The Digital Revolution in Monetary Policy: Understanding Central Bank Digital Currencies

  • Anuj Saxena

    Anuj Saxena, a Founding member of Knowledge Ridge, currently spearheads Global Strategic Partnerships and is a renowned thought leader in the Expert Network domain.

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<p>As we lose touch with paper currency, individuals and organizations across the globe are increasingly embracing the idea of digital currencies. And, as the digital economy continues to grow, <strong style="color: #3598db;">central banks worldwide are exploring the potential of </strong><a href="" target="_blank" rel="noopener"><strong style="color: #3598db;">Central Bank Digital Currencies (CBDCs)</strong></a><strong style="color: #3598db;"> as a new form of currency</strong>.</p><p><img src="" alt="CBDC Monetary Policy" /></p><p>While the concept of CBDCs has been around for a few years, recent technological developments have brought them to the forefront of monetary policy discussions. Though thus far, digital currency is primarily used in terms of the commonly known and so far, unregulated cryptocurrency, digital versions of a country&rsquo;s fiat currency also deserve our attention. So, what are Central Bank Digital Currencies?</p><p class="bbox"><em>CBDCs are virtual currencies issued and controlled by the central banks of respective countries. The value of a country&rsquo;s central bank digital currency is linked to its official paper currency.</em></p><h2><span style="font-size: 14pt;">The Origins of Digital Currency </span></h2><p>The stark difference between traditional currency and CBDC is the mode of circulation through the economy. However, the two can potentially be exchanged at face value. To understand a more nuanced difference between the two, we must delve into the origins of CBDC.</p><p>The idea of a digital form of central bank money was first proposed in the early 2010s with the emergence of cryptocurrency. Since then, we&rsquo;ve come a long way to bitcoin, stablecoins like libra/diem, and central bank digital currencies (CBDC) like the Bahamian sand dollar and the proposed<a href="" target="_blank" rel="noopener">e₹ in India</a>.</p><p>In 2014, the Bank of England became the first central bank to consider issuing a digital currency with a research paper titled &ldquo;<a href=";hash=B2C820FBF6A960C4A625C2DAB5B5B6CE4FEDF120" target="_blank" rel="noopener">One Bank Research Agenda</a>.&rdquo; Since then, many other central banks, including the US Federal Reserve, the People&rsquo;s Bank of China, and the European Central Bank, have also begun exploring the possibility of issuing their own digital currencies. Some have already started experimenting with pilot programs.</p><h2><span style="font-size: 14pt;">A Deep Dive into the Types of CBDCs </span></h2><p>Central Bank Digital Currencies (CBDCs) are categorized based on their features and implementation approach. These are the two main types:</p><ul><li style="list-style-type: none;"><ul><li><h3><span style="font-size: 12pt;">Retail CBDC</span></h3></li></ul></li></ul><p>A retail CBDC is a digital currency for everyday transactions. Retail CBDCs are intended to be a digital form of cash and are designed to function similarly to physical banknotes and coins. An example of a retail CBDC is the e-Krona, developed by the Swedish Central Bank.</p><ul><li style="list-style-type: none;"><ul><li><h3><span style="font-size: 12pt;">Wholesale CBDC</span></h3></li></ul></li></ul><p>A wholesale CBDC is a digital currency used for interbank payments and settlements. Wholesale CBDCs are typically available to banks and other financial institutions, facilitating faster and more efficient payment and settlement processes. An example of a wholesale CBDC is the Jasper project, developed by the Bank of Canada and used to test the use of <a href="" target="_blank" rel="noopener">blockchain technology for securities settlement</a>.</p><p>It&rsquo;s worth noting that some central banks are also exploring hybrid models that combine elements of both retail and wholesale CBDCs. For example, the <a href="" target="_blank" rel="noopener">People&rsquo;s Bank of China is developing a digital currency</a> that can be used for both retail transactions and interbank payments. Similarly, the <a href="" target="_blank" rel="noopener">European Central Bank is exploring the possibility of issuing a digital euro that individuals and institutions could use</a>.</p><h2><span style="font-size: 14pt;">Benefits of CBDCs &ndash; Why are Central Banks Interested in This Disruption? </span></h2><p><strong style="color: #3598db;">While cash, or &lsquo;public money,&rsquo; is a central bank liability that ensures its security, digital money originates in the private sector, most commonly in the form of bank deposits.</strong> Regulatory and policy support for virtual currency, as in the case of <a href="" target="_blank" rel="noopener">India&rsquo;s new economic policy</a>, could significantly impact the global position of the currency, as well as the country&rsquo;s economy.</p><ul><li style="list-style-type: none;"><ul><li><h3><span style="font-size: 12pt;">Improved payment systems and financial inclusion</span></h3></li></ul></li></ul><p>Improving payment systems through more secure, immutable, and reliable technologies like blockchain/DLT, cryptography, and smart contracts could directly impact the inclusivity of CBDCs. With CBDCs and a wide range of compatible platforms, economies could develop a holistic, safe, and accessible solution for the unbanked and underbanked.</p><ul><li style="list-style-type: none;"><ul><li><h3><span style="font-size: 12pt;">Enhanced monetary policy implementation and regulation</span></h3></li></ul></li></ul><p>CBDCs offer governments and policymakers an unprecedented hold over the currency. Policy decisions could be affected at a single point by adjusting interest rates and supply. Monetary policies could stabilize and align the economy based on policy objectives.</p><ul><li style="list-style-type: none;"><ul><li><h3><span style="font-size: 12pt;">Reduced financial intermediaries&rsquo; transaction costs and risk</span></h3></li></ul></li></ul><p>A more transparent and accountable financial system like the CBDC would prevent financial crimes and systemic crises. More transparency and security also come with the elimination of intermediaries. Additionally, one could expect a significant reduction in intermediary costs.</p><ul><li style="list-style-type: none;"><ul><li><h3><span style="font-size: 12pt;">CBDCs as a hedge against private digital currencies</span></h3></li></ul></li></ul><p>Even though the origins of digital currencies are in the private sector, they&rsquo;ll achieve legitimacy and stability only with national backing and regulations. As has been evident in the recent past, private digital currencies can be volatile. With CBDCs, countries can expect better control and streamlined policy implementation. A great example would be the US digital currency, being developed as a bank-to-bank digital currency during the crypto collapse.</p><h2><span style="font-size: 14pt;">Risks Associated with CBDC Implementation </span></h2><p>CBDCs can potentially integrate with existing payment infrastructure, such as card networks and mobile payment systems. This can help increase their adoption and usage, as end-users can access CBDCs using their existing payment channels. However, given the significance and scope of CBDCs, policymakers must consider all aspects of CBDC implementation.</p><h2><span style="font-size: 14pt;">Risks to financial stability</span></h2><p>Without any safety rails, nationally adopting a CBDC might result in a dramatic shift in the monetary system. Savings account holders may withdraw their cash from banks in large numbers to invest in CBDC, which could complicate the process of issuing loans, a critical function of banks in the economy.</p><h2><span style="font-size: 14pt;">Regulatory and Legal Issues</span></h2><p>CBDCs must comply with existing regulatory frameworks and standards to prevent financial crimes and misuse. This requires compliance mechanisms to ensure all users&rsquo; safe and legal use of CBDCs.</p><h2><span style="font-size: 14pt;">Cybersecurity Risks </span></h2><p>Even though technologies like blockchain boast unprecedented security and accountability, CBDCs are subject to cyber-attacks that jeopardize the digital currency system&rsquo;s integrity and security.</p><p>Here&rsquo;s an interesting article on <a href="" target="_blank" rel="noopener">how data security breaches impact business stability</a>.</p><h2><span style="font-size: 14pt;">The Knowledge Ridge Advantage </span></h2><p class="bbox"><em>The evolution of global economies has been shaped by changing consumer preferences, advancements in technology, the expansion of international trade, and improvements in supply chain management. However, the macro-level disruption that affects entire nations and the micro-level disruption that affects individuals are unparalleled.</em></p><p>As financial institutions and other organizations navigate this gradual but significant shift, they must grapple with the challenges of mitigating risks, ensuring security, complying with regulations and laws, and more. The introduction of retail or wholesale CBDCs and the need for businesses to comprehend the marketplace can generate anxiety and uncertainty for the economy. <strong style="color: #3598db;">At this time, markets will need reliable expertise.</strong></p><p>Since CBDCs are a relatively new area of finance, many nuances and complexities are involved in their design, implementation, and use. When it comes to navigating the intricacies of Central Bank Digital Currencies (CBDCs), <a href="" target="_blank" rel="noopener">Knowledge Ridge can help connect you with the best experts</a> who have deep knowledge and experience in this area, including:</p><ul><li style="list-style-type: none;"><ul><li><strong>Design considerations: </strong> Experts can help navigate the various design choices that must be made when creating a CBDC, such as whether it should be account-based or token-based, whether it should be centralized or decentralized, and what type of technology should be used.</li><li><strong>Regulatory issues: </strong> CBDCs are subject to a complex regulatory landscape that varies from country to country. Knowledge Ridge experts can provide insights on navigating these regulations and ensuring compliance.</li><li><strong>Implementation challenges:</strong> Implementing a CBDC is a complex process that involves integrating with existing financial systems and infrastructure. Experts can guide how to overcome implementation challenges and ensure a smooth rollout.</li><li><strong>Use cases:</strong> CBDCs can transform how people and businesses transact, and experts can provide insights into the various use cases for CBDCs, such as cross-border payments, micropayments, and financial inclusion.</li></ul></li></ul><p><strong style="color: #3598db;">By connecting with the best experts through Knowledge Ridge, you can gain valuable insights and guidance on navigating the intricacies of CBDCs and make informed decisions about leveraging this emerging technology</strong>. Our <a href="" target="_blank" rel="noopener">expert network services</a> comprise a strong team of over 350,000 SMEs delivering customized end-to-end solutions for strategy development and augmented services. We also provide <a href="" target="_blank" rel="noopener"> executive and board placements</a> for long-term operations and continuous consultations.</p><div class="row" style="background-color: #09142d; margin-left: 5px; margin-right: 5px; padding: 13px 0px; margin-bottom: 15px;"><div class="col-sm-8 " style="margin-bottom: 0px !important;"><div><p style="vertical-align: central; color: white; text-align: center !important; margin: 10px 0px; padding-bottom: 0px!important;">Ready to Navigate the Future of Finance?</p></div></div><div class="col-sm-4 " style="vertical-align: central; text-align: center !important; margin-bottom: 0px !important;"><a id="kbtn" class="btn" style="padding: 9px 20px; color: white; border-radius: 6px; background-color: #16acef;" href="" target="_blank" rel="noopener" type="button"> Let's Connect </a></div></div><h3><span style="font-size: 14pt;">Frequently Asked Questions </span></h3><h2><span style="font-size: 12pt;"><strong>Is CBDC a Cryptocurrency?</strong></span></h2><p>CBDCs are digital currencies akin to cryptocurrencies in principle and technologies used. But CBDCs are equivalent to a nation&rsquo;s fiat currency. CBDCs are regulated legal tender, unlike private cryptocurrencies.</p><h2><span style="font-size: 12pt;"><strong>Which country has CBDC? </strong></span></h2><p>About 114 countries are exploring or experimenting with CBDCs. China, India, Nigeria, and the Bahamas are a few countries that have already implemented digital currencies. Others, like Sweden and Japan, are planning rollouts.</p><h2><span style="font-size: 12pt;"><strong>Is CBDC Based on Blockchain?</strong></span></h2><p>CBDC uses components of blockchain technology. However, it is not an essential requirement.</p>

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