Put simply, a Central Bank Digital currency or CBDC is a digital version of the traditional fiat currencies that we use today.
But, most money is already digital today, isn’t it?
After all, most of us can make payments worldwide without necessarily using cash, can’t we?
Is a CBDC really so different from the normal digital transactions we’re accustomed to?
Well, to better explain the difference, let me use an example.
Let’s say you are shopping for new shoes online, right?
You find the brand that you want and order a pair. Typically, you would pay using a bank-issued card.
Now, the merchant who is selling the shoes will basically charge the amount from your card, which will, in turn, ultimately be withdrawn from your bank account.
Once the charge goes through, the money will be transferred from your bank account to the merchant’s account.
All these transactions happen digitally, but significantly, in this case, it is a bank-to-bank transaction.
In other words, the payment for the shoes is settled between two banks.
But how different will this transaction be if we were living in an era of central bank digital currencies?
So, How Do Central Bank Digital Currencies Actually Work?
Well, it is actually pretty simple.
You won’t need to go through a bank to complete the transactions anymore.
In a world where CBDCs operate, everyone has an account at the central bank.
Also, every single transaction for each account is recorded in one big, central public ledger or record.
So, when I want to pay for my shoes online, the only thing I have to do is transfer the money directly from my central bank-issued account to the merchant’s central bank-issued account.
In essence, the entire transaction goes through without the need for any extra intermediary banks.
Another way to think of CBDCs is as normal cryptocurrencies that, instead of being decentralized, are actually controlled by a central entity that determines supply and utility.
Let's use another example.
Imagine you want to buy a birthday present for a loved one.
You go into a store and find a nice present, and decide to buy it. When you are checking out, you provide a debit card. The card is charged, and the money is transferred.
Now, what most people don't know is that these transactions are not instantaneous.
In other words, when the store charges your debit card, it does not actually mean that physical cash has exchanged hands exactly at that moment.
What happens is that a record showing your bank owes the seller’s bank the amount charged for the birthday present is created.
These records are constantly being created all day, every day, quickly cumulating into tens of millions of transactions.
So, how does the exchange of money happen?
Once all records of who owes who are created, the transfer of funds will be completed in 24 hours. This is where the central bank comes in.
In essence, the central bank looks at the record of transactions, determines which bank owes which bank money, and makes the transfer of funds.
The banks then credit the transfers from the central bank to the individual accounts, minus their fees, of course.
Let’s compare this to how a CBDC works.
As mentioned, it's pretty much the same way you transact money digitally now.
The only difference is that there are no banks.
Once a transaction is made, the money is moved across different CBDC-issued accounts instantly.
There is no 24-hour wait period, and there are no extra processing fees.
Once you pay, the money goes directly to the target account.
It’s not the only reason why CBDCs are seen as an attractive option, either.
Here come yet more Potential Benefits of CBDCs
Firstly, CBDCs could play a huge role in extending financial inclusion.
Although in most developed countries, many people have access to banking services and the financial system, in the developing world, things are very different.
CBDCs, which could be featured in central bank-issued mobile wallets, have great potential to provide access to finance in unbanked and underbanked communities.
Another advantage is that CBDCs could potentially help reduce transaction costs.
Since they allow people to transfer money directly from account to account, there will be no need for third-party banks and their associated fees.
Besides, this could also mean that transactions are cleared much faster, leading to greater efficiency in an economy.
Additionally, CBDCs could open a new world where people more directly can relate with central banks and economic planners.
This will make it easier for central bankers to help align economic policy more closely with people’s actual needs.
For instance, we have seen a lot of cases where central banks have issued economic stimulus packages, which are essentially direct cash to stimulate the economy, only for this money to end up with wealthy corporate CEOs.
With CBDCs, central bankers will have the opportunity to directly send stimulus directly to consumers and impact the economy in ways that are easier to measure.
Now, like any upcoming technology, CBDCs have plenty of proponents, but also a fair amount of opponents, too.
What are some the Risks of CBDCs?
Despite the benefits, CBDCs are not 100% perfect, and there are some concerns worth noting.
First, it is possible that the widespread use of central bank digital currencies could render the existing banking system obsolete.
After all, if you are able to bank directly with the central bank and transact using a central bank-issued digital currency, you won't need any third-party banks to assist.
This could have unexpected ramifications for both consumers and economies in general.
Secondly, there is also the question of privacy.
Even with current digitized payments, there is a certain degree of anonymity on what you spend money on.
In fact, in the traditional model, only your bank holds data on where and how you are spending your money.
Banks are also obligated by law not to share this info with anyone unless compelled to by law enforcement agencies or the taxman of course.
However, with a CBDC, where the central bank manages all transactions, it is easier for the government to keep track of spending habits.
It is something that could quickly infringe on the freedoms and liberties of individual citizens.
There are also a lot of concerns that CBDCs could give central banks incredible power in controlling the economy.
They may use their data to influence spending habits, control the flow of money, or even implement other Orwellian tactics.
If this power were to be abused, it could lead to disastrous consequences.
Still, this isn’t something which could happen overnight.
How Close Are We to CBDCs Anyway?
You might be wondering, with all this buzz about Central Bank Digital Currencies, just how close are we to CBDCs as part of our everyday lives?
Well, while the concept of CBDCs has brought a lot of discussion, the truth is, we're still in the early stages of them.
Out of all the countries across the globe, about 89 are currently exploring the idea of CBDCs.
However, it's essential to note that exploration doesn't necessarily mean it gets implemented.
Of these 89 nations, only about 18 have taken real steps towards creating their own digital currencies. And even within this group, the progress varies greatly.
For example, China has been piloting its Digital Yuan in select cities, with some success.
This makes it one of the few large economies that are actively testing a CBDC.
Nigeria has also launched its own CBDC, the eNaira, becoming one of the first African countries to do so.
On the other hand, in many developed countries, especially those part of the G7 - CBDCs remain as research and discussion.
Many of these countries, including the US, the UK, Canada, and Japan, are taking a cautious approach.
There’s a lot to be done to understand the full effects and possible disruptions that a CBDC might bring about.
So it’s safe to say we are still not really that close to a CBDC yet.
Conclusion
So that wraps up this article for you!
At their core, CBDCs are a digital version of traditional fiat money.
The main difference, however, is how they’re governed.
Rather than operating as a decentralized system like many cryptocurrencies, CBDCs would be governed by central banks.
This article also uncovered CBDC's potential to change financial systems by increasing financial inclusion, minimizing transaction fees, and creating better relationships between consumers and economic planners.
It could mean more efficient economies and a real shift in how monetary policy works with the public.
I also showed you how the road to CBDCs isn't without its problems.
There are privacy concerns in a world where every transaction could be traced, and disrupting traditional banking is never going to be easy.
Furthermore, the concentration of power in the hands of central banks could, if misused, have severe consequences.
Finally, you saw that while CBDCs have been making headlines, it's crucial to remember that wide-scale adoption is still a long way off.
Although numerous countries are exploring the concept, only a fraction are actually doing any development.
So! CBDCs represent an interesting junction between traditional finance and digital technology, with both great potential but also big challenges.
That’s it for now.
Will you be using a CBDC soon? Maybe so!
