Breaking down central bank digital currency

The way we handle transactions has seen a constant evolution throughout human history— from bartering to gold, metal coins, credit cards, and now digital currency. With each progression, older systems are phased out.

According to the Bank of England, 96% of all money is electronic and the other 4% is held in the form of physical cash. Presently, no single payment method seamlessly caters to both offline and online transactions.

This is prompting banking institutions to explore solutions, such as Central Bank Digital Currencies (CBDCs).

Defining CBDCs

Central Bank Digital Currencies (CBDCs) come into the picture as a novel approach to digitising money. Renowned consulting firm, McKinsey & Company, describes CBDCs as digital financial assets, issued and controlled by central banks. Their value is directly tied to the official currency of the country that issues them.

CBDCs can be segmented into two primary categories: retail and wholesale. Retail CBDCs are intended for public use, enabling everyday transactions like physical cash. On the contrary, wholesale CBDCs serve as a medium of settlement between financial institutions.

While CBDCs represent a promising future for digital transactions, they are still in the developmental stage. Various central banks globally are conducting thorough research to understand the potential advantages and challenges they may encounter when issuing CBDCs. The Bank of Canada, for instance, is one such institution that has taken an interest in this digital evolution.

Distinguishing physical currency from offline transactions

Physical currency and offline transactions have distinct features. Physical currency includes banknotes, metal coins, and cheques, none of which can be utilised for online transactions. Offline transactions represent a variety of payment methods designed to bridge the gap between digital and physical realms.

Differentiating these offline transactions, we find:

• The internationally embraced platform, PayPal, stands as a robust payment methodology. It offers both convenience and security, capable of executing transactions through affiliated bank accounts or credit cards.
• The digital revolution brought us cryptocurrency, an emerging yet promising entrant. Encapsulating diverse forms like Bitcoin, Ethereum, and Litecoin, it offers a decentralised, secure alternative for online purchases.
• Facilitating direct transfers between bank accounts, Electronic Funds Transfer, or EFTs, supplements online payments without the prerequisite of a credit or debit card. They predominantly find their uses in substantial purchases or recurring payments.
• As conventional as they may seem, credit cards are widely accepted and preferred for online transactions. They offer immediate funds availability along with the benefits of convenience and security. Mainstream networks include powerhouses like Visa, Mastercard, American Express, and Discover.

Given that CBDCs are in their nascent stage, the practical applications are broad and, often, lack a clear definition.

CBDCs vs. cryptocurrencies

Cryptocurrencies are decentralised and unregulated, with their value governed by investor sentiments, adoption rates, and general interest. These digital assets are characteristically volatile, making them more suited for speculation rather than consistent use in a financial system necessitating stability.

In contrast, CBDCs mirror the value of conventional fiat currency, designed to be stable and safe forms of digital money. Similar to conventional fiat currencies the aim with CBDCs is to manage the money supply responsibly.

The vision behind CBDCs

In countries like the U.S. and many others, a significant number of individuals still lack access to fundamental financial services. For instance, in 2020, 5% of U.S. adults didn't even have a bank account. On top of that, another 13% of adults depended on costly alternative services such as money orders, payday loans, and check cashing.

The primary objective in introducing CBDCs is to offer businesses and consumers an array of benefits including privacy, transferability, convenience, accessibility, and financial security. By reducing the maintenance cost of a complex financial system, CBDCs could also lower cross-border transaction costs and provide affordable options for those who currently rely on alternative money-transfer methods.

Additionally, CBDCs could minimise the risks associated with using digital currencies or cryptocurrencies in their current form. Cryptocurrencies are notorious for their volatility, with values constantly fluctuating. This instability could potentially lead to significant financial stress for many households and negatively impact the overall stability of an economy. On the other hand, CBDCs, being backed by a government and controlled by a central bank, promise to provide households, businesses, and consumers with a secure way to exchange digital currency.

CBDCs provide central banks with a novel means of implementing monetary policy, shaping interest rates, and spurring economic expansion. By fine-tuning the interest rate tied to CBDC holdings, these financial institutions have the power to motivate or dissuade borrowing and expenditure, thereby modulating overall demand and the pulse of economic activity. The unprecedented capability to directly manipulate the volume of digital currency imparts central banks with superior adaptability in their economic governance.

Creating a CBDC system for broader acceptance

In the pursuit of enhancing CBDC adoption, the design of the system plays a pivotal role. There are two distinctive ways a CBDC system can be tailored to operate offline, with the duration of the offline period influencing crucial design elements, technological foundations, and user capabilities.

End users engage with the offline CBDC system through a device that provides offline functionality, which can be either a standalone custom device or a smartphone with a built-in application. Notably, offline functionality does not exclude online purchases. For example, a consumer could receive funds offline in one transaction and seamlessly proceed to order items from an online store or request a taxi through a mobile app in a subsequent transaction.

Exploring intermittent offline CBDC systems

An intermittent offline CBDC system offers users the ability to conduct transactions during shorter, intermittent offline periods, such as when the internet is temporarily unavailable. This offline capability complements an online CBDC solution.

During a transaction, the payee claims a portion of the payor's CBDC funds (clearing), with the payor confirming and locking those funds, preventing further spending. The actual transfer of funds (settlement) takes place later when either the payor or payee regains connectivity with the online system.

As the online CBDC system logs the final state of transactions and balances, settlement is deferred until internet connectivity resumes, allowing the system to update accordingly.

Delving into extended offline CBDC systems

Conversely, an extended offline CBDC system facilitates transactions during more prolonged offline periods, particularly when an internet connection is consistently unavailable or undesirable.

This system forms a distinct ecosystem supported by dedicated devices equipped with a local fund store. Devices featuring extended offline functionality enable peer-to-peer payments without internet connectivity. Funds are settled after the transaction, ensuring the payee becomes the exclusive owner of funds.

Furthermore, these funds are transitive, enabling the payee to spend them in subsequent transactions without awaiting updates from the remote service. Users may adopt an extended offline solution as their primary financial tool for day-to-day transactions.

Charting the course for CBDCs

For a significant number of individuals worldwide without access to bank accounts, CBDCs could offer a groundbreaking solution to receive and make payments, securely store their money, and pay their bills.

Even though CBDCs bear the potential to reshape finances, risks like data privacy and government overreach need careful consideration. This new, centralised monetary format could lead to misuse of personal financial data and over-control of people's financial behaviour, limiting their economic options. Implementing CBDCs, therefore, requires airtight safeguards, transparency, and accountability to ensure respect for individual privacy.

On the other hand, CBDCs could potentially streamline the complex requirements of maintaining a financial system and provide cost-effective options for cross-border transactions, benefiting those who currently rely on other, more costly methods of money transfer.

This digital progression symbolises a decisive step forward in redefining the financial landscape to be more inclusive and efficient, thereby heralding a new era in the world of digital transactions.