What Is a Central Bank Digital Currency (CBDC)?

As decentralized finance (DeFi) takes the world by storm, many are left asking themselves how the multi-trillion dollar centralized banking industry takes part in Web3. 

With the goal of DeFi to put power into people’s hands rather than under the control of conglomerate entities, some think Central Bank Digital Currencies (CBDCs) are counterintuitive to the Web3 movement. Alternatively, CBDCs can help underdeveloped countries with poor banking infrastructures progress fiscally at unheard-of rates.

This article explores all things CBDC, which include definitions, examples, launched projects and the potential effects on the average investor.

Overview of CBDCs

CBDCs are a novel form of monetary unit being tested by government agencies across the globe to incorporate banks into the ever-growing Web3 space. 

What distinguishes a CBDC from other non-cryptocurrencies seems to be that enthusiasts believe it will be able to employ new technologies, such as a blockchain or digital ledgers, to improve payment efficiency and reduce costs.

Free cash and savings maintained by qualifying financial institutions with the central bank are the two most common forms of central bank money. CBDCs are a new type of currency that uses smart documentation or virtual tokens to represent a country's virtual currency, and the technology is attempting to be a third form of central banking money. A CBDC is generated and administered directly by the banking system and can be used by consumers, corporations and investment firms.

An important aspect to consider seems to be the kind of blockchain that CBDCs use. Because commercial banks, for acceptable or unacceptable motives, desire to not immediately publish activities or other financial information on the blockchain, CBDCs are generally built on a private blockchain system.

This form of ledger, often referred to as a permissioned blockchain, is distinct from decentralized blockchains like Bitcoin, Ethereum and Solana. The ability to monitor and conduct operations on the blockchain must be granted to peer nodes by a centralized power, and this power is typically granted by centralized banks.

A slew of countries have been involved in research to permit their economies to use a CBDC. In fact, according to CBDC Tracker, well over 50 countries have been working on the integration. Nigeria, The Bahamas and China are out of the gates early.

Given the U.S. dollar’s global importance, the U.S. Federal Reserve is looking into harnessing CBDCs but has to verify the efficacy and make sure there aren’t policy problems regarding this new initiative.

How Are CBDCs Different From Cryptocurrencies?

To explain the inherent differences between CBDCs and cryptocurrencies, it’s important to define these terms. Cryptocurrencies are digital, decentralized assets built natively on permissionless blockchains. Cryptocurrencies may be used for both financial transactions and speculation. No centralized authority can regulate their usage. Furthermore, their supply has historically been restricted, and it cannot be adjusted without the approval of a majority of users.

CBDCs are a centralized digital currency controlled by a central institution, whose blockchain network can only be viewed and engaged with by a select group of financial institutions. CBDCs may only be used for payment; investing isn’t possible since the coin isn’t tied to the value of the specified dollar, it is the fiat currency itself.

Three distinct differences between CBDCs and cryptocurrencies emerge:

1. Confidentiality: Crypto users remain anonymous whereas CBDC users have their name associated in some capacity with digital currency.
2. Utility: Crypto can be used for investing and storing value in general whereas CBDC transactional value is limited and only permitted within its own system.
3. Blockchain/centralization status: Crypto users are familiar with the decentralized permissionless blockchain. CBDCs use a permissioned blockchain.

Countries Working on Central Bank Digital Currencies

Many countries are working toward CBDC integration, including Nigeria, The Bahamas and China.

Nigeria

Nigeria’s CBDC is arguably the most important among the countries listed. The Central Bank of Nigeria (CBN) launched its CBDC, the “eNaira,” on Oct. 25, 2021. The eNaira, like currency and money, is a CBN asset. This categorization is important because Nigeria is one of two fully launched CBDC protocols, and Nigeria is much larger than The Bahamas. 

The eNaira is held in digital wallets and may be used for financial transactions; it can also be transferred digitally and for free to anybody having an eNaira wallet anywhere in the world. However, there remain significant discrepancies relative to crypto assets. The eNaira, for starters, is subject to strict central bank access rights limitations. Second, unlike crypto assets, the eNaira is a digital version of a national currency that derives its value from the actual naira, with which it is tethered at parity. 

The Bahamas

The Bahamas is in a similar situation. It was the first country to launch a CBDC. The Sand Dollar is a digital version of the Bahamian dollar that was issued by the Central Bank of The Bahamas in October 2020. It is one of only two fully operating retail CBDCs in the world. The Sand Dollar is issued by approved financial institutions and has the same legal standing as normal money. It may be used for a range of transactions.

China

China’s situation is highly notable for many reasons. Digital currencies supported by central banks have yet to be properly launched in China. However, numerous financial institutions have pilot programs and research initiatives in place to determine the feasibility and use of a CBDC in their economy. China is the country that has progressed the most along this approach, having created the framework and launched a pilot program for the introduction of a digital yuan. The digital yuan is being adopted quickly at the start of 2022 to be used during the 2022 Beijing Olympics.

What Blockchains Do CBDCs Use?

CBDCs use permissioned blockchains that are different from permissionless blockchains. ​​Although both permissionless and permissioned blockchain technologies provide comparable value propositions, inherent qualities make each one better suited for some applications and far less suited for others.

Permissionless blockchains are most commonly used in applications that have a large financial component or require highly decentralized blockchains.

Permissioned blockchains have opened up new possibilities for applications that rely on privacy and security.

CBDCs vs. Stablecoins

 CBDCs and stablecoins exhibit many differences and a few similarities. 

Differences

To begin, stablecoins are a cryptocurrency and therefore are open and can be transferred on third-party services. Stablecoins are more publically transparent than central bank digital currencies. 

CBDCs are inherently different because the issuer hosts the currency, decides its use cases and keeps transactions private. 

Similarities

They both represent a 1:1 backed dollar and are easily redeemable for fiat currency.

Are Central Bank Digital Currencies Decentralized?

CBDCs are not decentralized. Complete decentralization of a country’s financial system would likely be perceived as a challenge to the inherent nature of its governance.

Cryptocurrency Prices

The crypto market is extremely bearish as of January 2022. Bitcoin going below $40,000 and Ethereum dipping below $3,000 are potentially indicative of a bear run with well over a 30% decrease from their all-time highs.

Can You Invest in CBDCs?

No, CBDCs can be held but aren't intended to be used as an investment. You can think of CBDCs in the same way as cash where they are used almost entirely for simple transactions. CBDC transactions are similar to debit cards. Furthermore, if you're looking to earn interest on a token pegged to the US dollar, then stablecoins provide a better option, as they're interoperable with lending programs like Aave and Curve.

CBDCs will probably not take markets by storm if they are properly integrated. They function as a way for governments and banks to integrate themselves with Web3.