Motives, structure, and effects on commercial banks
Companies and customers are adjusting to digital payment methods more quickly than they could have predicted. What motivates central bank digital currencies, an electronic version of central bank money, and what are the essential design factors? What is the equivalent effect on commercial banks? The development of CBDCs will impact the entire financial ecosystem, even though there is no one solution.
An overview of CBDCs
A CBDC is an electronic version of central bank currency that businesses and households may use extensively to make payments and store value. It is digital money issued by central banks denominated in national units (such as the US dollar). It functions as a legal tender and is subject to central bank liability, much like circulation-level physical cash. Because of this, compared to other digital currencies, CBDCs are less volatile and more safe. An overview of the goals of CBDCs and frequent misconceptions about them are shown in the following table.
Digital currency issued by central banks is…
- Digital versions of traditional money that are issued and managed by a nation’s central bank;
- Supply and value are influenced by a nation’s central bank, trade surpluses, and monetary policies; they are also based on a digital ledger and may or may not use distributed ledger technology or blockchain.
Digital currency from central bank is not..
- cryptocurrencies (such as Bitcoin) that are managed by decentralized autonomous communities as opposed to a central authority;
- value-driven and totally driven by the market; or
- equivalent to electronic cash with a claim against an intermediary like a commercial bank, such as the amount in a digital wallet or prepaid card.
CBDCs are a fast-developing concept, and different central banks may implement them in various ways. There are confident design choices that are not widely agreed upon, such as the following:
- central bank digital currencies’ capacity to replace coins and notes
- Level of privacy or anonymity
- Availability and accessibility
- Capacity to bear interest
CBDCs would provide a novel kind of central bank money and a paradigm shift in the payments infrastructure. It is crucial to understand the advantages of central bank digital currencies and their effects on the larger payments landscape.
See Deloitte’s study to examine the legislative and regulatory factors about central bank digital currencies.
the CBDCs’ drivers
The demand for more effective domestic and international financial transactions, real-time payments and settlements, and the swift digitization of economies are the main factors driving the need for central bank digital currencies. The International Monetary Fund (IMF) claims centralized technologies like CBDCs can lower costs, promote seamless money transfers, enhance financial inclusion, and offer safer digital money access. On the other hand, many central banks are worried about possible effects on the economic system as they become aware of the growing importance of digital currencies.
The four main factors listed below are what we believe have encouraged central banks to investigate CBDCs:
- assisting in the digitalization of economies
- simplifying the present payment methods
- Improving fiscal and monetary policies
- Increasing accessibility to finance
CBDCs generally offer a more robust payment environment, fostering innovation, efficiency, competition, and controls. They would also increase the availability and usability of legal central bank money to counteract the decline in the use of cash.
CBDC design considerations
Central banks are investigating several CBDC designs while considering variables, including distribution method, access, and privacy. For central bank digital currencies, there are two typical design formats: account-based and token-based. Each strategy has differences in the technical infrastructure, access, and privacy levels.
Token-based central bank digital currencies rely on a digital token that users must be familiar with to access and make claims (public-private key pair). Although this method usually provides a high level of anonymity, central banks can impose identity restrictions to access the network. Token transfers require a type of distributed ledger technology to validate payment transactions and confirm the chain of ownership in each token since they depend on the sender’s capacity to verify the legitimacy of the payment item—the increased end-user risk of misplacing a key or token stored in a non-custodial wallet results from this.
To ensure compliance with requirements about know your customer (KYC) and anti-money laundering/combating the financing of terrorism (AML/CFT), commercial banks would have to be the first line of defense in a token-based strategy. In contrast to other designs, this approach can make CBDCs accessible to all people, but it also makes law enforcement more difficult.
Account-based access to and claims from the central bank digital currencies are connected to a bank account linked to the account holder’s identity. Because this approach still necessitates a financial relationship, it presents a challenge for widespread access. Banks would debit the sender’s and the beneficiary’s CBDC accounts to process each payment and transfer money. Because user IDs must be used to verify transactions, robust identity management systems are necessary to keep each individual’s unique identity across payment systems.
The central bank is responsible for adhering to AML/CFT and KYC regulations using an account-based approach. In an account-based system, verifying transfers is contingent upon implementing suitable measures to prevent fraudulent activities, identity theft, and unauthorized transfers from legitimate accounts.
To choose the best CBDC implementation, several design factors need to be carefully examined, such as distribution, access, and privacy. A central bank can choose the optimal course of action by examining the trade-offs and promised benefits and learning from previous CBDC and cryptocurrency methods.
Present-day central bank digital currencies landscape worldwide
Figure 1 illustrates that CBDCs are more than just a theoretical concept; there are actual CBDCs and several proofs of concept across the globe. Significant highlights include:
More than 60 central banks are investigating central bank digital currencies at different stages of maturity.
14% of central banks are proceeding with development and pilot agreements.
There are now three active retail CBDC projects: Eastern Caribbean DCash, Bakong Cambodia, and Bahamas Sand Dollar.
While larger nations have spearheaded research and pilot programs in the last few years, smaller countries are driving the actual implementation of central bank digital currencies pilots. These countries include China, Sweden, Canada, and the United Kingdom. The Sand Dollar, a digital currency backed by the central bank of the Bahamas, was introduced in the latter part of 2020. A large archipelago has become more accessible for transacting business thanks to the Sand Dollar. Improvements in transaction simplicity, service delivery expenses, and financial inclusion are additional intended outcomes.
CBDCs’ effects on commercial banks
Commercial banks, who are crucial partners in the successful implementation of a central bank digital currencies, are granted CBDC design options and are intensely focused on customer-facing operations, secure transactions, and regulatory reporting. To stay up with the need to provide suitable products, central bank digital currencies introduce an electronic form of central bank money, which adds a great deal of complexity for commercial banks and may necessitate considerable organizational changes.
A paradigm shift in how local and international economies function could result from central banks using CBDCs to start their digital currency journey. The design of a CBDC will affect the whole financial ecosystem, even if there are still many unanswered questions.
