Central Bank Digital Currency — Possibilities and Potential Risks

6 min readOct 26, 2022

What is CBDC ?

CBDC is an acronym for Central Bank Digital Currency. Much like the digital or crypto currencies currently available in the market such as Bitcoin or Ethereum but backed by Central bank and therefore guaranteed in value by Central bank like a bank note. CBDC can be implemented either using a blockchain or without one.

Why we might need CBDC ?

To counter challenges posed by 3 Important factors — Decline of Cash, Shifting structures of Payment industry and rise of credible non-native digital currencies

As the society is moving towards digitalisation, cash in the economy has been declining in most economies. This has been accelerated by the plethora of payment options available in the market. The ease of use of digital payments and expense related to cash management are the other factors which are accelerating this.

Many payment companies have introduced digital payment systems, as they grow in scale and move towards becoming a monopoly they try and charge users and merchants more. They also use customer data and implement innovative use cases in the process. Payment ecosystems can grow into giants and can disregard the national borders altogether e.g. Alipay. This makes payments costly, rent seeking and a difficult to breach barrier for new entrants.

Finally there is the emergence of non-native digital, crypto currencies such as Bitcoin, Stable coins etc. Central banks don’t like these decentralised money instruments like Bitcoin because they can’t control the supply and they can’t control their value unlike the traditional currencies. Therefore central banks can’t implement monetary policy mandates with such currencies. This is a problem because the mandate for most central banks is to keep the currency stable and control inflation.

Another issue with these instruments is the central banks will not be able to track and check money laundering or terrorism financing with Crypto currencies like Bitcoin. The Private decentralised money has the potential to get the central banks out of job.

Bitcoin automates the functions of a modern central bank and makes them predictable and virtually immutable by programming them into code
- The Bitcoin Standard by Saifedean Ammous

The risk is, the possibility of a foreign digital currency issued by foreign central bank or a technology company becoming prevalent in domestic market for exchange replacing the domestic currency as the primary medium of exchange. This can be controlled with prudent legislation but only to an extent. While the risk of foreign digital currency replacing domestic currency seem to be low now, change can be very rapid.

the European Central Bank (ECB) has raised fears that stablecoins will “pose serious risks, both to…monetary sovereignty and financial stability” (Panetta, 2020).

How does CBDC differ from current digital payment systems ?

Current digital payment systems rely on the debit and credit from bank accounts or accounts with the fintech companies. The balances are not directly linked to or the liability of Central banks. CBDC however is going to be a direct liability of the central banks and are most likely to be token based with each token represented on a blockchain established by the central bank. Thus a CBDC is more like digital cash where the liability is with central bank whereas any digital money held with private banks or payment company wallets is the liability of private parties and not a sovereign guarantee (although deposits are guaranteed to a limit by Govts)

The cost of e-payment in advanced economies is still high. A CBDC could help bring a level playing field and a cost effective way of e-payment for market participants

Possible Implementation Structure of CBDC

A CBDC can be wholesale i.e. only for institutions or for retail. A retail CBDC would be issued by the Central Bank and will likely be distributed through banking channels

Most common implementation architecture being discussed by central banks is the two-tier structure where the CBDC is distributed through private partners while the settlement is handled by the central bank through a digital ledger.

What are the advantages of having CBDC ?

First advantage of a CBDC is in lowering the cost of payments. It is potentially a challenger to the fintech and payment companies. Having a CBDC would allow anyone to pay securely to a counterpart without being worried about the value of the underlying instrument. Its a digital equivalent of the bank note or paper currency currently in use.

A CBDC would also remove the dependency on solvency of bank, which comes with having the deposit with banks.

It will remove barriers to entry and create a level playing field encouraging newer participants while ensuring a minimum level of welfare protection.

Central banks would have the more efficient control over flow of money in the economy with CBDCs because CBDC would allow more flexibility than current instruments of interest rates. A programable CBDC would allow control/modification of all attributes of the digital currency. For example a central bank can set an expiry date to the CBDC forcing the velocity of money to increase in the economy. It would also allow to transfer money directly to people, thus making the transfer more efficient. Central Bank may or may not choose to pay interest rate on the CBDC.

Instead of being decentralised, the CBDC can be implemented by a centralised blockchain where the Central bank controls who joins the network and if the transaction is valid or not. Essentially, a blockchain with centralised approver.

What are the potential risks involved ?

In times of crisis people generally withdraw cash from bank accounts. If people could convert bank deposits to CBDC with a click of a button banks could potentially face a funding issue and a liquidity risk.

In the presence of an elastically supplied retail CBDC, systemic runs on the entire banking system are more likely to occur, and at greater speeds during times of financial stress.
- MAS Paper on Retail CBDC

CBDC being a digital programable currency can be targeted to spending in desired sectors by Govts but it also raises the concern for access to payment privacy. Physical cash maintains privacy because there are no cetralised records of holdings or transactions, this will not be the case with CBDC. State intervention in everyday transactions

“We approach a CBDC through the lens of the trilemma and show that the optimal system can maintain privacy by design through an actual CBDC without disrupting current two-tiered banking structures and the required regulatory oversight.”
-Goodell

Possibility of cyber-attacks on CBDC servers to bring down the economy to a halt. However if CBDC structure is built as a parallel system to existing payment infrastructure then it will help reduce the concentration risk and also help reduce single point of failure risks.

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