Now You Understand: Central Bank Digital Currency (CBDC) Explanation and Usage - Part I

CBDCs have been discussed quite a bit in recent years, and various countries are exploring the possibilities of implementation. You may have heard or read about this digital currency, but do you have a good understanding of how CBDC is structured, how it can be used, and what impact central bank digital currency will have on the future of finance?

Welcome to my Now You Understand article series, where I share my expertise to explain the most complicated blockchain and web3 topics.

This is the first part of my article on CBDC, where I will cover what it is, the use cases, and the solutions used to implement it.

What is CBDC?

Central Bank Digital Currency (CBDC) - a digital form of national bank money that is created, controlled, and maintained by the central bank. It is legal tender and is the same central bank debenture as ordinary bank notes. CBDC is operated by a digital ledger that might or might not be a blockchain. This provides faster and more secure transactions between banks, institutions, and individuals. Central banks control the issuance of CBDCs and stand as guarantors of this form of money as compared to cryptocurrencies.

CBDCs now can take the following forms:

• Retail is used for settlements between individuals and legal entities, is designed for simple payments, and represents a digital form of currency.

• Wholesale is used for interbank payments as a new infrastructural solution.

• CBDCs can also represent digital assets, they are also registered in a digital registry, which can be distributed or not distributed.

  
  

CBDC is a major step forward in the digitalization of money and the economy as a whole,  increasing its transparency, security, and efficiency, including the automation of many processes and the reduction of transaction costs.

CBDC: Use Cases

CBDC is implemented mainly on platforms based on distributed ledger technology (DLT) with support for smart contracts (applications). That gives us many areas of usage and makes this implementation of a digital form of currency really useful for the financial system. Due to the platform’s support for smart contracts, it extends CBDC beyond just digital currency to a programmable form of currency.

Smart contract support allows you to deploy programs that interact and operate with digital currency. For example, when we execute a property deal, we need someone to check the deal for compliance, approve it, and register it.

In the case of CBDC, we do not need a third party to do this, we can just implement a smart contract, the logic of which will be similar to the logic of the deal. For instance, to control that one side owns the property, the other side has paid the declared value, and then makes the transfer of this property, as an option in the form of a token.

In this way, we can automate the majority of transactions with almost any property, which significantly increases their availability, speed and performance. It also removes the workload from the infrastructure that is created for deals, cutting out the need for intermediaries and thereby reducing transaction costs.

Tokenization is the process of converting rights to assets or property into digital tokens. Exactly it allows to be fully digital and automated with the use of smart contracts.

It has been researched that the cost of clearing and settlement of securities for the Central Banks of the G7 countries is more than $50 billion per year, due to the resource costs of asset transfers and account reconciliation.

A DLT-based CBDC successfully solves the problem of inefficiencies and vulnerabilities compared to the current infrastructure. CBDC is natively digital and does not demand the expensive and labor-intensive reconciliation currently required for e-commerce and cross-border payments.

It also allows to optimization of the operation of any registry that is responsible for storing records of rights to property or assets. For example, DLT technology can replace and improve the work of registries of movable and immovable property, securities such as stocks, bonds, etc. It also makes it possible to make deals available 24/7 by eliminating the need for a third party to determine the availability of transactions. Digital property/asset transactions increase the accuracy and security of transactions.

Offline payment technology, which provides access to the financial system in areas not covered by banking services and allows transactions to be made without access to the Internet, is currently being actively researched and realized.

We can see that CBDCs move the financial system into a digital form, which opens up many possibilities and optimizes the operation of the system as a whole. Thanks to this, CBDC has direct control over the money supply, simplifying the distribution of state benefits, and improving the control over transactions for tax control. Thus, timely payment of taxes or payment of bond coupons can be automated. The implementation of CBDC also allows for reduced costs and increased availability of cross-border payments, including reducing credit risks by providing payment versus payment settlement.

CBDC vs Stablecoins: what’s the difference?

There are several types of stablecoins: fiat-backed, cryptocurrency-backed, commodity-backed and algorithmic. In this comparison, we will focus on the first type - fiat-backed ones, because they have more in common with CBDCs and are the most popular. Examples of this type of stablecoins are Tether (USDT) and USD Coin (USDC).

The principle of Stablecoins is that organizations issue tokens based on the reserves of traditional money in their accounts. That is, in this case the issuance and control of such tokens remain with private institutions and they are not directly controlled by Central Banks.

While CBDC is a form of national currency, their issuance and control is owned by Central Banks, which provides higher security. Due to such regulation CBDC can ensure compliance with tax policy, while in stablecoins do not. It is also important to note that stablecoins use private money as collateral, while CBDCs are backed by government-issued money.

What is the difference between private solutions and public blockchains ?

Public blockchains are primarily defined by the fact that they are open to the public. That means anyone can join and participate in the network. A popular example of public blockchains is Ethereum.

The consensus mechanism means that such a network is managed by the majority. In particular, transactions are verified and included in new blocks.

They are completely open and transparent, everyone can see all transactions and balances of any accounts. In order to complete a transaction in a public network, it is necessary to verify and confirm the agreement of the majority of participants, which involves commissions, which are the motivation, as well as a longer waiting time due to the fact that it is necessary for the majority of nodes to reach an agreement.

Among the advantages of this solution, we have full transparency and no need to rely on a single control structure due to the high decentralization of the network, which ensures that no single entity controls the network.

A private network is closed and restricted to authorized participants who have full control over the network and transactions on it.

Private solutions allow centralized control over the network and also enable private transactions and private smart contracts. This solves privacy challenges that are very important for governments and corporations.

Private solutions consensus mechanisms involve a very limited number of participants who verify and approve transactions, so transactions are much faster because they do not require majority verification.

They also do not need such a concept as native currency and there are no transaction fees. These solutions appeal to governments and companies because of their centralized control and confidentiality solutions that also allow them to control the legality of their operations. Guarantee of this network are their participants, for example, governments and corporations. Examples of this type of solutions are Quorum, Corda, Hyperledger Besu etc.

CBDC: Why use private solutions?

There are several key reasons why public solutions are not suitable for CBDC implementation.

1. High volatility: Public cryptocurrencies mean an open market and they are subject to significant price movements, which entails heavy risks for both the government and ordinary users.

   
   

   This makes it difficult to use as a payment method, as changes in value can be in the tens of percent. In the case with private solutions, the Central Bank is the guarantor and has full control over the digital currency. CBDC is a form of currency rather than a cryptocurrency in its traditional meaning.

2. Privacy considerations: In public solutions, all data is publicly available. Open data potentially brings risks for directions in which this is a key factor. In private solutions, it is possible to control privacy issues through private smart contracts, private transactions, and restrictions on network participants.

3. Account control: With public solutions, accounts and funds are under the control of the users themselves or organizations to which the users have delegated control.  In the case of private solutions, account control is usually performed by authorized entities.