Central banks explore digital currencies to offer stability amid the current crypto craze? Image Credit: Shutterstock

Central Bank Digital Currencies are a new form of electronic money that, unlike well-known cryptocurrencies, are issued by central banks of certain countries.

These central bank-issued digital currencies are simply digital tokens, similar to cryptocurrency, pegged to the value of a country's currency. But they are not a form of cryptocurrency.

CBDCs are not cryptocurrencies

Although the idea for CBDCs came from cryptocurrencies, they are two very different types of digital currencies. The key difference between CBDCs and cryptocurrency is centralisation.

Centralisation is simply the control of an activity under a single authority. A cryptocurrency is a decentralised digital currency, meaning there's no central party that controls it.

CBDCs are most similar to Stablecoins, which are cryptocurrencies that are pegged to fiat money and attempt to maintain the same value. The main difference is that the world's governments issue CBDCs.


So what is the difference between cryptocurrencies and CBDCs?
Cryptocurrency transactions are processed and recorded on a block chain, which is a public, distributed ledger. As the name implies, a central bank digital currency is controlled by a central bank.

CBDC is managed on a digital ledger (which can be a block chain or not), expediting and increasing the security of payments between banks, institutions, and individuals.

Cryptocurrency also provides much greater privacy than CBDCs. Transactions are sent and received through wallet addresses, and it's possible to retain some degree of anonymity.

Certain types of cryptocurrency are even thought to be untraceable. With a CBDC, the central bank will have a record of users and their transactions.
So what is the difference between cryptocurrencies and CBDCs?

80-plus countries and counting..

More than 80 countries around the world are researching or developing CBDCs, and they're at various stages of the process.

In 2020, a group of seven central banks including the US, Europe, Japan, Switzerland, Canada, Sweden, and England, indicated an intention to assess the feasibility of implementing publicly available CBDCs.

Other countries are considering or beginning to implement CBDCs including China and Russia as well as a host of smaller nations including South Africa, Uruguay, Barbados, Switzerland, Thailand and Iran.

Clearly, the motivation for CBDCs is compelling. Late last year, the Central Bank of the UAE became the latest monetary regulator to express an interest in issuing a central bank digital currency (CBDC).


Why do we need CBDC?
The two main driving forces for CBDCs are the challenge presented to national currencies by cryptocurrencies, and the uncertainty about future currency stability in the world in general.

This is because the US dollar has been losing its exclusive position as the peg for other currencies and for conducting international trade.

The public reasoning is often more guarded. Centralised oversight of the movement of currency could put an end to a lot of any transparency-related fraud. Identifiable digital currency is also hard to steal.

Moreover, a currency that can move without sorting banks and clearing houses involves far lower costs, especially for corporations that conduct thousands of transactions per day.

Since CBDCs could affect the crypto market, understanding them is important if you're investing in cryptocurrency.

How does a CBDC work?

So a central bank digital currency (CBDC) is essentially an electronic form of cash that can be exchanged much like you exchange traditional ‘money’. We already exchange digital money on a daily basis, whether via bank transfer, digital wallets or card payments, but there is a difference.

Most digital payments are essentially checks – instructions for a bank to pay ‘real’ money from your account. As such, multiple actors are involved to enact the transactions, clearing payments and administering millions of individual accounts.

A CBDC on the other hand, has evolved from decentralised digital currencies like Bitcoin and Ethereum and is more like cash itself in cutting out the middlemen – it seemingly travels directly from person to person or from customer to vendor like a coin.

Both cryptocurrencies and CBDC are dependent on networked electronic resources to create, track and validate transactions. In the case of most cryptos, such as Bitcoin, those resources are distributed and anonymised.

Since CBDCs could affect the crypto market, understanding them is important if you're investing in cryptocurrency.

In the case of CBDC, a central database ultimately controlled by a central bank issues the currency and provides every e-currency with a unique serial number to identify it. Usually, central banks will also peg the electronic currency to their existing national currency.

Since national currencies today are ‘fiat’, CBDCs are alternatively called digital fiat currencies. Fiat money is a type of money that is not backed by any commodity such as gold or silver, and typically declared by a decree from the government to be legal tender.

How can I benefit from CBDCs?

Central bank money is the safest form of money available. A CBDC could also lead to transactions that are much faster, cheaper, which benefits everyone involved.

In countries that create retail CBDCs, consumers can get direct access to central bank funds. Many countries have large unbanked populations, and CBDCs could help solve this problem.

When it comes to benefits, a CBDC can be classified into two - 'Retail' CBDC, would be used like a digital extension of cash by all people and companies, and a 'Wholesale' CBDC, which could be used only by permitted institutions as a settlement asset in the interbank market.

Retail CBDCs are issued to the general public. Under this model, consumers are able to own a CBDC in a wallet or account and use it for payments. This type of CBDC would serve as a public digital banking option that anyone can use.

Key takeaways

A CBDC is essentially a legal currency issued by a bank in a digital format and it is no different from hard cash, apart from the fact that they are in a digital or virtual form. It is not meant to replace hard cash, but co-exist as an additional form of payment method.

The idea for central bank digital currencies stems from cryptocurrencies and block chain technology. CBDCs are backed by a government and recognized as legal tender where they have been implemented.

So a central bank digital currency is the digital form of a country's fiat currency. A CBDC is issued and regulated by a nation's monetary authority or central bank.

CBDCs promote financial inclusion and simplify the implementation of monetary and fiscal policy. As a centralised form of currency, they may not anonymise transactions as some cryptocurrencies do.

Many countries are exploring how CBDCs will affect their economies, existing financial networks, and stability.