CBDC Primer: Overview, Types, and the Difference Between CBDCs & Cryptocurrencies

Central banks around the globe are racing to speed up the process of developing and launching the digital versions of their official national currencies, also known as central bank digital currencies. In general, a central bank digital currency (CBDC) is a digital representation of fiat currency issued by a government that is not backed by a commodity such as gold.

On November 9, 2021, the United Kingdom’s HM Treasury (HMT) and the Bank of England (BoE) next steps on the exploration of a UK’s central bank digital currency. As per the release, the HMT and the BoE plan to launch a consultation that will set out their assessment of the case for a UK CBDC, including the merits of further work to develop an operational and technology model for a UK CBDC. The consultation will also consider the design, benefits, and implications for users and business, as well as other relevant issues. The results of the 2022 consultation will determine whether UK authorities intend to move forward with a CBDC.

Around the world, five countries have already launched CBDCs, with another 14 including Sweden and South Korea in the pilot stage, according to the Atlantic Council's CBDC tracking project. Following an official announcement by Nigerian President Muhammadu Buhari on October 25, 2021, Nigeria’s CBDC, the eNaira, went live. eNaira can be accessed via eNaira speed wallet and eNaira merchant wallet applications, available on Google and Apple app stores. With this development, Nigeria’s CBDC trial has now become the second-largest behind China’s digital yuan.

On October 18, 2021, a report from Bloomberg revealed that Ghana is working towards adding offline capabilities for its upcoming CBDC. According to a statement made by Kwame Oppong,Head of Fintech and Innovation, Bank of Ghana, the CBDC that Bank of Ghana is set to pilot, the e-cedi, will potentially facilitate transactions without power or connectivity.

China is continuing with its digital yuan rollout with trials in multiple regions. China’s digital yuan (e-CNY) is quickly gaining traction among individuals and corporations alike, according to the People’s Bank of China’s (PBoC) Digital Currency Institute head Mu Changchun. Speaking at the conference on Wednesday, Mu said the number of individual digital yuan accounts hit 140 million, while corporates created another 10 million accounts.

The global interest in CBDC might be fuelled due to the following reasons :

• With consumer reliance on electronic payment methods such as credit cards and payment gateways increasing, the use of physical cash is decreasing.
• CBDCs are more cost-effective as they have lower transaction costs.
• As compared to cash, a CBDC system, especially an offline one, may provide better means to distribute and use funds in geographically remote locations or during natural disasters.
• An interoperable CBDC system –– one that is compatible with other CBDC systems — could play a role in improving cross-border payments.

Types of CBDCs

CBDS can be divided into two categories: wholesale or retail. Wholesale CBDCs will be restricted to commercial banks, and financial and clearing institutions whereas retail form may widen CBDC access to corporate, businesses, and general consumers.

Wholesale CBDCs can be compared to traditional central bank reserves. Wholesale CBDCs may facilitate financial transactions through the existing tier of banks and financial intermediaries. Under this two-tier structure, the central bank will oversee payment service providers who will manage customer-focused activities.

Essentially, wholesale CBDCs and central bank reserves operate in a very similar way. Settlement is made by debiting the account of the bank that has net obligations to the rest of the system and crediting the account of the bank that has a net claim on the system. These accounts are granted to commercial banks and other non-bank payment service providers by the central bank. Therefore, there is a high likelihood that wholesale CBDCs will most likely be exchanged and traded between commercial banks, financial and private institutions.

Retail CBDCs will modify the conventional two-tier monetary system. A two-tier monetary system refers to the traditional two-tier distribution model, wherein the central bank issues digital currency to authorized intermediaries (such as banks) and these intermediaries distribute the digital currency to the consumers. In a two-tier monetary system, the redemption claim lies with the intermediaries. The retail CBDCs will modify the two-tier system in that they make central bank digital money available directly to the general public. In this case, the redemption claim will lie with the central bank and not the intermediaries. 

Retail CBDCs can be further divided into two categories. One category, which has a cash-like design, may be more privacy-centered. Individual users will be given passwords like digital signatures using private-public key cryptography, without requiring personal identification like fiat currency/cash. The second approach is based on creating a digital identity scheme so that the identity of the users can be verified. Under this approach, in order to preserve privacy, the personal transaction data  of the users could be shielded from commercial parties and even from public authorities by appropriately designing the payment authentication process.

How do CBDCs work?

The central banks will design a mechanism to guarantee part convertibility between physical cash and CBDCs. In the case of CBDC, the distributed ledger technology (DLT) will create multiple copies of financial records of transactions instead of just one central database. Each copy in this ledger will be managed and stored by a different financial entity, who in turn will be controlled by the central bank. These entities share the ledger in a distributed fashion. The central bank will give access to the ledger holding financial records only to selected entities. These entities will have the power to modify or completely alter financial records through a predetermined governance system.

Difference between crypto and CBDCS

Permissioned Blockchain - Essentially, cryptocurrencies like Bitcoin are decentralized digital assets stored on the public and permissionless blockchain. Since cryptocurrencies are permissionless anyone can join and validate transactions on the blockchain. CBDCs on the other hand function on a permissioned blockchain a select few entities can access and/or alter the blockchain. In addition, central entities control who gets access to the blockchain.

Use Case - CBDCs can only be used as a means of payment, and any form of hoarding or investment activity is most likely to be forbidden; however, there is no such bar placed on crypto, users can utilize crypto both for payments and for speculative purposes.

Centralization - On CBDC networks, a central bank will make all the rules and take the majority of the decisions. In contrast, in crypto networks, the decision-making is delegated to the user base that makes decisions by reaching a consensus. How decision-making is done is based on the blockchain’s governance structure.

Supply - Cryptocurrencies usually have a predetermined supply limit, for instance, Bitcoin has a limit of 21 million bitcoins built into the protocol. This limit is known as a hard cap and it is extremely difficult, if not impossible to change it. Conversely, CBDCs will be controlled by central banks, which will have the power to choose when to add or remove the supply of CBDCs. The central banks may do it for various reasons such as to stimulate the economy in times of economic distress, increase or decrease the money supply, and set national interest rates. Like fiat currency, there may be no upper limit placed on the supply of CBDCS.

How can Merkle Science help?

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