Central Bank Digital Currencies (CBDCs) explained

This blog provides overview of Central Bank Digital Currencies (CBDCs) including the risks, benefits and latest research.

What is a CBDC?

A CBDC (central bank digital currency) is a type of digital currency used and controlled by a country’s central bank. “In simple terms,” says the Bank for International Settlements, “a central bank digital currency would be a digital banknote. It could be used by individuals to pay businesses, shops or each other (a retail CBDC), or between financial institutions to settle trades in financial markets (a wholesale CBDC).”

What is the difference between a cryptocurrency and a CBDC? 

A CBDC represents a central bank’s official currency in digital form. Unlike decentralised cryptocurrencies such as Bitcoin, a CBDC would be regulated by the relevant monetary authority and would not be subject to the kinds of market fluctuations that have recently impacted Bitcoin and the like. 

In general, most banks are cautious about investing in unregulated cryptocurrencies due to their volatility. However, many feel a centralised digital currency would allow people to reap the benefits of this type of technology, without the associated risks. HSBC chief executive Noel Quinn has expressed his support for CBDCs: “CBDCs can facilitate international transactions in e-wallets more simply, they take out friction costs and they are likely to operate in a transparent manner and have strong attributes of stored value,” he said.  

A 2021 BIS survey found that 86% of central banks were “actively researching” the potential of CBDCs and 14% were already deploying pilot projects. The Bank of England recently launched a dedicated CBDC taskforce and the Federal Reserve Bank of Boston is conducting a study with the Massachusetts Institute of Technology (MIT). The Bank of France and the Swiss National Bank are also in the process of testing cross-border payments between the two countries using their respective CBDC prototypes.  

What is a stablecoin?

A stablecoin is another type of cryptocurrency which is currently unregulated (though governments are already consulting in this area and UK regulators have prioritised regulating stablecoins over standard cryptocurrencies.) 

Stablecoins are different to cryptocurrencies like Bitcoin and Dogecoin because they are backed by actual tangible assets. One example of a stablecoin is Facebook’s Diem project. Diem coins are “backed by a reserve of assets made up of cash or cash equivalents and very short-term government securities,” according to the project’s website. This is different to a CBDC because it is not centrally controlled, it is privately owned and instead of being designed to digitally represent or replace a fiat currency, it is simply backed by it. 

As the name suggests, stablecoins are considered to be a more stable, low-risk alternative to ordinary cryptocurrencies. Diem is marketed as a means to provide people everywhere with “access to safe and affordable financial services,” enabling them to “live better lives.” Other examples of stablecoins include TetherPaxos or USD coin.

Which governments already have a CBDC?

The Bahamas has already launched the world’s first ever official CBDC known as the Sand Dollar. It is currently only offered to residents, but will be available to tourists in the future. A partnership between Mastercard, Central Bank of The Bahamas and digital payments provider, Island Pay, allows Bahamians to convert their Sand Dollars into traditional fiat currencies to pay for goods and services. It has the exact same legal status as the standard currency.

Out of the larger nations exploring CBDCs, China is generally believed to be the closest to implementation and is in the process of testing a potential CBDC with more than 100,000 of its citizens. It has even proposed a set of global rules for the use of CBDCs, including interoperability across jurisdictions and “a scalable and overseen foreign exchange platform supported by DLT (distributed ledger technology like blockchain) or other technologies.” 

What are the potential benefits of CBDCs? 

CBDCs essentially take out the middleman – i.e. traditional banking institutions and even fintechs – making payments easier, safer and quicker for both consumers and businesses. 

Any funds deposited in CBDC form would be guaranteed by the country’s central bank, providing a secure, low-risk place for people to keep their money, especially during times of economic crisis.  

Allowing anyone digital access to central bank funds via something as simple as a mobile phone app would democratise central bank money, allowing ordinary people to benefit, not just banks.

Addresses the risks associated with cryptocurrencies
The driving force behind central banks’ enthusiasm for exploring CBDCs is the growing interest in cryptocurrencies. Cryptocurrencies could eventually replace cash altogether, devaluing traditional currencies and giving central governments less power. Creating a centrally governed cryptocurrency which provides many of the same benefits as unregulated options, could address this risk. 

Reducing criminal activity
If governments choose to monitor payments placed through CBDCs it would reduce the ability of criminals to launder cash, therefore potentially reducing criminal activity. 

Reducing the number of unbanked citizens
In developing countries, CBDCs could help bring citizens who have no bank account into the banking system, boosting the economy.  

Streamlining allocation of funds during a crisis
CBDCs could vastly improve the ability to get government funds to where they need to be, quickly. Support payments related to the COVID-19 pandemic for example, could easily have been deposited directly to most citizens via CBDC. Other examples of where a digital currency could help in this context include natural disasters such as earthquakes and floods in developing countries where resources are needed quickly in order to save lives. 

What are the potential risks associated with CBDCs?

Banks left vulnerable 
Having a central digital currency could leave banks vulnerable in times of economic stress. If everyone could simply move their funds to the central bank during a financial crisis, what is to stop them from doing that, resulting in potential collapse for the banks? CBDCs could even replace traditional banks altogether if they offer interest on deposits. This could reduce the amount of funding available to banks for lending and so could have an impact on the wider economy. One possible solution to this would be for governments to put a cap on CBDC holdings. 

Privacy concerns
In a world where data is king, do we want governments to have access to the details of every transaction made by their citizens? There have been numerous examples of misuse of data in recent years, such as the Facebook and Cambridge Analytica case, which highlight the risks of sensitive data falling into the wrong hands. 

Some argue that having a fully digitalised currency could leave central banks vulnerable to hacking. Recent high-profile cyber incidents have shined a spotlight on this area of risk, including the attack on Colonial Pipeline in the US earlier this year, which caused gas shortages across the entire East Coast. Colonial recently confirmed it paid a US$4.4m ransom to the attackers in order to regain access to its systems. 

Consumer protection
There are still questions around how consumers will be protected and who will be held responsible in the event of a hack or error involving a CBDC transaction. 

Internet access concerns
For a CBDC to be fully functional and accessible to all, a strong internet connection is essential. Instead of increasing accessibility and democratising money as promised, CBDCs could actually widen the digital divide between demographic groups, discriminating against those with little or no internet access. 

Useful terms: 

Altcoin: Bitcoin was the first cryptocurrency to go mainstream and so all subsequent cryptocurrencies were dubbed “altcoin,” meaning “alternative coin.” 

Blockchain/digital ledger technology (DLT): A blockchain is a digital ledger or database containing all of the transactions happening within a particular digital currency. Its name comes from the way data is stored – in blocks which are then chained together. 

Fiat currency: Fiat currencies are simply traditional cash currencies produced by a country’s central bank, such as the pound or dollar. 

Stablecoin: Stablecoins are cryptocurrencies which (unlike ordinary cryptocurrencies such as Bitcoin and Dogecoin) are backed by actual tangible assets. They are generally seen as the lower-risk alternative to standard cryptocurrencies, which can be very volatile. 

Mining: Mining is the process used to create new digital coins or tokens (i.e. money) within a cryptocurrency. Sophisticated computers are used to complete the complicated mathematical equations needed to mine new digital coins (or create new blocks within the blockchain.) Most cryptocurrencies like Bitcoin involve this process, but a CBDC would not need to use mining to generate more coins or funds – the central bank could simply create more money itself at the click of a mouse. 

Britcoin: The unofficial name given to the digital currency currently being explored by the Bank of England. 

Sand Dollar: The world’s first official CBDC, issued by the Central Bank of The Bahamas. 

Digital Yuan: China’s CBDC, which is being trialled with 100,000 of its citizens. 

Jura: A collaboration project between the Bank of France and the Swiss National Bank testing cross-border CBDC payments between the two countries. It was dubbed “Jura” after the mountain range that separates France and Switzerland. 

e-krona: The CBDC currently being trialled in Sweden by the Swedish Central Bank (Sveriges Riksbank.) The Bank began investigating the possibility of a digital krona in 2017 and is yet to reach a conclusion on its viability. 

Further reading

Ready steady go? – Results of the third BIS survey on central bank digital currency: https://www.bis.org/publ/bppdf/bispap114.pdf 

Central Bank Digital Currencies: Tools for an Inclusive Future? by Harvard Kennedy School Belfer Center for Science and International Affairs:  https://www.belfercenter.org/sites/default/files/2020-09/cbdc-brief.pdf 

PwC CBDC Global Index report: https://www.pwc.com/gx/en/industries/financial-services/assets/pwc-cbdc-global-index-1st-edition-april-2021.pdf 

Central Bank Digital Currency: A Literature Review by the US Federal Reserve: https://www.federalreserve.gov/econres/notes/feds-notes/central-bank-digital-currency-a-literature-review-20201109.htm 

A digital euro to meet the expectations of Europeans, speech by Fabio Panetta, Member of the Executive Board of the ECB: https://www.ecb.europa.eu/press/key/date/2021/html/ecb.sp210414_1~e76b855b5c.en.html 

New forms of digital money, by The Bank of England: https://www.bankofengland.co.uk/paper/2021/new-forms-of-digital-money 

UK Treasury’s consultation on cryptoassets and stablecoins: https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/950206/HM_Treasury_Cryptoasset_and_Stablecoin_consultation.pdf 

Central bank digital currencies by The Bank of England: https://www.bankofengland.co.uk/research/digital-currencies 

Reinventing the wheel (with more automation), speech by Andrew Bailey from the FCA: https://www.bankofengland.co.uk/speech/2020/andrew-bailey-speech-on-the-future-of-cryptocurrencies-and-stablecoins