Central banks worldwide have been ramping up interest in central bank digital currencies (CBDC). The Bahamas became the first country in the world to adopt a CBDC, the Sand Dollar, in October 2020. This was followed by Nigeria, which launched eNaira, Africa’s first CBDC, in October 2021. Eighty-seven countries (representing over 90 percent of global GDP) are exploring a CBDC, according to Atlantic Council’s Central Bank Digital Currency Tracker. In May 2020, only 35 countries were considering a CBDC as per the tracker.

The People’s Bank of China (PBOC), China’s central bank, is racing ahead with its own CBDC project and has given away millions of dollars’ worth of the sovereign digital currency or the digital yuan (also called e-CNY) in real-world trials in a number of cities that include Shenzhen, Beijing, Shanghai, Suzhou, Xiongan, Chengdu, Hainan, Changsha, Xian, Qingdao and Dalian. China, the world’s second-largest economy, aims to replace some of the cash in circulation by digitalizing its bank notes and coins. 

Europe's first cross-border trial of CBDC payments, which occurred last month, has been described as a success by the central banks of Switzerland and France. In September 2021, the Bank for International Settlements (BIS) announced that four countries – Australia, Malaysia, Singapore and South Africa – will collaborate with the BIS Innovation Hub to test cross-border payments using CBDCs in early 2022.

CBDC considered as an official or legal tender issued by a central bank in a digital form has emerged as a hot topic for the financial community. However, it is often confused with cryptocurrencies.

CBDC versus cryptocurrency

Although the idea for CBDCs came from cryptocurrencies, CBDC does not use blockchain technology or decentralized cryptocurrency. CBDC is virtual money backed and issued by a central bank. Cryptocurrencies are decentralized, digital currency privately owned and fueled by blockchain technology.

CBDC and its benefits

CBDCs have gained traction globally because central banks envision them not only as a medium of financial exchange, but also as vehicles for monetary policy, financial regulation and stability, and financial inclusion. The other benefits of a CBDC include increased security, efficiency and convenience, better services, improvement in cross-border payments, and limitations on the risks of currency substitution. Also, CBDCs are considered widely accessible and easily transferable in peer-to-peer settings.

CBDCs can be used for retail payments, which are everyday payments between consumers and businesses, or wholesale payments that tend to be between financial institutions and businesses.

Token-based and account-based CBDC

How does the official tender work? Generally, there are two design formats for CBDC: token-based and account-based.

A token-based CBDC is a cash-like instrument because it is a digital version of physical cash. Each digital currency is represented as a token with specific denomination.

The only thing required is verifying the validity of the object used to pay – in this case verifying the authenticity of the token (is it real or counterfeit?), just like physical bank notes. Token-based CBDCs are not linked to the identity of the user.

An account-based CBDC is not a circulating currency like paper bank notes or digital coins, but a bank-account-like instrument.

An account-based system requires that each user of the digital currency holds an account with the central bank. An account-based model mandates a process for verifying or authenticating the identity of the account holder and their balance, akin to an electronic funds-transfer service that banks, companies and government agencies rely on to send or receive payments from their own accounts. Bank deposits or credit cards that can be used to make payments are other examples of account-based systems.

Account-based CBDCs will enable businesses and individuals to open an account and hold money directly with their central bank and get benefits from commercial bank services.

Public-private CBDC partnership

In Japan, a consortium of roughly 70 Japanese companies, including the country's three mega-banks, said it aims to launch a yen-based digital currency in fiscal 2022 after beginning trials in coming months, as was recently reported by Reuters. This has laid the foundation for a public-private partnership on CBDCs and may become a wider trend in 2022.

CBDC challenges

There are several challenges that accompany the CBDC turf and need careful consideration. Critics believe that CBDC is too centralized and can boost government surveillance, particularly in authoritarian governments or undemocratic regimes that may infringe upon consumers’ right to privacy. Additionally, it could undermine the role of retail or commercial banks as consumers flock to place their deposits with central banks directly, rather than trusting their money with a retail or commercial bank.

Establishing direct relationship with the central bank may mean that consumers move their money or existing deposits to CBDCs, which can adversely affect the fortunes of commercial banks. 

Effect of CBDCs on cryptocurrencies in 2022

Towards the end of 2021, the Indian government is set to ban cryptocurrencies while also forging ahead to develop its own CBDC. Countries with national legislation can always hinder the adoption of decentralized currencies that do not fall under their central bank regulations. There is a possibility that some central banks may crack down on cryptocurrencies, given their longstanding scepticism toward bitcoin and other digital tokens that they believe could be used for money laundering and other illegal activities.

The next disruption of the financial ecosystem has begun. In time to come, the CBDC could dethrone cash as the new king and become the future of money. It sure has a long way to go, but given that there is an intense financial technology rivalry brewing between global central banks for dominance in digital currencies, there will be an exponential amount of innovation resulting from this digital legal tender race.