Banking Article, Banking Finance 2022, Banking Finance June 2022

Central Bank Digital Currency (Virtual form of a fiat currency)

Background

Money is not everything in life but it is hard to imagine life without Money. Money is an object that is generally accepted as

  • Payment for goods & services
  • Medium of exchange
  • Store value
  • Repayment of a debt
  • Unit for measurement of economy

Evolution of money to the present form

Over the last few years, there is growing interestin cryptocurrencies like Bit-coin, Litecoin and Dogecoin which work on a distributed ledgertechnology known as the block chain network. Cypto-currency is a type of digital currency that exists electronically. Such virtual currencies have gained immense popularity due to its decentralized and regulation-free nature. There is no transparent method about any suitable reserve maintenance to back-up the valuation of crypto currency. The popularity and continued launch of new crypto currencies has also raised concerns about the possibility of scam, theft & hacks. The rise in use of crypto-currencies is a possible threat to banking system and Central Bank is also unable to control the growth & influence of such crypto currencies. Many Central Banks across the globe are working-on or intendingto launchtheir own version of regulated digital currencies.

These regulated crypto currencies are called Central Bank Digital Currencies (CBDC) and will be operated by the respective monetary authority or Central Bank of a particular country.

Central Bank Digital Currency (CBDC) iscentralized electronic record or digital token which represents the virtual form of a fiat currency. It belongs to a particular nation or regionbacked by a suitable amount of monetary reserves like gold or foreign currency reserves which is issued & regulated by the competent monetary Authority of a country.

Each CBDC unit will act as a

  1. secure digital instrument equivalent to a paper bill
  2. can be used as a mode of payment
  3. a store of value
  4. an official unit of account

Like a paper-based currency note that carries a unique serial number, each CBDC unit will also be distinguishable to prevent imitation. Since it will be a part of the money supply controlled by the Central Bank of the respective country, it will work beside other forms of regulated money like coins, bills, notes & bonds. It aims to bring in the best of both worlds i.e., convenience & security of digital form like crypto currencies but regulated andalso backed by reserves. Central Bank or other Monetary Authority of the country will be solely responsible and liable for its circulation and operations.

Knowing the history of CBDC

  • It is a known concept in the field of economics. However, the present concept of “CBDC” may have been partially inspired by Bit-coin & similar block chain based crypto-currencies.
  • Bank for International Settlements published a report in Dec-2020 listing the known wholesale & retail projects of CBDC. By April 2021, there would be at least 80 different Central Banks in the world that are looking at digital currencies.

Examples of CBDC

  • To date, no country has officially launched a CBDC. Many Central Banks, however, have launched pilot programs & research projects aimed at determining a CBDC’s viability & usability
  • Since 2014, China’s Central Bank has been working on a project called Digital Currency Electronic Payment (DCEP)
  • The DCEP is often referred to as the “Digital Yuan” as it would be backed by the Yuan
  • In 2017, the People’s Bank of China organized a programme for Banks & Institutions to jointly develop DCEP system
  • In April 2020, DCEP began testing in 4 Chinese cities (Shenzhen, Suzhou, Xiong’an& Chengdu)
  • It is aimed to have the currency put into usefor the Winter Olympics – 2022

Approach

  • A Central Bank Digital Currency would likely be implemented using a database run by the Central Bank, Government or approved private-sector entities
  • The database would keep a record (with appropriate privacy & cryptographic protections) of the amount of money held by every entity, such as People & Corporations
  • In contrast to crypto currencies, CBDC would be centrally controlled and so a block-chain or other distributed ledger would likely not be required or useful even as they were the original inspiration for the concept
  • Researchers propose multiple ways that a retail CBDC could be technologically implemented

Characteristics

  • CBDC is a high-security digital instrument like paper bank notes
  • it is a means of payment, a unit of account & a store of value and like paper currency, each unit is uniquely identifiable to prevent counterfeit
  • Digital fiat currency is part of the base money supply together with other forms of the currency. As such, DFC is a liability of the central bank just as physical currency is
  • It’s a digital bearer instrument that can be stored, transferred & transmitted by all kinds of digital payment systems & services.
  • The validity of the digital fiat currency is independent of the digital payment systems
  • Proposals for CBDC implementation often involve the provision of Universal Bank accounts at Central Bank for all citizens
  • There are two types of CBDCs
  1. Retail: Retail CBCDs are meant for use by individuals, Households & Corporations
  2. Wholesale: Wholesale CBCDs are meant for use by Financial Institutions

Potential advantages of CBDC

  1. Technological efficiency: instead of relying on intermediaries such as banks & clearing houses, money transfers & payments could be made in real time, directly from the payer to the payee. Being real time has a couple of major advantages:
  • Reduces risk: Payment for goods & services needs to be done in a timely manner. With instant payments, Merchants no longer need to use intermediaries to handle the risk or to absorb the risk cost themselves
  • Reduces complexity: Merchants will no need to separately keep track of transactions that are slow, (where the customer claims to have paid but the money has not arrived yet) therefore eliminate the waiting queue, which could simplify the transaction process
  • Financial inclusion: Safe money accounts allowing any legal resident or citizen to be provided with a free or low-cost basic bank account
  • Preventing illicit activity: CBDC makes it feasible for a Central Bank to keep track of the exact location of every unit of the currency. This tracking has a couple of major advantages
    • It makes tax avoidance & tax evasion much more difficult, since it would become impossible to use methods such as off-shore banking and unreported employment to hide financial activity from the central bank or government
    • Combating crime: It makes it much easier to spot criminal activity and thus put an end to it. (in cases where criminal activity has already occurred, tracking makes it much harder to successfully launder money, and it would often be straightforward to instantly reverse a transaction & return money to the victim of the crime)
  • Proof of transaction: a digital record exists to prove that money changed hands between two parties which avoids problems inherent to cash such as short-changing, cash theft & conflicting testimonies
  • Protection of money as a public utility: digital currencies issued by Central Bank would provide a modern alternative to physical cash – whose abolition is currently being envisaged
  • Safety of payments systems: Secure & Standard interoperable digital payment instrument issued & governed by Central Bank boosts confidence and increases trust in the entire national payment system
  • Preservation of seigniorage income: Avoid a predictable reduction of seigniorage income for Government in the event of a disappearance of physical cash. (Seigniorage income is essentially the profit earned by the Government by printing currency)
  • Banking competition: the provision of free bank accounts at the Central Bank offering complete safety of money could attract bank deposits
  • Monetary policy transmission: Issuance of Central Bank base money through transfers to public could constitute a new channel for monetary policy transmission (helicopter money) which would allow more direct control of money supply than indirect tools such as quantitative easing and interest rates. (Mr. Milton Fiedman used the term, Helicopter money to signify “unexpectedly dumping money onto a struggling economy with the intention to shock it out of a deep slump”
  • Financial safety: CBDC would potentially render deposit guarantee schemes less needed

Though there is good number of advantages, there is potential risks too

  • A general concern is that the introduction of a CBDC would precipitate banks’ funding position weaker
  • Since CBDCs are centralized, the controller of CBDC can add or remove money from anyone’s account with a flip of a switch

By knowing the difference between CBDC and Cypto-currency, we can understand the concept in a better way

Point CBDC Crypto currency
Support Government backed money Private money
Block chain type Use permissioned (private) blockchains Use permission-less (public) block chain
Anonymity Users will have their identity tied up to an existing bank account and an equal amount of personal information Users enjoy anonymity
Decentralisation Central Bank decides the rules Authority is delegated to the user base
Use case Can be used for payments and other monetary transactions Used for speculative purposes and for payments as well
Data privacy & security Less likely emphasize privacy and data Undoubtedly independent with peer to peer model

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