a person holds cash, it can be said that he or she directly has a claim on a Central Bank Balance Sheet. However, this is not true by having deposits in a bank account. Even though the banks are required to hold reserves (as a cautionary measure) in the Central Banks, the requirement is generally quite modest and can be merely 10%-15% of the assets. Thus, most of the general public’s money deposits are backed by the combination of relatively illiquid long- and short-term loans. In most advanced economies these deposits are protected, or insured, by a third party up to a certain amount but this is not the case for quite a high number of countries in the world.

CBDCs — Wholesale vs Retail

Wholesale CBDCs are just another way for banks to hold reserve deposits in a central bank. Although it has some benefits like slightly improving payment efficiency and reducing credit and liquidity risks, I believe it still lacks the “game-changer” component in its design.

Retail CBDCs, on the other hand, can be used by individuals everyday, like cash or debit cards, to make payments, settle debts, pay taxes, etc. It empowers the general public and increases the degree of “financial inclusion” for them. It can have some positive effects for people living in advanced economies, but the potential benefits for emerging or frontier countries will probably be much greater.

Up Next: Cost-Benefit Analysis (CBA) of Introducing a CBDC

A CBA is a powerful tool for decision making, if the variables are relatively weighted correctly. Introducing a CBDC into any country can definitely have some benefits and costs, and they will differ from country to country mainly based on the state of their economies.

My next post will be about how “bank runs” can be facilitated through a well-developed CBDC during economic crises (a cost), how international payments can be made faster and more efficiently (a benefit), and what cyber-security risks are inherently enhanced (a cost).

I will also touch on some key facts around CBDC development in different countries.

Stay tuned!

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