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Central Bank Digital Currency (CBDC)

Central Bank Digital Currency (CBDC)

By Shobhit Seth   Updated March 09, 2022  Reviewed By Jefreda R. Brown  Fact Checked By Suzanne Kvilhaug

What Is a Central Bank Digital Currency (CBDC)?

Central bank digital currencies are digital tokens, similar to cryptocurrency, issued by a central bank. They are pegged to the value of that country's fiat currency.

Many countries are developing CBDCs, and some have even implemented them. Because so many countries are researching ways to transition to digital currencies, it's important to understand what they are and what they mean for society.

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KEY TAKEAWAYS

A central bank digital currency is the digital form of a country's fiat currency.

A CBDC is issued and regulated by a nation's monetary authority or central bank.

CBDCs promote financial inclusion and simplify the implementation of monetary and fiscal policy.

As a centralized form of currency, they may not anonymize transactions as some cryptocurrencies do.

Many countries are exploring how CBDCs will affect their economies, existing financial networks, and stability.

Understanding Central Bank Digital Currencies (CBDCs)

Fiat money is a government-issued currency that is not backed by a physical commodity like gold or silver. It is considered a form of legal tender that can be used to exchange goods and services. Traditionally, fiat money came in the form of banknotes and coins, but technology has allowed governments and financial institutions to supplement physical fiat money with a credit-based model in which balances and transactions are recorded digitally.

Physical currency is still widely exchanged and accepted; however, some developed countries have experienced a significant decrease in its use, and that trend accelerated during the COVID-19 pandemic.1

The introduction and evolution of cryptocurrency and blockchain technology have created further interest in cashless societies and digital currencies. Thus, governments and central banks worldwide are exploring the possibility of using government-backed digital currencies. When, and if, they are implemented, these currencies would have the full faith and backing of the government that issued them, just like fiat money.

Goals of Central Bank Digital Currencies

In the U.S. and many other countries, many people do not have access to financial services. In the U.S. alone, 5% of adults do not have a bank account. An additional 13% of U.S. adults have bank accounts but use expensive alternative services like money orders, payday loans, and check-cashing services.2

The main goal of CBDCs is to provide businesses and consumers with privacy, transferability, convenience, accessibility, and financial security. CBDCs could also decrease the maintenance a complex financial system requires, reduce cross-border transaction costs, and provide those who currently use alternative money transfer methods with lower-cost options.

 A CBDC also provides a country's central bank with the means to implement monetary policies to provide stability, control growth, and influence inflation.

Central bank digital currencies would also reduce the risks of using digital currencies in their current form. Cryptocurrencies are highly volatile, with their value constantly fluctuating. This volatility could cause severe financial stress in many households and affect the overall stability of an economy. CBDCs, backed by a government and controlled by a central bank, would provide households, consumers, and businesses with a stable means of exchanging digital currency.

Types of CBDCs

There are two types of CBDCs, wholesale and retail. Wholesale CBDCs are primarily used by financial institutions. Retail CBDCs are used by consumers and businesses, much like physical forms of currency.3

Wholesale CBDCs

Wholesale CBDCs are similar to holding reserves in a central bank. The central bank grants an institution an account to deposit funds or use to settle interbank transfers. Central banks can then use monetary policy tools such as reserve requirements or interest on reserve balances to influence lending and set interest rates.

Retail CBDCs

Retail CBDCs are government-backed digital currencies used by consumers and businesses. Retail CBDCs eliminate intermediary riskā€”the risk that private digital currency issuers might become bankrupt and lose customers' assets.

There are two types of retail CBDCs. They differ in how individual users access and use their currency:3

 

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