Understanding CBDCs and how they work

Understanding CBDCs and how they work

Currency, as a medium of exchange for goods and services, has evolved over the last few decades, from fiat currencies to crypto currencies, and now to digital versions of fiat currencies known as CBDC.

WHAT IS A CBDC?

CBDCs should not be mistaken with Stablecoins also pegged at fiat currencies which we'll discuss soon.

As of July 2022, 3 countries and a region called Eastern Carribean Union (comprising of about 7 countries) have launched a CBDC.

It is expected that people will be able to use CBDCs the way we use our fiat currencies.

WHY CBDC?

The fundamental idea behind central bank digital currencies is that while they are maintained by blockchain technology or distributed ledger technology, they are still under the supervision of a central authority. CBDCs will serve as a medium of exchange and a store of value, and they will continue to be vulnerable to the numerous factors that affect the value of fiat currency (politics, supply, demand, trade, etc).

In 2020, the Covid-19 pandemic brought nations of the world to their knees and one of the affected services was the usage of fiat currencies to pay for goods and services. It is now estimated that cash represents 19% of transactions in the US since the Covid-19 pandemic.

CBDCs are expected to make financial transactions more swift and enable digital inclusion in the society. Although the idea for CBDC came from cryptocurrencies, they are very different from each other. The only similarity between CBDC and Cryptocurrency is that they are both digital assets.

HOW DOES CBDC WORK?

One might wonder how CBDCs plan to work since most currencies already support digital payments. In the real sense, digital payments of the traditional financial systems are instructions for banks to remove or add real money to your account, this means a number of actors are involved in the transaction process before the real money eventually leaves or gets to your account. CBDCs on the other hand will remove these Intermediaries thereby making the system fast.

A central bank will issue the CBDC directly and attach a unique serial number to every CBDC (let's say e-dollar) to identify it.

A CBDC system is expected to be flexible and available, that is, the currency should be adaptable to changing conditions and payments should be possible 24/7.

ADVANTAGES AND DISADVANTAGES OF CBDCS

ADVANTAGES

  1. CBDC eliminates risk of a commercial bank run (bank collapse)
  1. Transactions on the network will be easy to track.

A direct connection is expected between Central banks and citizens with CBDC, this will further open up the country to a range of financial inclusion. In the same vein, keeping track of transactions and preventing fraud will be simpler with a transparent ledger. The central bank can then assist in lowering money laundering and criminal activities.

  1. CBDCs means more efficient and secure cross-border payments CBDCs would make international money transfers more effective. This would substantially lower the costs associated with sending and receiving cash.

DISADVANTAGES

  1. Programmability Yes, fiat currencies are programmable but with CBDC in place, currencies can be more tweaked to suit the decision of the government or Central bank For example, the e-yuan(CBDC) of China was rumored to have been programmed with an expiry date feature in order to allow the Central bank of China to effectively boost consumption demand or impose negative rates as the case may be.

  2. Central banks would most likely turn to competitors with commercial banks and financial service providers. This is because Central banks might introduce financial services like borrowing and lending.

  3. Privacy There is a view that CBDCs will reduce the privacy of citizens because the central bank will now have access to the way each and every citizen spends, invests, saves etc. Even with the absence of CBDCs, central banks of most countries monitor the accounts of citizens indirectly through commercial banks.

CBDCS VS STABLECOINS (CRYPTOCURRENCIES)

One major difference between CBDC and a Cryptocurrency is that the value of a CBDC is regulated by a central entity while that of a crypto is not regulated, hence the value can fluctuate(volatility)

1 Bitcoin can be worth 50,000 USD today and by tomorrow, the value could have moved up or down to 43,000 USD. However, the value of 1 USD will always be 1 USD although the purchasing power can change due to a number of reasons like inflation, policies etc.

Now, moving to Stablecoins. Stablecoins are cryptocurrencies whose value are linked- pegged to another coin, good, or fiat currencies- asset backed. The aim of Stablecoins is to provide alternatives to high volatility of Bitcoin and other Altcoins. A popular example is the USDT which is pegged to the US dollar.

A stablecoin in a case where it is pegged to the currency of a nation can be traded against other currencies on the Blockchain ,that is, the Blockchain network recognizes stable coins.

CBDCs on the other hand hold the status of legal tender of that particular country in a digital format and cannot be traded against cryptocurrencies. For example, the Nigerian E-naira is only available on the e-Naira wallet and not on centralized or decentralized crypto exchanges like NGNT.

TYPES OF CBDCs

There are two types of CBDCS, we have the wholesale CBDC and Retail CBDC.

Wholesale CBDC

The type of CBDC used by financial organizations is a wholesale CBDC. Interbank transfers and related wholesale transactions are settled via wholesale CBDCs.

Retail CBDC

A retail CBDC is a type of CBDC used by individuals and businesses. Citizens will be able to make payments for services using retail CBDC.

COUNTRIES THAT HAVE LAUNCHED CBDCS

According to Wikipedia, the Central Bank of The Bahamas (Sand Dollar), the Eastern Caribbean Central Bank (DCash), the Central Bank of Nigeria (e-Naira), and the Bank of Jamaica(JamDex) are the four central banks that have introduced CBDCs.

Most central banks are still considering the advantages, disadvantages and risks involved with CBDCs

CONCLUSION

Central Bank Digital Currency is an innovative idea with either distributed ledger technology or Blockchain technology in mind. However, it is different from cryptocurrencies and will only be treated as the digital version of the available fiat currencies.

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