What are CBDCs? Central Bank Digital Currencies Are Transforming Global Finance

The global financial system is undergoing a digital transformation, with Central Bank Digital Currencies (CBDCs) emerging as a major innovation in monetary policy and payment systems. As traditional cash usage declines and digital transactions increase, central banks worldwide are exploring state-backed digital currencies to enhance financial stability, economic efficiency, and monetary sovereignty.

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CBDCs have become a key topic on the global agenda, with their significance growing through discussions at major financial conferences and policy meetings. Their inclusion as one of the major topics in the P2PFISY Workshop 2024, an event on peer-to-peer (P2P) financial systems founded by Paolo Tasca, chairman and co-founder of Exponential Science, is a key example. At the event in Dubai, academics and policymakers discussed how CBDCs could reshape economies, increase financial inclusion, and improve payment systems.

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But what are CBDCs, and why are they becoming a priority for central banks worldwide? What are the fundamentals of CBDCs, their benefits, challenges, some of their real-world applications, and their role in the future of digital finance?

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The basics of CBDCs

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A Central Bank Digital Currency (CBDC) is a digitally issued form of a country’s fiat currency, backed and regulated by the central bank. Unlike commercial bank deposits, CBDCs offer direct access to digital central bank money without the need for third-party institutions, ensuring a secure, efficient, and government-backed method of payment. CBDCs can be built using either centralised databases or blockchain-based infrastructure, leveraging distributed ledger technology (DLT) for increased transparency and security.

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CBDCs function as legal tender, meaning they can be used for payments, savings, and transactions just like physical cash. They provide a government-backed alternative to private digital payment systems that rely on blockchain technology, such as Bitcoin (BTC). By integrating digital currency into regulated monetary systems, CBDCs also help central banks maintain monetary sovereignty in an increasingly digital economy. 

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Key Characteristics of CBDCs

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CBDCs possess distinct features that differentiate them from physical cash, cryptocurrencies, and stablecoins:

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• Sovereign Digital Currency:  Unlike stablecoins (which are issued by private companies) or decentralised digital assets such as Bitcoin, CBDCs are directly issued and regulated by central banks and represent a nation’s official currency in digital form, ensuring monetary sovereignty and stability.
• Legal Tender Status: CBDCs are officially recognised digital money. They hold the same legal standing as physical cash, making them universally accepted for transactions within the issuing country. Unlike cryptocurrencies, which exist outside the traditional banking system, CBDCs are backed by government reserves and obligations.
• Direct Claim on the Central Bank: Unlike commercial bank deposits, CBDCs are direct liabilities of the central bank, offering users a risk-free digital asset.
• Programmability: CBDCs can incorporate smart contract functionalities, enabling automated processes such as tax collection or conditional payments, enhancing efficiency in various financial operations.
• Financial Inclusion: Designed to be accessible without the need for a traditional bank account, CBDCs can provide digital payment solutions to unbanked and underbanked populations, promoting broader financial inclusion. This is particularly relevant in developing nations where traditional banking infrastructure is limited.
• Enhanced Security and Transparency: Utilising advanced digital ledger technologies, CBDCs can offer secure and transparent transaction records, reducing risks associated with fraud or illicit activities, and enhancing the integrity of the payment system.

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Types of CBDCs

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CBDCs are classified into two primary categories based on their use cases and target users.

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1. Retail CBDCs for public use

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Retail CBDCs are designed for everyday use by individuals and businesses, providing a digital alternative to cash and traditional bank accounts.

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• Use Cases: Everyday payments, e-commerce, peer-to-peer transfers, and public transport fees.
• Accessibility: Available through digital wallets, mobile banking apps, payment platforms and government digital IDs, ensuring broad accessibility.
• Economic Impact: Retail CBDCs can improve financial inclusion by giving unbanked and underbanked populations access to a secure digital payment system.
• Examples:
  
  • China’s Digital Yuan (e-CNY): One of the most advanced CBDCs, integrated into popular payment platforms like WeChat Pay and Alipay.
  • Nigeria’s eNaira: Africa’s first CBDC, aimed at increasing digital transactions and financial inclusion.
  • The Bahamas’ Sand Dollar: The first fully operational CBDC, designed to improve payment accessibility across remote islands.

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2. Wholesale CBDCs used by banks and financial institutions

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Wholesale CBDCs are developed especially for banks, financial institutions, and central bank operations, to streamline large-scale financial operations. 

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• Use Cases: Facilitate faster interbank payments, cross-border settlements, and real-time clearing of large transactions, reducing reliance on traditional, slower banking networks.
• Efficiency: By eliminating third-party financial intermediaries, wholesale CBDCs lower transaction costs and settlement delays, enhancing overall financial system efficiency.
• Examples:
  
  • Project Helvetia (Switzerland): The project explores the integration of a CBDC into existing financial market infrastructures, testing its feasibility for settling tokenised assets on distributed ledger technology (DLT) platforms.
  • Project Jura (France-Switzerland): A cross-border CBDC project improving international settlements between European financial institutions. It uses tokenised central bank money for real-time foreign exchange (FX) transactions and cross-border payments.
  • Project Ubin (Singapore): A pilot wholesale CBDC designed to test real-time interbank payments using blockchain technology. It evaluates multi-currency CBDC settlement models and decentralised payment networks.

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Retail vs. Wholesale CBDCs: Key Differences 

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While retail CBDCs focus on consumer convenience, wholesale CBDCs aim to modernise and enhance institutional financial operations.

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CBDCs vs. Cryptocurrencies vs. Stablecoins

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CBDCs are often compared to cryptocurrencies like Bitcoin and stablecoins like Circle’s USDC. However, they differ significantly, in terms of issuance, control, stability and privacy, among other characteristics.

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For instance, CBDCs are state-issued digital currencies backed by government reserves, ensuring stability and regulatory oversight. In contrast, cryptocurrencies such as Bitcoin (BTC) and Ethereum (ETH) are decentralised digital assets that operate on blockchain networks without central authority control. Their value is market-driven, making them highly volatile.

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Meanwhile, stablecoins, such as Tether (USDT) and USD Coin (USDC), are issued by private companies or Decentralised Autonomous Organizations (DAOs) and are pegged to fiat currencies to reduce volatility while still operating on blockchain technology. Unlike CBDCs, both cryptocurrencies and stablecoins are not typically considered legal tender, though there are exceptions, for example, Bitcoin has been recognised as legal tender in El Salvador.

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While cryptocurrencies promote decentralisation and financial freedom for retail users, CBDCs primarily survey corporate and government entities and prioritise regulatory oversight, economic stability, and security.

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How Do CBDCs Work?

CBDCs rely on digital payment systems, often integrating with blockchain technology or centralised digital ledgers. The main components include:

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1. Technology Infrastructure

CBDCs can be built using:

• Centralised Databases: Managed entirely by central banks, ensuring full control.
• Blockchain-Based Systems: Utilising Distributed Ledger Technology (DLT) for transparency and efficiency.

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2. Distribution Models

There are two main approaches for issuing CBDCs:

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1. Direct Model: The central bank issues CBDCs directly to consumers, bypassing commercial banks.
2. Two-Tier Model: CBDCs are distributed through banks and fintech providers, maintaining the existing financial system.

A two-tier model is favoured by most central banks as it integrates CBDCs within the existing financial system without disrupting traditional banking.

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Why are Central Banks and Financial Institutions Embracing CBDCs?

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Apart from the core benefits of CBDCs, several macroeconomic and technological trends are accelerating their adoption:

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1. Decline of Cash Usage: As digital payments become dominant, central banks seek a digital alternative to cash to maintain monetary sovereignty.
2. Competition with Stablecoins & Cryptocurrencies: The rise of private digital currencies like USDT, USDC, and Bitcoin potentially challenges traditional banking. CBDCs offer a regulated alternative that central banks can control.
3. Modernising Financial Infrastructure: CBDCs improve transaction speed, security, and efficiency, reducing reliance on outdated banking systems.
4. Stronger Monetary Policy Tools: CBDCs allow for real-time control of money supply, direct stimulus distribution, and improved interest rate management.
5. Regulatory Oversight & Financial Transparency: Unlike physical cash, which is difficult to trace and often used in illicit activities, CBDCs offer built-in traceability, helping to combat money laundering, tax evasion, and financial crime.

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Benefits of CBDCs

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CBDCs offer a wide range of advantages for economies, governments, businesses, and consumers, including:

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• Faster & Cheaper Transactions: CBDCs enable instant, low-cost transactions, eliminating the need for intermediaries like payment processors or correspondent banks, which can significantly reduce fees for businesses and consumers.
• Lower Currency Management Costs: By digitising currency, central banks can reduce expenses related to printing, distributing, and managing physical cash, optimising financial infrastructure.
• Stronger Monetary Policy: CBDCs give central banks real-time data and control over the money supply, enabling faster and more precise adjustments to stabilise inflation and interest rates.
• Greater Financial Inclusion: CBDCs can serve unbanked and underbanked populations, providing access to financial services without requiring traditional bank accounts.
• Better Security & Fraud Prevention: The traceable nature of CBDC transactions can help prevent financial crimes like money laundering and tax evasion. Some CBDC implementations use blockchain or distributed ledger technology (DLT) for tamper-proof transactions, improving security and transparency.
• Boosting Payment Innovation: CBDCs encourage new financial products and services, driving innovation in digital payments, cross-border transactions, and decentralised finance (DeFi).

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Challenges and Risks of CBDCs

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Despite their advantages, CBDCs pose several risks:

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1. Privacy Concerns: A government-controlled digital currency raises concerns about financial surveillance and the potential for excessive control over individual spending habits.
2. Impact on Commercial Banks: If people move large amounts of money from commercial bank accounts to CBDCs, banks may lose deposits, affecting their liquidity and lending capacity.
3. Cybersecurity Threats: The shift to a digital currency system increases the risk of cyberattacks, hacking, and digital fraud, requiring robust cybersecurity infrastructure.
4. Regulatory Complexities: Ensuring cross-border compatibility and developing consistent global standards for CBDCs remains a major challenge for central banks.

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These issues were highlighted at P2PFiSY Workshop 2024, where financial experts debated how to balance innovation, regulation, and financial privacy.

Read also:  Shaping the Future of P2P Financial Systems in Dubai: P2PFISY 10th Edition 

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CBDCs: A Turning Point for the Global Economies?

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CBDCs are more than just digital cash; they represent a fundamental shift in global finance, offering secure, efficient, and government-backed digital payments. From financial inclusion to cross-border transactions, their impact could be transformative, but careful implementation is crucial.

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With over 130 countries exploring CBDCs, their future adoption appears quite probable. The next decade will likely bring multi-CBDC platforms, smart contract integration, and AI-powered financial solutions, enhancing CBDCs' potential to become the dominant form of digital money.

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CBDCs no longer seem to be just a concept; they are becoming a reality shaping the future of economies worldwide. However, privacy concerns, technological challenges, and banking sector implications must be addressed for widespread adoption.

The global financial landscape is at a turning point. The question remains: Will CBDCs become the future of money, or will private digital assets continue to dominate? The coming years will reveal whether CBDCs will coexist with traditional finance, reshape banking, or emerge as the dominant form of money in a digital-first economy.

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