What are central bank digital currencies and what could they mean for the average person?

Money has taken many forms over the centuries. In fact, it’s not even always been money at all. It gradually evolved from bartered commodities to pieces of metal, before becoming paper money and eventually debit and credit cards. The next step in this evolution could be central bank digital currencies (CBDCs).

CBDCs are already in use today. A total of 11 countries have launched one, and another 21 have pilot programs, according to the Atlantic Council’s CBDC Tracker. A further 79 are developing or researching a digital currency.

Well over 90% of the money in circulation today is already digital, according to Harvard Business Review (HBR), with rapid declines in the use of cash having accelerated because of the pandemic.

But just because more payments are happening digitally, does that mean we need central banks to adopt digital currencies?

A CBDC is digital money issued by a central bank. It would not replace cash but complement it. “In a CBDC world, the digital code for each virtual currency unit will be held in a digital wallet and transferred seamlessly by the wallet-holder to other people’s digital wallets,” HBR says.

A CBDC would differ from cryptocurrency as it would be issued by a central bank, rather than a private coin like Bitcoin. This means the currency would be backed by the issuing government, ensuring its value would be stable, unlike with cryptoassets where large swings in value can happen for a number of reasons.

There are several expected benefits that countries could unlock by modernizing existing financial systems and introducing CBDCs:

When migrants send money back to people in their home country, they face an average charge on the transaction of 6.25%, the World Bank says. This is hacking away at the remittances that provide critical support for developing economies.

CBDCs could reduce the costs of these cross-border transactions by removing the need for money transfer operators, the Bank for International Settlements (BIS) says.

CBDCs could also speed up cross-border transactions. International payments often take one or two days, but some can take five. With CBDCs, digital payments could happen within seconds at any time of day.

There is a counter-argument that systems are already being developed that could enable near-instantaneous international payments, as BIS research points out. That said, current real-time payment methods face interoperability issues because of the patchwork of non-standardized payment systems that have gradually been developed around the world, according to payment provider Swift.

The Bahamas was the first country to adopt a CBDC. It launched the Sand Dollar in 2020 because it wanted to increase financial inclusion for its citizens, who live across a series of 700 islands, some of which offer limited access to cash machines and banking services.

“We didn’t start with the idea of a central bank digital currency,” says John Rolle, Governor of the Central Bank of the Bahamas. “We focused on eliminating as many obstacles as possible for persons having access to the equivalent of a deposit account or a mobile wallet account to conduct transactions.”

The Sand Dollar came about shortly after the Bahamas suffered its worst ever natural disaster, Hurricane Dorian. Digital currencies were seen as a way for the government to send immediate financial aid to citizens after such events, when bank branches or cash machines may have been damaged or become inaccessible.

CBDCs could have also helped governments around the world with recent energy bill support payments prompted by soaring gas prices, according to HSBC Global Economist James Pomeroy. Some of these support payments took the form of discounts applied to energy bills, but this risked excluding people who have prepayment meters (which are often used in lower-income areas).

“In a world where every single person … has a CBDC account, what you could do is essentially drop payments into people’s accounts,” Pomeroy told the Poundcast podcast.

Increasing financial inclusion was one reason Nigeria introduced its CBDC, the eNaira, in 2021. Around a third of people in Nigeria do not have bank accounts.

The benefits of financial inclusion include helping eliminate poverty, create jobs, improve gender equality and raise health standards, according to the World Bank.

There have been large drops in poverty in rural India thanks to moves to bring people into the banking system. And better financial access for farmers in Malawi is helping them invest in equipment, which is in turn boosting their yields and their potential crop earnings by over a fifth.

Giving people access to financial services is seen as key to achieving the UN’s Sustainable Development Goals. CBDCs could transform financial inclusion as they can be used directly via a mobile phone, potentially benefitting the more than 600 million people around the world who have access to a mobile but not to a bank account.

CBDCs would allow for the creation of digital records and traces, and this could make it easier to stop money laundering and flows of money used to finance terrorism, BIS says.

That said, there is the possibility that the added traceability of CBDCs could push these sorts of transactions further away from the formal banking systems and lead to criminals seeking out other ways to circumvent regulations.

The potential traceability of CBDCs also gives rise to one of the biggest objections to digital currencies.

Privacy is one of the most commonly cited concerns when it comes to CBDCs, as the World Economic Forum’s Digital Currency Governance Consortium White Paper Series points out.

It’s a legitimate concern given the rise of data protection and online privacy issues in our increasingly digital world. However, just as governments around the world have brought in new legislation to tackle these concerns, they will have to introduce rules around CBDCs, such as enforcing the use of privacy-enhancing technology and ensuring consumer protection, the Forum points out.

These kinds of rules will also be required to protect personal data against the inevitable cybersecurity risks of digitizing sensitive financial information.

Banks including the European Central Bank (ECB) are already looking hard at how to embed anonymity in CBDCs. “While the question of whether or not to issue CBDC is still primarily a policy matter, that question cannot be answered without a deep understanding of the various specific design features that a CBDC could have,” the ECB points out.

The US Federal Reserve also says security would be a key consideration before any decision to go ahead with CBDCs. But it points out that many of the underlying technologies that may be used already exist in today’s digital payments systems. CBDCs would also benefit from the additional security benefits of blockchain and cryptography, the Fed says.

Every time money has changed its form, it has taken time for people to learn to trust it.

It took a huge leap for people to move from a system where goods were bartered directly against one another to one where a tiny piece of metal was understood to represent the value of those goods.

Even a decade ago, large numbers of people did not trust new contactless card payments. Now, the chips in these cards are understood to make them more secure than their predecessors, which had to be swiped.

Time will also be needed to build trust in CBDCs, and that trust will only be built if governments and central banks are transparent and honest about the potential advantages and risks of digital currencies, about the reasons to pursue CBDCs, and about the rationale behind their technology choices.

International regulations and cooperation will also be critical bricks in the wall that will secure sturdy and long-lasting public faith and confidence in CBDCs.

Another key step in building trust will be ensuring that accurate and accessible information is available about CBDCs. Education and awareness will be crucial to counter any misinformation on the topic, and to drive trust and adoption of possible future CBDCs.

People only gained trust in money because they saw that it not only worked, but also made their lives easier and better. CBDCs will need to prove that they can do the same.