Central bank digital currencies (CBDCs) are a bit of a hot topic in the financial community right now.
Broadly speaking, they’re a type of digital money that’s designed to replicate the government-backed fiat money that we already use in our day-to-day lives.
But how do CBDCs even work? And how do CBDCs differ from cryptocurrencies like Bitcoin (BTC)?
In this post, I’ll go through exactly what CBDCs are, how they work, and what makes them different from cryptocurrencies like bitcoin, as well as stablecoins.
Let’s get to it.
What is a CBDC?
CBDCs, or central bank digital currencies, are a type of virtual currency. They’re designed and backed by governments and their central banks to electronically represent a country’s fiat currency, like the British Pound.
There are many ways to define a CBDC. However, most organisations would define a CBDC as an electronic version of a fiat currency that people and businesses can use to pay for goods and services.
The idea is that CBDCs are backed by their issuing government in the same way that a fiat currency (e.g., British Pound) is backed by a central bank (e.g., Bank of England). But instead of walking around with a wallet full of £5 and £10 notes, you’d be able to send money electronically to friends, family, and businesses, instead.
What’s the point of a CBDC?
At this point, you might be thinking, “Electronic money would be convenient, but don’t we already have that? Don’t we already use electronic money when we send bank transfers or use a credit card?”
The short answer? Yes.
However, electronic money and CBDCs aren’t the same things. Understanding the difference between these two types of digital currencies is critical to comprehending the point of a CBDC.
First, we need to recognize that electronic money does exist, but, in the UK, only select financial institutions are allowed to hold and manage it.
These are called electronic money and payment institutions and they include everything from banks like Barclays to digital payments services like PayPal. Banks and digital payments providers are the only institutions that can handle electronic money, which is why you need to have a bank account to send money electronically.
A retail CBDC would bring electronic money to everyone – not just banks and payment services.
With a retail CBDC, anyone would be able to send and receive electronic money without the need for a third-party organisation like a bank. Using CBDCs would still require that you have some sort of payment interface, like a digital wallet, but this implementation would eliminate the middleman (i.e., banks) in many transactions.
According to the Bank of England, one potential reason to develop this kind of electronic money is that a “CBDC could create new opportunities for payments and the way the Bank keeps prices and the whole UK financial system stable”.
How do CBDCs work?
As their name suggests, central bank digital currencies are digital currencies that are issued by central banks.
We’ve already discussed what makes a digital currency unique, so let’s focus on the central bank aspect of CBDCs. In reality, the fact that CBDCs are issued by central banks is what makes them fundamentally different from other types of electronic money.
The idea behind a CBDC is that a nation’s central bank (in the UK, that’s the Bank of England), would control all the CBDCs in circulation.
This makes a CBDC the liability of a central bank and not of a commercial bank. Many current forms of electronic money are the liability of the commercial bank that issues them – not of a central bank.
Once these central banks issue CBDCs, they’ll then maintain a core ledger of all the transactions that occur with said CBDC. If you send money to your nephew as a birthday gift, that transaction will be recorded on the same ledger as a rent payment someone makes to their landlord.
Businesses and consumers would be able to connect to this core ledger using payment interfaces. We don’t quite know what these payment interfaces will look like in many countries. But they may take the form of digital wallets where you can transfer money directly to or request money directly from anyone else.
There’s a lot that we still don’t know about what CBDCs will look like.
For a detailed look at one potential model, check out the 2020 Discussion Paper written by the Bank of England on CBDCs.
Types of CBDCs
When you think about CBDCs, you might picture a digital version of the British Pound. But the term CBDC doesn’t refer to just one kind of central bank-backed digital currency. In fact, there are multiple types of CBDCs that could exist.
The two major types of CBDCs that are in development are:
- Retail CBDCs. A retail CBDC is designed by a central bank for use by the general public (which is what I’ve covered above). It would serve as a digital banking option for anyone to use. But retail CBDCs could remove some of the risks that arise when you work with a private bank because all the funds would be directly issued by the government.
- Wholesale CBDCs. A wholesale CBDC is designed by a central bank for use by financial institutions. These CBDCs would potentially supplement or replace traditional bank transfer methods (like the Faster Payments Service or SWIFT) because they would make funds transfers much cheaper and more efficient.
Some countries like France are also pursuing a hybrid version of a CBDC that would combine elements of a retail and a wholesale CBDC.
The hybrid model would allow people to send and receive the same CBDC that banks use – but through different payment interfaces. Proponents argue that hybrid CBDCs would be easier to scale, but detractors claim that their underlying architecture would be more complicated than two separate retail and wholesale systems.
CBDCs vs Cryptocurrencies
One of the most common comparisons you’ll hear people make when discussing CBDCs is between CBDCs and cryptocurrencies.
In many ways, this makes sense. The idea of a fully digital currency was popularised by cryptocurrencies, so this connection is understandable.
However, CBDCs are not cryptocurrencies.
How are CBDCs different from Bitcoin (BTC)?
CBDCs often get compared to cryptocurrencies like Bitcoin (BTC).
This makes sense because Bitcoin (BTC) and CBDCs share some similar features, like their digital nature and their potential to reach people who are currently underbanked or unbanked.
But there are some key differences between Bitcoin (BTC) and many of the CBDC projects that have been proposed or implemented to date. These include:
- Centralisation vs Decentralisation: The biggest difference between Bitcoin (BTC) and a CBDC is that BTC is decentralised by design and CBDCs are centralised by design. Since CBDCs are issued and managed by a central bank, that bank has full control over the currency and the ledger that records all its transactions.
- Permissioned vs Permissionless: Since CBDCs are inherently centralised, they lack the permissionless systems that come with many cryptocurrencies like Bitcoin (BTC). Technically, anyone can access the Bitcoin network without permission from the network itself (hence the title of ‘permissionless’). Each CBDC that eventually goes into circulation will be different. However, it’s likely that most central banks will have restrictions on who can use these CBDCs – both domestically and overseas.
- Privacy & Security Trade-Offs: Proponents of CBDCs argue that their centralised nature can help prevent fraud and secure the network. However, this centralisation and theoretical security come with serious privacy risks. While you can maintain some semblance of privacy in your Bitcoin (BTC) transitions, privacy might be impossible on a centralised CBDC ledger that’s controlled by national governments.
- Price Stability: One of the biggest critiques that people make when it comes to using Bitcoin (BTC) as a payment method is the fact that Bitcoin’s price is so volatile. Advocates of CBDCs argue that the stable nature of a CBDC’s price (most CBDCs are pegged to a fiat currency) would make it more practical for use in daily payments.
- Inflationary vs Deflationary: CBDCs are issued by central banks so the amount of any given CBDC in circulation is determined by a government. If governments issue more CBDCs, this could lead to price inflation in the long term. Bitcoin (BTC), on the other hand, has a fixed supply cap of 21 million BTC and no more coins can ever be minted.
However, we’re still in the early days of CBDC development and we don’t yet know what many countries’ CBDCs might look like. In other words, this could all change over time if/when CBDCs hit the market.
How are CBDCs different from stablecoins?
CBDCs are often compared to stablecoins, and for good reason. Many stablecoins, like CBDCs, hope to serve a type of price-stable digital payment method.
But CBDCs are not stablecoins and there are some major differences between how both types of digital currencies operate.
One of the main differences is that CBDCs are centralised, permissioned systems that offer government-backed protection and security – though these potential benefits come at the cost of the privacy and open access that we get with stablecoins.
Of course, there are some potential benefits to CBDCs when compared to stablecoins.
For example, with fiat-backed stablecoins, like Tether (USDT), users need to trust that the company that issues Tether has enough US dollar (USD) in reserve to back all the USDT in circulation. CBDCs are backed by central banks, so there’s no need to trust that a private company truly has all the reserved assets that they need to back their stablecoin.
Alternatively, with algorithmic stablecoins, like Terra USD (UST), users needed to trust that the algorithm would effectively maintain the stablecoin’s price over the long term – which, as we’ve recently seen, wasn’t possible.
CBDCs require no such trust because they’re issued by central banks. But as mentioned before, CBDCs can lose value due to inflation or if a government stops backing them.
Ultimately, the biggest difference between CBDCs and stablecoins is who backs them and what that backing means for a person’s ability to transact with that digital currency. What you might gain in security through the government regulation of CBDCs, you lose in privacy and accessibility.
CBDCs: The Future of Money?
CBDCs are still a relatively new concept, both in the world of traditional finance and in the world of digital assets. Only time will tell whether national governments will eventually adopt central bank digital currencies, and, if they do, how those CBDCs will operate and affect our daily lives.
But what do you think?
Let us know in the comments below!
CBDC FAQs
Is a CBDC a cryptocurrency?
No, a CBDC is not a cryptocurrency. Many CBDCs resemble cryptocurrencies because they operate on the blockchain. But unlike true cryptocurrencies, like Bitcoin (BTC), which are decentralised, CBDCs are centralised assets that are fully controlled by their issuer—in this case, a central bank.
Does a CBDC use blockchain?
Yes, many current and proposed CBDC projects use blockchain technology – but this isn’t a requirement. Additionally, the centralised blockchain technology that’s used to create CBDCs is inherently different from the decentralised blockchains that are used to build cryptocurrencies. Some governments may also choose to use non-blockchain digital ledgers for their CBDCs, instead.
Does the UK have a CBDC?
The UK does not currently have a CBDC. The Bank of England and HM Treasury currently operate a CBDC Taskforce to assess the possibility of a future CBDC in the UK. But there hasn’t yet been an official announcement about whether a CBDC will be deployed in the UK.