CENTRAL BANK DIGITAL CURRENCY (CBDC): AN INTRODUCTION

A Central Bank Digital Currency is a digital form of a country's currency issued by the country's central bank. It's divided into two categories - wholesale and retail CBDCS. Unlike crypto, these currencies are fully centralised, and transactions are not anonymous. Many governments are turning towards this type of currency to promote financial inclusion and simplify fiscal policy implementation. Rather than printing money, the central bank issues government-backed and generally accessible digital coins or tokens that have the same value as the national currency.

Although physical currency is still widely in use, the rise of cryptocurrencies like Bitcoin and the development of blockchain technology have caused financial institutions and individuals to pay more attention to digital money. Hence, central bank governments worldwide are researching and exploring the potential of government-backed digital currencies.

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 decentralized digital currencies like bitcoin and Ethereum and is more like cash itself in cutting out the middle-men – it seemingly travels directly from person to person or from customer to vendor like a coin.

Types of Central Bank Digital Currencies

CBDCs are split into two categories - wholesale and retail. Wholesale CBDCs are principally used by financial institutions, while regular businesses and everyday users use retail CBDCs.

1. Wholesale CBDCs: Wholesale CBDCs function similarly to having reserves in a central bank. The central bank provides a financial institution with an account to deposit digital currencies and conduct interbank transfers. Then the central bank utilises monetary policy tools like interest in reserve balances to set interest rates and manage general bank lending.

2. Retail CBDCs: In simple words, retail CBDC is a digital currency that an everyday citizen will use, for e.g., to pay for groceries, etc just like fiat money. It is digital money for ordinary people to make daily transactions eliminating intermediary risks. We can further divide retail CBDCs into two types: Token-based and Account-based.

   1. Token-based retail CBDC: These digital currencies are accessible with public or private keys, which provide transaction anonymity.

   2. Account-based retail CBDC: These types need digital identification to access an account.

Most people confuse CBDCs with cryptocurrencies, but both are quite different. There are three main key differences:

• Cryptocurrencies are decentralized in nature, while CBDCs are centralized (because they’re issued and backed by the central bank of a country/territory).

• Cryptocurrencies offer anonymity for financial transactions, while the central bank fully knows CBDC transaction details.

• Cryptocurrencies are generally not backed by the government and are therefore private currency, while CBDCs would have full government support, and therefore be legal tender.

Advantages and Disadvantages of CBDCs?

Advantages

There are several benefits of central bank digital currencies, including:

• Faster and Cheaper Transactions: CBDCs typically run on blockchain technology. Blockchain has a quicker processing time and lower processing fees than the current banking system. Users could send and receive their digital currencies within and outside the country faster and cheaper.

• Banking the Unbanked: Many countries have a large number of people who don't own bank accounts. They're known as the unbanked. With a CBDC, anyone with an internet-enabled phone can sign up for an account or wallet to send and receive funds. There would be little to no need to visit a physical banking institution to fill out multiple account opening forms.

• Enhanced Fraud Detection: All CBDC transactions are recorded and stored on a digital ledger. This will help authorities easily identify fraudulent transactions and other illicit operations.

Disadvantages

There are some drawbacks of central bank digital currencies, including:

• Privacy Concerns: The central bank will completely control its central currency's entire user data. An organisation holding such amounts of sensitive information is a potential privacy disaster. Furthermore, the central bank can block certain transactions and prevent users from accessing their funds for arbitrary reasons.

• Accessibility Barriers: Some people may not have the means required to use a CBDC, like a smartphone or internet access. Others may not trust the new currency and would instead stick to the type of money they're familiar with.

The financial world and how money works are evolving. As we move towards a fundamentally digital world, it is understandable that traditional banking systems are finding ways to stay updated.

Although most central bank digital currencies are still in the research or development stage, they'll likely become a standard part of financial operations worldwide. Countries like the USA, China, India, and more are already in the process of making their respective CBDCs managed by the local government.