What is Central Bank Digital Currency (CBDC)?

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Central Bank Digital Currency or CBDC has been a hot topic in the crypto world for quite some time, with several countries already making it a reality. But what is a CBDC? Will CBDCs steal Bitcoin’s thunder? Do they intend to kill all existing cryptocurrencies or pave the way for a new wave of crypto adoption?

In this article, Liquid is taking a deep dive into the curious case of central bank digital currencies, why more countries are working on them, and whether CBDCs are suitable for the crypto universe. Let’s start with some basics.

What is a central bank digital currency (CBDC)?

Stands for central bank digital currency, CDBC is a new and emerging form of digital currency.

There has been growing interest in cryptocurrencies like Bitcoin and Ethereum due to their decentralized nature. These digital currencies operate on a blockchain network serving as the backbone of the entire crypto ecosystem.

Similar to cryptocurrencies, CBDC will supposedly use the same distributed ledger payment technology with one significant difference: Unlike cryptocurrencies like Bitcoin and Ethereum, a CBDC will be a centralized digital currency issued and governed by a central bank, a financial institution responsible for overseeing the country’s commercial banking system and regulating its money supply, among other things.

From what it looks like, a central bank digital currency can be a digital payment token representing a digital form of fiat currency issued and backed by a central bank, thereby earning a legal tender status.

Why are many countries interested in having their CBDC?

Many governments around the world are currently evaluating the adoption of a digital currency for various purposes. However, it is still far from large-scale deployment. Some of the significant benefits of a blockchain-based CBDC are increased payment efficiency and reduced transaction costs. But there is more to the story. Let’s take a look at the list of potential applications of a centralized digital currency:

  • Increased payment efficiency and reduced costs

Having a CBDC could help increase the efficiency of the country’s overall traditional payment system. For instance, blockchain could pave the way for real-time gross settlement instead of the existing international payment system based on a net settlement, thereby saving fees to a significant extent.

  • Increased financial inclusion and accessibility

Financial inclusion could be another useful application of a CBDC. In emerging markets, the traditional payment system uses intermediaries like commercial banks, leaving many people unbanked with little to zero accessibility to financial services. In these markets where the lack of access to a physical currency is a significant problem, a CBDC could cut out intermediaries, thereby allowing a vast unbanked population to have easy access to the financial system.

  • Increasing the overall size of the economy

For many countries experimenting with a centralized digital currency, adopting CBDC could pave the way for increasing the overall size of the economy. For instance, in developing markets, a significant portion of the country’s gross domestic product (GDP) is used on printing physical currency bills. Having a CBDC can solve that problem and strengthen the overall economic position.

  • Cracking down on tax evaders

Countries experimenting with a CBDC are progressing towards a genuinely cashless economy wherein avoiding paying taxes could be next to impossible. When the entire financial system is digitized with a CBDC, it could potentially crackdown on a shadow economy encouraging black market transactions and undeclared work.

  • Simplifying cross-border payment transactions

It is by far the most prominent benefit of a CBDC. Having a CBDC could help speed up internal transactions and reduce currency and interest-rate risks associated with cross-border transactions. A CBDC promotes the idea that people should no longer be trading through major currencies like the US Dollar (USD), provided the technology is operationally implemented to simplify cross-border payment transactions.

CBDCs vs cryptocurrencies

A blockchain-based CBDC can also be used as a medium of exchange, a unit of measurement, and a store of value, striking a balance between the privacy and security of a centralized currency. But how are CBDCs different from cryptocurrencies? Let’s try to find out in this section.

Although both CBDCs and cryptocurrencies use the distributed ledger technology, their primary goals set them apart.

  • CBDCs use permissioned, private blockchains

Unlike cryptocurrencies, CBDCs employ permissioned or private blockchains because they have a centralized structure. As opposed to that, cryptocurrencies operate on permissionless, public blockchains.

  • Lack of anonymity with CBDCs

There are certain anonymity benefits enjoyed by cryptocurrency users, making the transactions virtual anonymous. Meaning, it is not possible to name or identify specific individuals involved in crypto transactions. On the other hand, users engaged in CBDC transactions will have their identity associated with their bank account and personal information.

  • Central banks decided CBDC rules

As far as a CBDC network is concerned, a respective central bank will be authorized to decide the rules. With cryptocurrencies, the authority to determine the network rules is delegated to the user base.

Will CBDC kill cryptocurrencies?

Does having CBDCs mean the end of cryptocurrencies? Is CBDC a threat to the crypto universe? It is a rather interesting question that doesn’t have an immediate answer.

According to Grayscale Investments, CBDCs are essentially looking to upgrade payment infrastructure while cryptocurrencies like Bitcoin attempt to upgrade money themselves. According to the report, having a CBDC raises significant privacy concerns, such as allowing the party controlling the central ledger to monitor CBDC transactions. On the other hand, cryptocurrencies like Bitcoin address these privacy concerns where users can enjoy anonymity with their transactions.

The report concludes that while CBDCs might displace the growth of cryptocurrencies, they are not a replacement for Bitcoin.

Conclusion

Central bank digital currencies are nothing but a digital form of fiat money whose implementation is far from over. They are fairly in the early stages of experimentation with blockchain technology, enabling frictionless, cross-border digital payments, among other benefits.

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