What Is a Central Bank Digital Currency (CBDC)?

A central bank digital currency (CBDC) is the digital form of a national currency. Central banks such as the Federal Reserve in the United States or the European Central Bank in the European Union are likely to play essential roles in managing digital national currencies. A central bank digital currency, which uses blockchain technology and exists only electronically, can generally be used for the same purposes as a fiat currency issued by a central bank.

Definition and Example of Central Bank Digital Currency (CBDC)

A central bank digital currency (CBDC) is the digital form of government-backed money. In the United States, for example, a CBDC would be the digital form of the dollar. A CBDC uses blockchain technology to maintain an electronic distributed ledger, just like Bitcoin and other cryptocurrencies.

Although CBDCs are conceptually equivalent to fiat currency, no CBDCs are currently in use at full scale. Governments and institutions worldwide have begun research, development, and limited testing on CBDCs. CBDCs are intended to augment the existing currency system rather than replace it.

An example of a CBDC comes from China, where the government created a digital yuan known as eCNY. This CBDC has been pilot tested since 2019 and was first widely used at the 2022 Beijing Olympic Games. The Chinese government is reportedly working with large companies such as McDonald’s, Visa, and Nike to expand the use and adoption of eCNY.

How Do Central Bank Digital Currencies Work?

Central banks developing digital currencies are using blockchain technology, just like other cryptocurrencies. To use a CBDC, you would need a compatible digital wallet to send, receive, and store your digital currency. Here’s how you would send money in the form of a CBDC:

1. Access your digital wallet: If you’re using a hardware wallet, you’ll need to connect the wallet to the internet.
2. Initiate a money transfer: You can send digital currency to anyone with a digital wallet that is compatible with that currency.
3. Wait for the transaction to process: The blockchain that secures the CBDC uses a series of cryptographic signatures to authorize the transfer. Cryptographic signatures are mathematical algorithms used to authenticate the transaction.
4. Confirm that the money is received: The balances of your and the recipients’ digital wallets should automatically update. You may be able to view all transactions (anonymized) in the CBDC’s network, using a blockchain explorer website.

Countries Using Central Bank Digital Currencies

CBDCs have yet to be used at full scale, but several countries are researching and developing their own digital currencies. Here are some of the countries exploring or already using CBDCs:

• United States: The Federal Reserve Bank in Boston and technical experts at the Massachusetts Institute of Technology (MIT) are collaborating on a potential CBDC.
• Nigeria: The eNaira is accepted in Nigeria as the country’s CBDC. The eNaira has been in use since October 2021.
• China: China’s eCYN was launched on a limited basis as a pilot test in 2019. The digital currency is being used for everyday transactions in conjunction with eCYN-compatible wallets.
• Russia: The Russian government, working with several domestic banks as partners, is conducting a pilot test of a digital ruble.

Pros and Cons of Central Bank Digital Currency

Pros Explained

• Secured by blockchain technology: CBDCs use blockchain technology, which is generally considered to be secure for financial transactions.
• Secured by government: CBDCs are fully supported and secured by the governments that develop them.
• Enables direct money transfers: CBDC users can transfer funds directly without the need for an intermediary such as a bank.

Cons Explained

• Control of blockchain network is centralized: CBDC blockchains can be considered less secure than other blockchains because they are controlled by a single centralized authority. Governments may be subject to attack or vulnerable to corruption.
• No opportunity for price appreciation: Many investors are drawn to digital currencies because of the expectation that the assets will gain value over time. CBDCs, simply as digital forms of traditional currency, are not poised in the same way to appreciate in value.
• Requires a compatible digital wallet: To send or receive a CBDC, you must have a digital wallet that is compatible with that CBDC. Your digital wallet stores money separately from traditional currency.

What Central Bank Digital Currencies Mean for Investors

As an investor, you may be wondering how or if central bank digital currencies fit into your portfolio. While you can consider using a CBDC if one becomes available to you, remember that a CBDC is equivalent to traditional money. If a country’s currency experiences inflation, then the digital currency issued by the same government also loses value. If you want to invest in digital assets that have the potential for price appreciation, other cryptocurrencies may be better choices.