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IF Insights: CBDCs are the new craze in the world of digital currencies

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CBDCs are envisioned to provide households, consumers, and businesses with secure means of exchanging digital currency

Japan’s Ministry of Finance will hold a meeting with its experts on July 21, 2023, as the country mulls launching a central bank digital currency (CBDC). To cut a long story short, the island country will make its presence felt in the crypto sector with its digital currency.

Nine experts from the fields of market economics, academics, consumer groups, and law, will compile a feasibility report on digital yen by 2023 end.

Shifting the attention from Japan, let’s find out what’s happening in the United Kingdom. The government there is pushing ahead with the plan of creating a digital pound, known as ‘Britcoin’, which will be issued by the Bank of England.

CBDC: The New Craze

The crypto market bloodbath of 2022 forced the experts to advocate for the sector to be regulated. Cryptocurrencies as of now don’t have a centralised authority to decide their value. That’s where CBDC comes into play.

India, Bahamas, Nigeria, China, USA, UAE, Jamaica, Ghana, Malaysia, Singapore and Thailand have already made significant strides in the CBDC field. In fact, Bahamas hit the headlines in 2020, as the island nation launched the world’s first-ever central bank digital currency, called the Sand Dollar.

Central Bank Digital Currencies (CBDCs) are the digital currencies issued by a country’s central bank, similar to cryptocurrencies, but differ from the latter in terms of getting their value fixed with government intervention, apart from being equivalent to the country’s fiat currency.

CBDCs’ role is to provide businesses and consumers with privacy, transferability, convenience, accessibility, and financial security, apart from reducing cross-border transaction costs, empowering those who currently use alternative money-transfer methods with lower-cost options and lessening the risks associated with cryptocurrencies.

While cryptocurrencies are notorious for their volatility and the resultant financial stress, CBDCs are envisioned to provide households, consumers, and businesses with secure means of exchanging digital currency.

CBDCs have two types, wholesale and retail. Financial institutions mainly use wholesale CBDCs, while consumers and businesses use retail counterparts. Retail CBDCs are further divided into token-based and account-based ones.

These currencies eliminate the third-party risk of events like bank failures, apart from lowering high cross-border transaction costs by reducing the complex distribution systems and increasing jurisdictional cooperation between governments.

CBDCs also remove the cost of implementing a financial structure within a country to promote maximum financial access to the unbanked population. Last but not least, CBDCs also establish a direct connection between consumers and central banks, thus taking out the need for expensive infrastructure.

CBDCs Are Not Perfect Either

As per a January 2023 report from the Atlantic Council’s Central Bank Digital Currency tracker, around 114 countries were exploring the CBDC option, and these economies in total, represent over 95% of the world’s GDP, thus suggesting a bright future for these digital currencies. However, the idea has its own problems as well.

The biggest of them lies at the privacy front. As per a Wall Street Journal report, a digital currency may allow governments to track every transaction a person makes. While the defenders of CBDC may promote the transparency aspect here, as such a mechanism would allow the law enforcement authorities to prevent crime/fraud much earlier; critics believe that CBDCs can also be weaponized, in order to introduce new kinds of social control.

Another drawback is the lack of data on how switching to CBDCs affects household expenses, investments, banking reserves, interest rates, and most importantly, a financial system’s stability. Will a central bank have enough liquidity to facilitate CBDC withdrawals during a financial crisis? How will these currencies deal with monetary policy controls? There are no conclusive answers to these questions yet.

Another doubt area is the cyber security aspect of these CBDCs. The cryptocurrency sector is known to be a hunting zone for threat actors. These criminals won’t spare a central bank-issued digital currency either. These banks need to ensure robust mechanisms, which would prevent system penetration, theft of assets and customer information.

Conclusion

Government employees in the Chinese city of Changshu will receive their salaries in digital yuan from May 2023. Zimbabwe too will introduce a gold-backed digital currency as its legal tender. These two developments alone show the growing popularity of the concept called ‘CBDC’.

These currencies have the potential to be safe bait in the long run, compared to unregulated and decentralised cryptocurrencies, whose values are dictated by investor sentiments, usage, and user interests, thus making these currencies volatile assets. Remember, cryptocurrencies are more suited for speculation, which makes them unlikely candidates for use in a stable financial system. CBDCs offer this much-needed financial safety in the coming days, but these currencies need to answer the grey areas quickly as well, to live up to the ‘safe bait’ status.

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