Following the path of digitalization in Slovenia and Europe: What are Central Bank Digital Currencies (CBDC), and what would they look like in practice?

At the beginning of the rise of cryptocurrencies, supporters made comments that banks and financial institutions would have to adapt to the new wave of digitalisation, or they would disappear. Central bank digital currencies may be their ticket into this new world.

The name itself tells us that central bank digital currencies, also referred to as CBDC, are digital tokens, similar to cryptocurrency in many respects, issued by a central bank. Therefore, it is about digital or virtual money, which is pegged to the value of that country’s fiat currency.

More than 80 countries worldwide are already researching or developing CBDCs; in some places, projects have been set aside or even cancelled, and in others, digital currencies have already been introduced.

The path to Central Bank Digital Currencies

The word fiat basically refers to government-issued currency. In the past, such currencies were backed by the value of something tangible, such as gold or silver, but that is no longer the case.

There is a general agreement that fiat currency is a form of legal tender that can be used to exchange goods and services. It started in the form of banknotes and coins, but technology has allowed financial institutions to supplement physical fiat money by digitally recorded balances and transactions.

A significant decrease in the use of cash has been noted. Photo: Pixabay.
A significant decrease in the use of cash has been noted. Photo: Pixabay.

Banknotes and coins still play an essential role in everyday life. However, some countries have experienced a significant decrease in the use of cash. That trend accelerated during the COVID-19 pandemic when we saw signs at many different places that contactless means of payment (payment cards) were recommended.

The development of cryptocurrencies, which can be highly volatile – their value can rise high or fall very low in an extremely short time – also contributed to the interest in virtual or digital currencies and payment methods.

Central banks, together with governments worldwide, are therefore thinking in the direction of their digital currencies, which would have a much more stable value. In return, we would have to give up one of the benefits of cryptocurrencies. CBDCs would be supervised by central banks, which is not the case with cryptocurrencies.

Together with the Bank for International Settlements (BIS), a group of seven central banks published a report two years ago outlining the basic principles that all CBDCs should follow.

CBDC must be able to coexist with cash.

CBDC must be able to coexist with cash.

The report was compiled by the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank (ECB), the US Federal Reserve (FED), and the Sveriges Riksbank (Sweden’s central bank). The report emphasises that a CBDC must be able to coexist with cash and other types of money in a flexible and innovative payment system.

In addition, any introduction should support broad policy objectives and not harm monetary and financial stability, and the characteristics of the digital currency should promote innovation and efficiency.

“Arguments for and against issuing a CBDC and the design choices being considered are driven by domestic circumstances,” they wrote. “There will be no ‘one size fits all’ CBDC. Yet domestic CBDCs would still have international implications. Cooperation and coordination are essential to prevent negative international spillovers and simultaneously ensure that much-needed improvements to cross-border payments are not overlooked.”

Wholesale CBDC and Retail CBDC

In last year’s annual report, the Bank for International Settlements explained that there are two types of central bank digital currencies, wholesale and retail. Namely, CBDCs can be designed for use either among financial intermediaries only (wholesale CBDC) or for use by the wider economy, consumers (retail CBDC).

Wholesale CBDCs would operate similarly to central bank reserves. They build on the current two-tier structure, which places the central bank at the foundation of the payment system. At the same time, activities for consumers and other customers are assigned to commercial banks and other payment service providers.

The central bank is the foundation of the payment system. Photo: AA.
The central bank is the foundation of the payment system. Photo: AA.

The central bank grant accounts to a financial institution for the deposit of funds or the settlement of interbank transfers. Wholesale CBDCs are intended to settle interbank transfers and related wholesale transactions. For example, to settle payments between financial institutions. The BIS added that the introduction of a wholesale CBDC could make central bank money programmable to support automation and mitigate risks.

However, the introduction of retail CBDCs is a much more far-reaching innovation. The CBDCs, described as retail, make central bank digital money available to the general public in a similar way as cash is available to the general public as a direct claim on the central bank.

This may not sound special, as we already have ways to put cash into digital form by depositing it in our bank account and sending the money to a friend or making a payment. However, with the CBDCs, this type of transaction would not take more business days and travel through several different banks. Everything could happen almost instantly within one digital database.

One of the characteristics of such CBDCs is that they do not pose any credit risk to users of the payment system, as they act as a direct claim on the central bank.

Monetary system with retail CBDC. Photo: R. Auer and R. Böhme/BIS.
Monetary system with retail CBDC. Photo: R. Auer and R. Böhme/BIS.

The figure above shows that retail CBDC is akin to a digital form of cash, the provision of which is a core responsibility of central banks.

Other forms of digital retail money represent a claim on an intermediary, leading to payment outages due to a temporary lack of funds or even insolvency. Such risks are already substantially reduced through collateralisation and other safeguards, but the CBDCs would put an end to any residual risk.

There are two variants of retail CBDCs that differ in how individual users access and use their assets.

The first option makes for a cash-like design, allowing for token-based access and anonymity in payments. This option would give individual users access to their money based on a password-like digital signature using private-public key cryptography known in the world of cryptocurrencies. Access would be possible without requiring personal identification.

The second option of CBDCs is built on verifying users’ identities so that access would be possible based on a personal user account. The BIS notes that this approach is more compatible with monitoring illicit activity in a payment system and would not rule out preserving privacy. With the appropriate design of the payment authentication process, personal transaction data could be shielded from commercial parties as well as from a government or public authorities.

Forms of central bank digital currency. Photo: BIS.
Forms of central bank digital currency. Photo: BIS.

Weaknesses of CBDCs

This seems great, and we could almost say that CBDCs represent a unique and developed solution. However, as with any new thing, we can find some downsides here as well.

When switching to digital, we always pause at the issue of privacy. Despite assurances that CBDCs bring some form of anonymity, we cannot ignore this issue. No matter how well transactions of this kind are protected, we must not forget that they are digital transactions still, and in one form or another, they will certainly be visible to central banks.

However, the use of cash brings an unattainable degree of anonymity, as it is virtually impossible to link a specific banknote to previous owners.

The Motley Fool website also drew attention to the fact that if consumers have access to retail CBDCs, commercial banks could lose a significant portion of their business. As mentioned above, transactions would no longer travel through commercial banks. This would be bad for banks and could impact the stock market since bank stocks could drop in value.

For now, the option discussed is the use of CBDCs in combination with cash, but theoretically, eventually, cash could also disappear. In this case, there are some additional disadvantages of digital currencies. Namely, central banks could stimulate consumption and accelerate money circulation through negative interest rates on deposits at banks.

Consumers would no longer be able to withdraw their money in cash and leave it in the piggy bank, so there would be only two options available to them. They either spend the money or lose part of it due to negative interest rates.

An even more extreme example is the possibility of programming digital currencies by central banks. In this case, they may decide to introduce an “expiry date” for the money, which China has already talked about. This means that a certain amount of money would disappear if not used in a specific timeframe.

Author: Marko Želko

Keywords: digitisation, CBDC, digital currencies, cryptocurrencies


This article is part of joint project of the Wilfried Martens Centre for European Studies and the Anton Korošec Institute (INAK) Following the path of digitalization in Slovenia and Europe. This project receives funding from the European Parliament. 

The information and views set out in this article are those of the author and do not necessarily reflect the official opinion of the European Union institutions/Wilfried Martens Centre for European Studies/ Anton Korošec Institute. Organizations mentioned above assume no responsibility for facts or opinions expressed in this article or any subsequent use of the information contained therein.