Learn Cryptocurrency
18 Feb 2022

Ten Things to Know about CBDCs: Technologies, Types, and Themes

Ananda Banerjee

The buzz in town after the Union Budget is all about the Indian government’s plans to launch its Central Bank Digital Currency (CBDC) by 2023. But are we even prepared for the grand reveal? Do we even know how a CBDC works and what it constitutes? Why would any government go through the pain of introducing a new financial instrument? And finally, do we know the exact vision behind its intercontinental rage?

Look no further for the answers.

Key Takeaways

  • In theory, CBDC is just like regular cash moving within the economy.
  • CBDC is a claim on the central bank of the country, which is RBI in our case
  • They are of two kinds: wholesale and retail CBDCs.
  • Wholesale CBDCs are meant for cross-border transactions.
  • Instrument economics, ledger design, underlying regulations, and incentivizing the digital currency are the four pillars of holistic CBDC development.

What’s a CBDC—A Crypto or Not?

A Central Bank Digital Currency (CBDC), as we know, is simply the digital variant of a country’s fiat or legal tender. A CBDC is strictly central bank money but is different from the traditional financial reserves of a country. Primarily conceptualized as a payment instrument, a CBDC is always a direct liability of the relevant central bank. It isn’t meant to challenge the existing financial instruments used within an economy, but to simplify day-to-day payments on a local and even international scale.

And no, a CBDC isn’t a crypto asset, and despite sharing the blockchain premise, the two are vastly dissimilar.

Having set the record straight on the CBDC-Crypto conundrum & what a CBDC is and isn’t, let’s now look at 10 things about it that need greater explanation.

1. It coexists with Fiat

Central banks, as we know, already manage the cash flow and financial reserves in an economy. However, commercial banks or intermediaries deal with a third type of money for inter-bank settlements and contingent liquidity (more like money in every citizen’s hand). But then, this commercial “money” sitting with banks isn’t the direct liability of a nation’s monetary authority. Therefore, if something wrong happens to an intermediary bank, user funds stand jeopardized. The CBDC will eliminate this issue. Well, the banks will still be there. Just that, CBDC will bring about a wide ecosystem focusing on accountability. 

So the plan is for CBDC to coexist with the existing financial forms, whilst powering efficiency and innovation along the way.

2. It is meant for Holistic Digital Payments

People often wonder why we need a CBDC. Aren’t we already using UPI payments, RTGS, NEFT, and other digital transaction modes? We are, but as long as we are linked to a commercial bank that provides us these services, there is still an intermediary in play that owes us nothing. Except for the sum insured.

CBDCs are an attempt to improve digital payment accessibility by safeguarding and focussing more on public needs. If we were to explain it plainly, governments are aiming to make the digital banknote of the central authority, i.e., the Reserve Bank of India in our case.

Over time, CBDCs are expected to develop into being the go-to backup payment option, for use whenever the existing digital setups start acting up and money needs to reach the source no matter what.

Still, payment diversity doesn’t come without its share of loopholes. The CBDC issuer needs to account for the digital hacks and vested interests of the service providers.

Note: Yes, over time, CBDCs need to be paired with more reliable intermediaries or “Payment Service Providers” to reach the interested parties.

However, for this kind of digital inclusion—that is, CBDC being a part of the digital payment setup—digital literacy is pivotal.

CBDC features

3. It isn’t like a Stablecoin

People often confuse stablecoins with CBDCs. The uncertainty is understandable as even a stablecoin or a Synthetic CBDC is pegged to something centralized. So let’s clear this up, once and for all.

In theory, stablecoins signify “narrow bank” reserves, where an intermediary makes funds available to the end-user and stores the assets issued by the central bank. But in case of a discrepancy, the user cannot set out a claim with the central bank in the picture.

Plus, liquidity is always an issue with Synthetic CBDCs as they cannot create liabilities or even expand their balance sheets like the central banking authority. To understand the differences between CBDCs and stablecoins better, check out this insightful post.

4. It helps with Liquidity

In India, as you may know, the RBI works around the Cash Reserve Ratio (CRR) to control the liquidity situation, which can impact exchange rates, the stock market, the rates of interest offered by banking institutions, and inflation. CBDCs can make it easier for the RBI to increase or decrease financial liquidity within an economy. With CBDC in the picture, the central bank can easily expand or shrink balance sheets to keep a tab on the inflationary or deflationary growth, as per its needs.

5. It is a Reliable Cross-border instrument

Even though CBDCs are meant to cater to the general public, currently transacting at the mercy of banks, they can also assume other roles. One such function is of a reliable cross-border payment facilitator. This call to action voices the need for highly interoperable CBDCs or, rather, wholesale CBDCs that global economies can use to pay for inbound and outbound products and services.

Having a wholesale CBDC manage cross-border payments—something that was ideated long back in the G20 meet—can prevent unintended consequences or financial spillover.

Fact Check: The spillover effect is an adverse economic event where the financial positioning of one country has a cascading effect on another (dependent) country.

As a part of the interoperable CBDC roadmap, there has to be a provision for domestic (retail) CBDCs and international (wholesale) CBDCs. And the Indian variant of the CBDC or Digital Rupee will bring both these concepts to the forefront.

For additional insights on these, kindly check out this detailed post about global CBDC developments at length.

6. It is ‘Private’ enough

Are you a decentralized evangelist unsure about CBDCs because the acronym starts with C and that stands for “central”? While your indifference is justified, there is a lot more to a CBDC than what meets the eye. Even though a CBDC doesn’t guarantee complete transaction autonomy, for obvious reasons, it will strike the perfect balance between privacy and disclosure by adhering to data protection rights in a precise manner.

7. It can be Designed as required

At the end of the day, CBDCs are still a financial instrument designed as per the government’s requirement. The instrument’s design choices across economies include one of two options: the interest-bearing mindset or an approach focusing on capped holdings. Also, the interest-bearing thought makes CBDCs more deposit-like instead of standard cash equivalents. Similarly, caps on holding take the crisis management feature away from this new form of money.

Therefore, it is evident that economies will find a middle ground to this by tiering interest rates to any holdings above a given threshold. And all this brainstorming is expected to add to the complexity.

Regardless of this, it is crucial that the instrument is convenient to use, convertible, broadly accepted, and low-cost, so as to not put the end-users in a spot.

8. It offers a ‘Choice of Ledger’

CBDCs, as an entity, need to have a database. And that is what the ledger is all about. Before we focus on the design aspects, it is necessary to consider security, low finality, resilience, excellent throughput, round-the-clock availability, interoperability, flexibility, and adaptability. When all these features are expected, while nothing strikes our minds as better than blockchains, some economies are considering other DLTs (Distributed Ledger Technologies).

If we are to propose ideas, Directed Acrylic Graph (DAG) and HASHGRAPH (multiple transactions-one timestamp) come to the fore as options with much potential.

As far as the Digital Rupee or the Indian CBDC is concerned, blockchains seem to be the way to go. The focus, therefore, will be on better payment authentication, improved structure, unified governance, controlled access, and multi-faceted functionality. All via a centralized ledger that is adequately private. 

9. It can be Incentivized

Much like the conundrum faced while designing the instrument, the CBDC incentivizing plan can also get tricky to put together. But why would the governments need to incentivize CBDC use?

Well, isn’t it obvious considering the massive infrastructure, capital expenditure, and running costs involved? Even though there isn’t a lot of clarity as to how the government will incentivize the CBDC project (related to the Indian contingent), it is safe to assume that the charges will be transparent, based on usage, and will be borne by users and merchants/payment service providers, in a fixed ratio.

10. It is Tech-Oriented

While there are several layers to any given CBDC, technology is probably the most important one. Legalities, standards, and acceptance aside, the CBDC tech is expected to be revolutionary, allowing individuals to make offline transactions, just like cash.

The time frames and thresholds of these offline transactions will depend on the liberties allocated by the central banks. As far as the technology side of the CBDC is concerned, the instrument will rely on convenience (made possible by QR codes) and contactless payments, security (enabled by the cryptographic techniques in play), fast (made viable through the type of ledger technology used), and interoperable (courtesy the relevant API integrations with servers and third-party resources).

Wrap-Up

A CBDC might not sound like much when it is just seen as a confluence of a standard financial instrument, a robust ledger to keep records handy, and a set of rules and regulations. Besides, despite the diverse use-cases associated with it, both national and global, it still has currency “singleness” as the focus. We hope that you are now able to see that there is much more to it, though. While these 10 pointers do not explain CBDC in its entirety, we also hope that you now understand it a bit more.

Before we conclude, we want to reiterate that CBDC is still and will always be at par with private money and cash. But it simplifies the way we deal with them.

FAQs

Q1. What is the purpose of CBDCs?

A1. CBDCs are entrusted with the task of lending additional financial and monetary stability to the economies concerned. At the ground level, its basic purposes include offering quick, transparent, and offline financial access to the public; increasing payment diversity; pushing financial inclusion; supporting cross-border transactions; speeding up fiscal transfers, and reducing the dependency on commercial banks.

Q2.What is the difference between CBDCs and cryptocurrencies?

A2. Despite both these disparate entities having blockchain technology in common, the instrument (token) and ledger governance create a divide. Most cryptocurrencies are stored on decentralized networks, aren’t regulated by a single entity, and have consensus-based tokenomics. CBDCs, on the other hand, are more like the digital replicas of relevant fiat currencies. Plus, they are issued, stored, and regulated in a centralized fashion—i.e., with a central authority overseeing every aspect.

Q3. Is CBDC a kind of cryptocurrency?

A3. No, a CBDC isn’t a cryptocurrency. The former is completely centralized. And the CBDC instrument or token—i.e., the Digital Rupee in India—is backed directly by the central bank’s financial reserves.

How do you feel about CBDCs after reading through this discussion? If the details helped and now you crave more informative content like this, read and learn more with CoinSwitch by your side.

Disclaimer : Crypto products and NFTs are unregulated and can be highly risky. There may be no regulatory recourse for any loss from such transactions. The information provided in this post is not to be considered as investment/financial advice from CoinSwitch. Any action taken upon the information shall be at user's own risk.

writer

Ananda Banerjee

Content Writer

Table of content