The craze around central bank digital currencies (CBDCs) has been incredible over the past year. China especially got things running, and the country has remained at the forefront of CBDC development. However, several other countries have also been actively involved in CBDC research and development. They believe that digitizing their currencies would be the only way to safeguard their economic futures.
With the anticipation of CBDCs still very much ongoing, there are still some arguments about whether these assets are genuine requirements or just a fad. Some have argued that many countries researching CBDCs are merely doing so due to the bandwagon effect. Others also claim that they aren't much of a necessity for everyone.
With the arguments on all sides being understandable, it is worth seeing the potential benefit of currency digitization and how this endeavor could help countries.
First, What Are CBDCs, and How Do They Work?
In a sense, CBDCs are the future of the technological innovation currently engulfing the financial system. Today, financial service providers and banks see more digitization in their services with online trading and banking, digital payments, and much more jumping to new heights of prominence.
At the same time, there have been centuries of development for money itself. We began with property, then moved to coins, and now we have noes, cheques, cards, and more. These different forms capture different eras, all of which are the hallmarks of digital financial innovation.
To that end, a CBDC takes advantage of innovative technology to revolutionize money. Essentially, it is the digital incarnation of a country's sovereign currency, and it is listed and issued by the country's central banking institution or any other monetary authority. A CBDC is central bank-issued, backed by a country's legal tender, and deemed currency as well. It can also be programmable and transferred from peer to peer.
The growth of CBDCs over the past year has primarily been due to the coronavirus pandemic. More countries have understood the need to improve their digital payments and move away from physical cash, transmitting the virus between people.
Also, with different countries implementing stimulus packages to keep their economies afloat, there is a need for a proper dissemination system that allows people to get paid much faster and more efficiently. Digital payments have become the ideal driver for this, and CBDCs have also entered into the conversation.
The Different Forms of a CBDC
Primarily, CBDCs vary on three levels based on their architecture:
- Direct CBDC: These assets primarily offer retail services. Central banks operate them, and they have direct claims on the assets as well. With a direct CBDC, a central bank maintains its transaction ledgers and is responsible for executing all payments.
- Hybrid CBDC: A hybrid CBDC primarily runs on two different frameworks. The first concerns retail payments, which intermediaries run. As expected, the central bank maintains its direct claim on the CBDC and maintains its transaction ledger. There is also wholesale transaction use, where CBDCs gain application in trade settlement and much larger transactions. If intermediaries fail, the central bank also maintains a backup technical infrastructure.
- Synthetic CBDC: In this architecture, intermediaries issue CBDCs and are in charge of retail payments with customers. The CBDC has backing from currency reserves with central banks, and intermediaries can back all retail clients' liabilities with central bank claims.
How Do CBDCs Benefit Government
Quicker Transaction Settlements
Today, one of the most prominent issues with the current financial system is that transactions remain very slow. This problem is especially true for cross-border transactions, which can take days to be completed via traditional means.
CBDCs put a stop to this, optimizing transaction settlement and allowing citizens to move money much faster. At the same time, governments can also benefit from this quality. They can disseminate relief funds much quicker in times of crisis, and they can also facilitate trade settlements faster.
Another significant benefit of running a CBDC via a blockchain platform is the increased security that the process will bring. Blockchains are known to be much harder to breach due to their decentralization. Today, it is easy for governments to get technical experts to build their dedicated blockchains.
When a blockchain is ready, a government can host its CBDC directly and work with it from there. The government enjoys the benefit of security in transactions, transferring these benefits to the citizens as well.
Discouraging Criminal Activity
CBDCs represent a shift away from paper money. With a CBDC system, governments can hold records of all transactions and keep them under control. With people making transactions with CBDCs, it would be much less convenient to launder money and engage in criminal activity.
Money laundering remains a prominent issue because it is paper-based. Eliminating the circulation of paper money means that CBDCs will enable a more transparent financial market where the government gets visibility into transaction trails and can cut funds to criminal organizations.
It is worth noting that getting this benefit might take a while. CBDCs are yet to come into circulation, and governments would most likely want to introduce a phasing period between them and cash when they finally get implemented. However, there is significant promise on this front, and excitement about it is relatively noticeable.
With an intricate mix of operational efficiency and crime detection, CBDCs are a trend that no one should miss out on. As explained earlier, many governments already understand their benefit and are researching them in full force.
It is now time to move towards the digital monetization trend, however form that might take.