CBDCs — Part 1: CBDCs vs Other Digital Payment Modes

Source: IntelligentHQ

Part 1 in a 2-part series. A look at what CBDCs are, and how they differ from the sundry digital payment modes in use today…

Cryptocurrencies are among the hottest topics today. Bitcoin’s value shot up to $58354 on February 21st, 2021 and then plummeted 25% in a week (and then went back up again, but you get the drill), large players like Tesla, Mastercard, Microstrategy have endorsed and invested in the asset.

The digital payments upsurge and evolving cryptocurrency ecosystem indicate an inexorable march of digital currency in the coming years. And governments are cognizant of the need to act on this front.

Enter Central Bank Digital Currency (CBDC)!

What are CBDCs?

CBDCs are digitised versions of a country’s fiat currency, created and circulated by Central Banks. It would serve as a third form of central bank money, fully fungible with cash and bank reserves. As legal tender, CBDCs are a digital form of Central Bank liability. Instead of printing currency notes, they would originate new CBDCs digitally.

One classification of CBDCs is as follows:

• Wholesale CBDCs: Accessible to financial institutions and large entities that hold reserves with the Central Bank
• Retail CBDCs: Available to individuals and corporations for day-to-day payments and as a store of value

Another classification basis the underlying infrastructure and technology is as follows:

• Centralised CBDC Accounts
• Centralised Token CBDC
• DLT-based CBDC Accounts
• DLT-based Token CBDC

Is Digital Money New?

Not at all! We use sundry digital payment mechanisms each day. People employ credit and debit cards, payment wallets, bank transfers and, in some instances, cryptocurrencies quite regularly.

So, why a CBDC?

CBDCs vs Other Payment Modes

Cash

Source: MoneyControl

• CBDCs are essentially digitised cash. Instead of physically holding Rs. 500, one would now have the same value in a digital format. CBDCs would directly be issued to people from the Central Bank.

Bitcoins and Altcoins

Source: BusinessToday

• Legal Tender Designation: Now, CBDCs, cash and cryptocurrencies all hold no inherent value. However, CBDCs (like cash) possess the blessings of the Central Bank and qualify as legal tender. Cryptocurrencies are not backed by fiat and don’t possess the backing of the sovereign.
• Centralization: Unlike cryptocurrencies which operate in a decentralised manner, CBDCs would involve the Central Banks at the heart of their operation
• Blockchains: CBDCs needn’t necessarily operate on blockchain systems for functionality. On the other hand, blockchain technology serves as a backbone for cryptocurrencies
• Privacy: A centralised, permissioned system for CBDCs may dilute the strength of privacy features offered by cryptos like bitcoins. Blockchain technology incorporation is an option, rather than a necessity. CBDCs can, of course, choose to adopt privacy-enhancing features from other cryptocurrencies.
• Asset Class Positioning: As we’ve seen recently, bitcoins and other altcoins play a major role as asset classes. CBDCs may not do so since they would primarily hold the position of legal tender and serve as a medium of exchange.

To know more about bitcoins and altcoins, check out these pieces (Crypto as an asset class, crypto as a medium of exchange) of mine.

Diem and Stablecoins

Source: Adweek

• Issuing Entity: While blockchain-based CBDCs and stablecoins do appear similar, the difference lies in the issuer — Government vs private entities. The two media of exchange would be competing variants of money, with private stable coins donning the hat of privately issued money
• Legal Tender Designation: Cryptocurrencies can be exchanged for legal tender, but the exchange ratio is subject to the high volatility (generally). Stablecoins can be exchanged for legal tender or any other asset at a fixed rate. CBDCs, on the other hand, are themselves a form of legal tender.

To know more about Diem (previously called Libra), check out this piece I’d written.

Bank Deposits

• Credit Risks: Money held in bank accounts are subject to credit risk. While your account balance may show a particular number, due to fractional reserve banking, that’s not a perfect indicator of what you really have. CBDCs don’t have any such risk unless mechanisms come into place that expand the fractional reserve banking idea to CBDCs as well.
• Interest Payments: Money in your FD generates returns. Some savings accounts also offer small interest payments. CBDCs in digital wallets, however, may operate differently. Central Banks would have to take a call on whether the currency would be interest-bearing or not.

eWallets and UPI

Source: Entrackr

• Bank Dependence: UPI is a vehicle that facilitates funds’ exchange from one bank account to another. eWallets are also intermediaries between banks. CBDCs are literally wallets that hold a legal tender. They don’t have to go through retail banks, just like how transferring cash from one wallet to another doesn’t have to pass through multiple banking channels.

Credit Cards

Source: Forbes

• Liability Incidence: CBDCs are liabilities of the Central Bank while credit card spending accrues as a liability to private banks
• Transaction Fees: Transaction fees would greatly differ. Exchanging CBDCs is essentially like exchanging cash, so whether there would be a similar 1–2% transaction charge is unclear
• Usage of credit cards can also occur in tandem with CBDCs, albeit in a different manner

Indeed, CBDCs’ value proposition contrasts the existing payment options to a certain degree. But, what are the implications of introducing CBDCs? And, what's the current status of CBDCs globally? Check out my next article in the two-part series to find out.