Central Bank Digital Currency (CBDC): Definition and explanation

CBDC is a digital form of fiat currency and can complement cash and traditional payment methods. In this guide, we explain what CBDC is, its advantages and disadvantages, and how it works.

• CBDCs are digital currencies issued by central banks that complement the traditional financial system in a digital form

• They can be used for everyday transactions and to promote financial inclusion

• A distinction is made between wholesale CBDCs for financial institutions and retail CBDCs for the general public

• Digital central bank money offers benefits such as convenience and security but also carries risks like increased surveillance and dependence on the financial system

CBDC – What is it?

The abbreviation CBDC stands for Central Bank Digital Currency. Literally translated, this means digital central bank currency, with the term digital central bank money also being commonly used in German for CBDCs. By definition, CBDC is a digital form of currency issued by the central bank. Digital central bank money is part of the traditional financial system of fiat currencies and is backed by the government of the respective country. The concept of the digital currency CBDC is inspired by cryptocurrencies such as Bitcoin or Ethereum but differs in that CBDCs are fiat currencies issued by central banks in digital form. If the European Central Bank (ECB) were to introduce such a digital currency, it would be the digital euro.

How does Central Bank Digital Currency (CBDC) work?

Digital central bank currencies can be implemented in different ways. CBDCs are based on blockchain technology, distributed ledger technology (DLT), or a customised solution designed to meet the specific needs of the central bank. The technologies used for digital central bank money are known for their transparency and security, making CBDCs well-suited for fast and secure transactions in everyday payments. Unlike cryptocurrencies, CBDCs are not decentralised but are directly linked to the currency of the respective country. This makes digital central bank money more stable and generally less prone to significant fluctuations in value.

CBDC is created in the form of digital tokens or account entries. In a token system, the CBDCs are issued as digital tokens based on blockchain or DLT technology. Alternatively, central banks maintain digital accounts for users through which transactions are processed. In both cases, the central bank can issue the digital currency directly into circulation without requiring other commercial banks or financial institutions as intermediaries.

How can digital central bank money be used?

CBDCs represent the digital equivalent of a national currency and serve as a bridge between a traditional monetary system and the digital world. Primarily, they are intended for use in everyday payments. You can use the digital central bank currency like cash to purchase products or services, carrying out secure transactions in real time. Furthermore, the currency can promote financial inclusion by making it easier for people without a bank account to access the financial system. CBDC also supports financial institutions. Using digital central bank money, financial service providers can offer their services more effectively, manage liquidity, and process transactions.

Types of Central Bank Digital Currency (CBDC)

There are two types of digital central bank money: wholesale CBDC and retail CBDC. Wholesale CBDCs are designed for industrial purposes and are intended for banks and financial institutions. Therefore, the wholesale currency is not issued to the public but is typically reserved for commercial banks and financial institutions. This form of CBDC is used for securities settlement and interbank trading and is intended to improve the efficiency of the financial system.

Retail CBDCs are available to the general public and are aimed at individuals and businesses. Retail CBDCs allow you to hold digital central bank money and carry out transactions without relying on a traditional bank. You can access the digital currency through a wallet or similar platform. The digital money enables you to make payments and transfers, receive funds, and carry out other financial transactions.

The role of the central bank in CBDC

The primary task of the central bank in the context of digital currency is its introduction, issuance, and management. All rules and regulations concerning CBDC are set by the central bank, including the issuance volume and any applicable security standards. The central bank is also responsible for ensuring financial stability even with digital money. It monitors and controls the money supply to manage inflation and mitigate other risks. Thanks to its long history of managing the financial system, the central bank also ensures public trust in the digital currency.

Is CBDC a cryptocurrency?

The concept of Central Bank Digital Currency (CBDC) is inspired by currencies in the crypto market but differs from them. Crypto market currencies are decentralised, whereas CBDCs are issued and regulated by a central bank. They also differ in terms of anonymity. Cryptocurrencies typically enable pseudonymous transactions where your identity is not fully disclosed. In contrast, digital central bank money transactions can be more closely monitored and traced to prevent illegal activities. However, it is worth noting that not all digital central bank currencies are the same. Some CBDCs may share greater similarities with cryptocurrencies due to the use of blockchain technology, while others may not.

Can I buy CBDC as an investment?

The primary function of CBDC is to serve as a digital form of government-issued money, not as an investment. The digital currency is intended to facilitate payment transactions, promote financial inclusion, and support the financial system. Unlike cryptocurrencies, which are created and traded, CBDCs are liabilities of central banks. Typically, there is no need for you to purchase CBDCs, as the digital money is issued by central banks and made available to users.

Advantages of central bank digital currency

A key advantage for consumers is the convenience of CBDCs. Digital central bank money can be stored and accessed via a wallet, eliminating the need to carry cards or cash. You can easily access the wallet through your mobile phone, enabling payments even without access to traditional banking services. Speed is another benefit of the digital currency. Transactions can be conducted and processed in real time. Additionally, the increased security of this payment method is a significant advantage. Transactions are recorded on a central ledger and can be tracked, making it harder for fraudsters to steal money. For central banks, the digital currency offers the opportunity to implement monetary policy more effectively, as they have direct influence over money creation and distribution.

Disadvantages of central bank digital currency

While digital central bank money offers some advantages, there are also criticisms and drawbacks associated with the potential introduction of CBDCs. The security of the payment method, cited as an advantage, can also be seen as a disadvantage due to the level of control it allows. Cryptocurrency advocates, in particular, criticise the centralisation of digital currency, which contradicts the decentralised nature of cryptocurrencies. Related to this is the risk of surveillance and data privacy concerns with CBDCs. Since all transactions are recorded on a central ledger, financial activities could be closely monitored.

Cryptocurrency advocates also argue that CBDCs increase dependence on the traditional financial system, which is often viewed as opaque and flawed. Moreover, digital central bank money must be accessible to everyone, requiring significant investment in infrastructure and education. Questions from consumers, which were previously addressed by commercial banks, would need to be handled by the central bank if CBDCs were introduced.

Conclusion: CBDC – balancing innovation and security

Central Bank Digital Currencies (CBDCs) offer an innovative way to bridge the gap between the traditional financial system and the digital world. Built on technologies like blockchain, CBDCs promise transparency, security, and efficiency in payment systems. They enable the direct and rapid exchange of digital central bank money for everyday use and to promote financial inclusion. However, the disadvantages of CBDCs must also be considered, such as the risk of surveillance, privacy concerns, and the potential for increased dependence on the traditional financial system. The role of central banks is crucial in ensuring stability and fostering public trust in this form of digital currency.

Further topics on cryptocurrency

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