Central bank digital currencies (CBDCs) are electronic versions of a country’s fiat currency issued and regulated by its central bank. They are a direct liability of the central bank and denominated in the national unit of account. Like physical currency, CBDCs can be used as a medium of exchange, account unit, and store of value.

Across the world, many central banks have increasingly become interested in CBDCs and are either researching, piloting, checking proof of concept, launching, or canceling their implementation. While some analysts have welcomed this move, some view these developments as attempts by governments to spread their sphere of influence to digital assets and maintain the old order.

This article will explore CBDCs in more detail, including their benefits, risks, and potential implications for the future of finance.

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Key takeaways

• CBDCs are digital versions of national currencies issued by central banks. They provide a secure and efficient alternative to physical cash while supporting monetary policy objectives and promoting financial inclusion.
• There are two main types of CBDCs: retail and wholesale. Retail CBDCs are intended for use by the general public, while wholesale CBDCs are primarily used for transactions between financial institutions.
• Central banks are interested in CBDCs because they can improve monetary policy implementation, enhance financial inclusion, and increase payment system efficiency.
• Several countries worldwide are exploring and implementing CBDCs, including India, China, and Nigeria.

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What are the different types of CBDCs?

CBDCs can be classified into two primary types based on their intended use and target audience: retail and wholesale.

Retail CBDCs

Retail central bank digital currencies are intended for use by the general public, enabling individuals and businesses to carry out everyday transactions. They work much like physical cash but in a digital form, accessed through digital wallets and mobile applications. Retail CBDCs seek to improve financial inclusion and offer consumers a secure digital payment alternative.

Wholesale CBDCs

Wholesale CBDCs are designed for transactions between financial institutions. They facilitate large-value transfers and interbank settlements, primarily operating behind the scenes in the financial system. These CBDCs are not accessible to the general public and aim to streamline and secure high-volume financial transactions.

How Central Bank Digital Currencies work

Underlying technology

CBDCs are built on blockchain and distributed ledger technology (DLT), which provide a secure and transparent way to record transactions. The ledger is shared across multiple entities without a central administrator, making it resistant to cyber-attacks. Some of the key features of the underlying technology include:

• Immutability: Once data has been recorded on the blockchain, it becomes unalterable. This ensures that entries in the ledger cannot be deleted or altered, ensuring the integrity of the data.
• Decentralization: Multiple copies of the ledger are maintained across the network, preventing data loss and eliminating a single point of failure.
• Transparency: All transactions are visible to authorized participants, promoting trust,auditability, and accountability.

Issuance and regulation

Central banks are responsible for issuing and regulating the digital currencies. They control the money supply by operating on a permissioned or private blockchain network, which allows them to set monetary policies and economic objectives tailored to their needs. The issuance process involves:

• Minting digital currencies: Central banks add CBDC tokens to the ledger, expanding the money supply as needed. 
• Distributing to users: CBDCs are available to the public, including digital wallets, bank accounts, and other authorized financial institutions.
• Monitoring transactions: Central banks track CBDC usage to ensure stability and prevent fraudulent activities like money laundering.

Why central banks are interested in CBDCs

Central banks are actively exploring the potential of digital currencies to realize the following objectives:

Monetary policy Implementation

CBDCs can enhance monetary policy’s effectiveness by giving central banks more precise control over the money supply and interest rates. By issuing a CBDC, central banks can:

• Fine-tuning the demand for central bank reserves and managing liquidity more efficiently will ensure a stable financial system.
• Precisely target short-term interest rates by adjusting the supply of reserves in the financial system.
• Facilitate faster and more efficient monetary policy transmission to the broader economy, reducing lags and enhancing policy effectiveness.

Enhance financial inclusion

CBDCs can improve financial inclusion by providing access to financial services for unbanked and underbanked populations through the following initiatives:

• Offering affordable and accessible options for individuals and businesses will lower the barrier to entry to digital payments and financial products.
• Reduce the costs of financial transactions for low-income individuals, making essential services more affordable and accessible.
• By expanding financial inclusion, CBDCs can stimulate economic growth, create new opportunities, and reduce economic inequality.

Payment system efficiency

CBDCs can increase the efficiency and security of payment systems, reducing transaction costs and settlement times. Some advantages include:

• Facilitating faster, more cost-effective, and highly secure transactions, benefiting individuals and businesses.
• Streamlining cross-border payments by reducing transaction times and minimizing currency conversion costs, promoting global trade and investment.
• Strengthening the resilience of payment systems by reducing reliance on intermediaries and providing real-time settlement capabilities.

What are the risks and challenges associated with CBDCs?

Some of the risks associated with CBDCs include:

Privacy concerns

One significant concern about CBDCs is the potential for increased surveillance and data collection by central banks. CBDC transactions could be easily traceable, raising concerns about the government monitoring individual financial behavior and potentially leading to a loss of financial privacy and civil liberties. 

Critics argue that CBDCs’ centralized nature could enable authorities to track all transactions, undermining the privacy protections that cash currently provides. The design and implementation of CBDCs will be crucial in determining how much privacy users can afford. If central banks prioritize monitoring and data gathering, the risk to personal privacy could be substantial, potentially leading to a system where the government scrutinizes every transaction.

Cybersecurity risks

CBDCs face significant cybersecurity risks. As digital currencies, they are vulnerable to hacking, phishing attacks, and other cyber threats. Cybercriminals may target CBDC systems to steal users’ digital assets or compromise transaction integrity. The centralized nature of many proposed CBDC systems could create a single point of failure, making them attractive targets for cyberattacks. 

Additionally, implementing smart contracts in CBDC platforms could introduce vulnerabilities if not properly secured. Robust cybersecurity measures, including encryption and continuous security assessments, are essential to protect CBDCs from these evolving threats.

Impact of CBDCs on the banking sector

Introducing CBDCs could shift deposit levels from commercial banks to CBDCs, impacting banks’ liquidity, lending practices, and interest rates. It could also disrupt established financial systems, necessitating banks to adapt their business models to retain customers. Understanding these potential impacts on the banking sector will be crucial for maintaining financial stability as central banks explore CBDC implementations.

Notable CBDC projects around the world

India’s Digital Rupee

The Reserve Bank of India (RBI) has been actively exploring the feasibility of a central bank digital currency (CBDC) called the digital e-rupee. Key milestones and developments include:

• Concept note on CBDC issued in October 2021, outlining the objectives, choices, benefits, and risks of issuing a CBDC in India.
• A pilot for the wholesale segment (e₹-W) launched in November 2022. It settles secondary market transactions in government securities.
• The retail segment (e₹-R) pilot launched in December 2022 in select cities. It allows users to make digital transactions using the e-rupee.
• The initial target of 1 million retail transactions per day was reached by December 2023, although usage has since declined to around 100,000 daily transactions.

The RBI aims to assess the technology, gain operational experience, and explore the feasibility of e-rupee for retail transactions. Plans include expanding the pilot to more banks and cities.

China’s Digital Yuan (e-CNY)

China has been at the forefront of CBDC development with its digital yuan (e-CNY) project. Key aspects of the project include:

• Development of the e-CNY began in 2014, with the People’s Bank of China (PBOC) leading the effort.
• Pilot programs launched in 2020 across major cities, allowing users to download e-CNY wallets and make transactions.
• As of October 2022, over 260 million personal and 5.6 million corporate wallets have been opened, with transactions exceeding $14 billion.
• The e-CNY aims to provide a cash alternative and promote financial inclusion while supporting the Chinese yuan’s internationalization.

China continues to expand the e-CNY pilot and explore its use cases, including cross-border payments and integration with other digital platforms.

Nigeria’s eNaira

Nigeria launched its central bank digital currency, the eNaira, in October 2021, making it one of the first countries to implement a CBDC successfully. Key aspects of the eNaira include:

• The eNaira is a digital version of the Nigerian naira, with the same value as the physical currency.
• Over 840,000 eNaira wallets have been opened, with transactions exceeding $10 million as of January 2022.
• The eNaira aims to promote financial inclusion, increase remittances, and support the growth of the Nigerian economy.
• Low adoption rates and technical issues are challenges, but the Central Bank of Nigeria remains committed to the project.

The eNaira is expected to continue evolving, with plans to integrate it with existing payment systems and expand its use cases.

These examples demonstrate the growing interest in and experimentation with CBDCs worldwide. Each project is tailored to the specific needs and goals of the issuing country.

Difference between CBDCs and cryptocurrencies

For starters, CBDCs and cryptocurrencies are both forms of digital currency. However, there are several key differences, as follows:

• Centralization and issue: CBDCs are centralized and state-issued, whereas cryptocurrencies like Bitcoin and Ethereum are decentralized and controlled through a distributed ledger. 
• Regulation and control: CBDCs are subject to strict government control, while cryptocurrencies operate outside the control of governments and financial institutions.
• Stability: The value of CBDCs is linked to the issuing country’s fiat currency and is relatively stable, while the value of cryptocurrencies can be highly volatile.
• Anonymity: CBDC transactions could be traceable, while most cryptocurrencies provide more anonymity and privacy.
• Purpose and usability: CBDCs provide a digital equivalent of physical cash, improve payment systems, and enhance monetary policy. Cryptocurrencies are primarily used as a medium of exchange and for investment and speculation.
• Interoperability: CBDCs may be designed to offer interoperability with other existing payment systems, while cryptocurrencies often operate on their blockchain network, which limits interoperability. 

Main differences between CBDCs and stablecoins

Issuing authority

Central Bank Digital Currencies are digital currencies issued and regulated by central banks. The government backs them and serves as legal tender, providing a digital alternative to physical cash. On the other hand, stablecoins are often issued by private entities and are pegged to a fiat currency or a basket of assets to maintain price stability. Examples of stablecoins include Tether (USDT) and USD Coin (USDC), which are commonly used for cryptocurrency transactions.

Backing

CBDCs, as digital representations of national currencies, aren’t backed by physical assets. Their value is anchored in the trust in the issuing government, making them a direct extension of traditional fiat currencies.

Stablecoins, on the other hand, typically maintain their value by being backed by reserves of fiat currency or other assets. This backing mechanism ensures that each stablecoin can be redeemed for a corresponding amount of the underlying asset, providing a degree of stability and security.

Regulation

CBDCs, being directly issued and regulated by central banks, operate under a robust regulatory framework. This ensures their stability, compliance with monetary policies, and protection against potential risks.

On the other hand, stablecoins are subject to varying regulatory landscapes across different jurisdictions. While they are regulated, the framework is often less stringent than that of CBDCs. This can lead to regulatory uncertainties, inconsistencies, and risks associated with their operations.

Transaction mechanism

CBDCs often leverage private or permissioned blockchains, which grant participants controlled access. This approach enhances security and allows for better monitoring and governance.

On the other hand, stablecoins typically operate on public or permissionless blockchains. This provides greater accessibility and transparency but can make controlling the network and addressing potential vulnerabilities more challenging.

Purpose and use cases

CBDCs are primarily focused on modernizing payment systems, enhancing the effectiveness of monetary policy, and promoting financial inclusion. They aim to provide a digital alternative to physical cash, streamline transactions, and make financial services more accessible.

Conversely, ecoins are primarily designed to serve as a stable medium of exchange within the cryptocurrency ecosystem. They facilitate trading and investment activities without the volatility associated with traditional cryptocurrencies.

Converting fiat into USDT or USDC on Paxful

CBDCs are not supported on most cryptocurrency exchanges. However, you may still turn your physical currency into digital currency through Paxful. 

To convert fiat currency into USDT or USDC on Paxful, follow these steps:

1. Sign up for a Paxful account for free, get a free Paxful account, and complete the required identity verification process to ensure security.
2. Choose the fiat currency you want to convert and the stablecoin (USDT or USDC) you wish to purchase.
3. Browse the marketplace for offers from other users willing to sell USDT or USDC for your chosen fiat currency.
4. Once you find an offer that meets your requirements, confirm the amount of stablecoin you want to buy and start the trade. This will open a live chat where you can communicate with the seller in real time.
5. Follow the seller’s instructions and then send the payment to their account.
6. Once the seller confirms receipt of the payment, the USDT or USDC will be released to your Paxful account.

This process allows users to easily convert fiat into stablecoins, facilitating participation in the broader cryptocurrency market.

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