Central Bank Digital Currencies

Central banks are exploring new means of digitizing money as digital payments become more prevalent, hoping to optimize speed and cost while driving innovation.

One option available to individuals and businesses alike is CBDC–or central bank digital currency. This digital form of cash that is completely under the control of its central bank.

What is a CBDC?

CBDCs, or digital central bank money, use payment technologies like blockchain to increase transaction efficiency and decrease transaction costs. Their proponents believe CBDCs can also promote financial inclusion while increasing national security by improving payment systems safety.

CBDCs differ from cryptocurrencies in that they use blockchain technology for private digital currencies built by individuals. While cryptocurrency use cases vary considerably across functions supported by blockchain technologies, CBDCs offer specific features like programmability, interoperability, renumeration (interest) and more that are all supported by existing blockchain platforms.

CBDCs offer many advantages for both individuals and businesses alike, but most efforts have been put toward creating wholesale CBDCs for use by financial institutions. Such an offering would streamline domestic and cross-border transactions while simultaneously improving security due to their digital ledger being easier to monitor for financial crimes like money laundering.

McKinsey advises central banks to develop strong business cases and scenarios based on thorough analyses of their current and future payment landscape, realistic adoption goals, and who they will serve. In doing this, central banks should leverage existing relationships with commercial banks, corporations and other relevant stakeholders in order to meet these goals successfully. Various stakeholders should prepare themselves for CBDCs’ arrival by creating new decision-making processes, adopting change management practices and recruiting talent who possess experience forging partnerships.

Why are central banks interested in CBDCs?

Central banks view CBDCs as an effective way of increasing the safety and efficiency of national digital payment systems while simultaneously strengthening local oversight over increasingly global payment infrastructures.

CBDCs could drastically cut costs associated with cross-border settlements for both individuals and businesses, potentially saving financial services providers over $400 billion annually in direct costs alone while eliminating the dollar as a tool to facilitate global transactions – this would eventually undermine correspondent banks which act as key nodes in the international financial system by carrying out settlements for their customers.

In theory, central bank-backed CBDCs could offer a solution to global settlement challenges and could enable countries to bypass the dollar-based system. But such an approach comes with risks; competition could arise over who develops interoperable CBDCs first or it may create tension among nations over how much “ownership” each nation can exercise over their CBDCs.

Note, however, that CBDCs don’t guarantee success on their own; in order for one to become viable it must provide tangible consumer benefits; for instance lower cost than traditional payment options or add to costs of business for retailers that already accept mostly card payments and have already gone cashless or mostly accept card payments as these could negatively affect both CBDC and retailers alike.

What are the CBDC use cases?

CBDCs serve a number of functions depending on their model. They can promote financial inclusion by offering consumer and nonfinancial businesses fully digital payments; improve resilience of financial systems by decreasing cash reliance; create programmable money to increase efficiency of payment flows; and promote transparency around money flow processes.

Retail CBDCs may help lower transaction fees and facilitate more secure transfers, especially if they offer irrefutable proof of ownership for each unit of account. They may also help lower risk associated with clearing and settlement by eliminating intermediaries; in some models central banks can use CBDCs as an intermediary-free form of liquidity provision directly in each market thereby decreasing counterparty risk.

Wholesale CBDCs can be an ideal solution for financial institutions with reserves deposited with central banks, providing increased liquidity and security through faster securities transaction settlement times. Furthermore, these investments can enhance cross-border transactions by eliminating third-party trust issues; and assist with solving issues surrounding exchange of legal tender between jurisdictions.

CBDCs generate large volumes of data, opening the way to real-time economic insights. However, it should be noted that although CBDCs are being actively researched by central banks worldwide, they have yet to gain widespread adoption as retail payment mechanisms.

What are the CBDC challenges?

The digital revolution is rapidly sweeping our lives, reaching every aspect of society and business alike. Financial intermediation – an essential component of the economy – has not escaped its influence, as transaction settlements become more automated and digital currencies become a possibility. Central banks face many challenges as they implement CBDC deployments such as finding an equilibrium between innovation and stability while protecting financial systems against systemic risk.

CBDCs must be highly scalable and interoperable, and integrate seamlessly with existing infrastructures, including multi-currency ecosystems. Furthermore, their design should prioritize security and privacy concerns; according to McKinsey report there are various approaches available when creating such entities: for instance private firms could offer accounts or wallets as intermediated platforms which enable people to use CBDCs without full identification – thus mitigating privacy concerns as well as illicit money flows.

Considerations should also be given to how a CBDC would impact other aspects of the financial system, including household expenses, investments, banking reserves and interest rates. It remains uncertain how the transition would impact liquidity and whether central banks will accept responsibility for customer identification and anti-money laundering responsibilities that commercial banks typically manage.