CBDCs Explained

What Are CBDCs, and How Do They Differ from Cryptocurrencies and Stablecoins?

CBDCs are digital currencies issued by central banks, representing a direct liability on the bank. This central authority guarantees their value and security, differentiating them from decentralised cryptocurrencies like Bitcoin, which operate independently of central authorities and often experience extreme price volatility.

Cryptocurrencies such as Bitcoin have witnessed massive fluctuations in value, with prices sometimes rising by 300% and falling just as significantly. In contrast, CBDCs are designed to provide a stable, secure form of digital currency that integrates into the existing financial system, offering individuals and businesses a reliable alternative to physical cash and cryptocurrencies.

Stablecoins, a subset of cryptocurrencies, aim to provide stability by pegging their value to a fiat currency or commodity. However, their stability mechanisms have proven vulnerable, as illustrated by the collapse of TerraUSD, an algorithmic stablecoin that was supposed to maintain parity with the US dollar. While stablecoins attempt to bridge the gap between cryptocurrencies and fiat money, they lack the legal backing and security that CBDCs possess.

Unlike cryptocurrencies, which rely on decentralised systems and operate outside the traditional financial structure, CBDCs are tightly integrated into the respective national monetary system. This allows central banks to exercise full control over the currency, offering tools to monitor and regulate its flow in ways that are impossible with cryptocurrencies. In addition, CBDCs offer central banks the ability to implement monetary policy more effectively, such as through negative interest rates or direct transfers to citizens during economic crises.

Global Momentum in CBDC Adoption

CBDC initiatives have gained significant traction globally. As of 2023, 134 countries representing 98% of the global economy were exploring CBDCs, with nearly half of them at an advanced stage of development. This surge in interest is driven by several factors, including declining cash usage, the need for financial inclusion and concerns about monetary sovereignty and stability.

Notably, several pioneering countries have already launched CBDCs. The Bahamas, Jamaica and Nigeria have introduced their versions of digital currencies, with growing usage reported in recent months. China, which operates the world’s largest CBDC pilot scheme, has processed transactions worth nearly 7 trillion yuan ($987 billion) with its digital currency, the e-CNY.

The European Central Bank (ECB) has also made significant strides in the development of the digital euro. The ECB’s multi-year pilot program aims to offer a digital complement to physical cash, with a focus on maintaining the privacy of users while ensuring the security and efficiency of transactions. The ECB is particularly focused on using the digital euro to promote financial stability and prevent the rise of private cryptocurrencies that could disrupt the Eurozone’s financial system.

The United States, despite its hesitancy in adopting a retail CBDC, has begun to explore the use of a digital dollar. The Federal Reserve, alongside six other major central banks, is working on cross-border CBDC projects aimed at improving the efficiency of international payments. While political resistance and privacy concerns have slowed the progress of a retail CBDC in the U.S., the potential for wholesale CBDCs (used between banks) to streamline large-scale financial transactions has garnered support.

The UAE’s Bold Steps Toward CBDC Adoption

The UAE has emerged as a leader in CBDC development, aligning its efforts with the broader strategy of modernising its financial infrastructure. In 2021, the UAE launched its CBDC initiative, with a focus on cross-border payments and financial inclusion. The UAE Central Bank has collaborated with international partners, including China and Saudi Arabia, through the mBridge project.

One of the UAE’s key objectives is to enhance the efficiency of cross-border payments, particularly in regions where traditional banking infrastructure is lacking. The deployment of the Digital Dirham as part of its CBDC strategy represents a significant step forward in this regard. The UAE is also addressing regulatory concerns by embedding strict data privacy and security standards into its CBDC framework, acknowledging public fears about government overreach.

Regulatory Challenges Surrounding CBDCs

As CBDCs evolve from theory to practice, several regulatory challenges must be addressed. One of the primary concerns is data privacy. With central banks gaining direct access to user transaction data, there is a fear that CBDCs could lead to an erosion of individual privacy. This concern is particularly acute in regions where trust in government institutions is low.

To mitigate these concerns, central banks are exploring privacy-enhancing technologies and policies that balance the need for oversight with respect for individual autonomy. The European Central Bank, for instance, has emphasised that privacy will be a fundamental pillar of its digital euro project, aiming to ensure that users’ financial data is protected.

Another regulatory challenge involves interoperability. As different countries develop their own CBDCs, ensuring that these digital currencies can work seamlessly across borders is crucial for global trade and financial stability. The mBridge project is one example of a multi-country effort to address this challenge, offering a platform for interoperable CBDCs.

There are also concerns about financial stability, particularly in relation to the risk of bank runs. In times of economic crisis, consumers may rush to convert their bank deposits into CBDCs, which could destabilise commercial banks. To address this risk, some countries are considering imposing limits on the amount of CBDCs that individuals can hold or designing CBDCs to discourage large-scale withdrawals from banks.

The Outlook for CBDCs

The future of CBDCs looks promising, with many experts predicting widespread adoption within the next decade. For emerging markets, CBDCs offer a path toward financial inclusion and stability. Countries like Nigeria and the Bahamas have demonstrated that CBDCs can be successfully implemented to address gaps in traditional banking infrastructure. However, widespread adoption will depend on public trust, regulatory clarity and the ability of CBDCs to offer tangible benefits over existing payment methods.

In the near future, we can expect more countries to pilot or fully launch CBDCs, driven by the need to modernise payment systems, enhance monetary policy tools and reduce reliance on physical cash. As more central banks join international projects like mBridge, the global financial system will likely become more interconnected, with CBDCs playing a central role in facilitating cross-border transactions and promoting financial stability.