How CBDCs are transforming global finance

Central Bank Digital Currencies (CBDCs) are no longer a farfetched dream. They represent the next frontier in digital finance, with governments across the world embracing and accelerating their development. For businesses, fintechs, and forward-looking consumers, CBDCs present both a challenge to existing systems and an opportunity to engage with a new financial paradigm.

CBDCs are government-issued digital currencies, fully backed by central banks and are equivalent in value to their physical fiat counterparts. Unlike cryptocurrencies such as Bitcoin, Ethereum, and Cardano, or even stablecoins like USDC, CBDCs are legal tender, which means they are a direct liability of the issuing central bank. 

In summary, there are two types of CBDCs:

• Retail CBDCs: Designed for public use in day-to-day transactions from consumers and businesses. These can be divided into two types: token-based retail CBDCs (accessible with private keys, public keys, or both), and account-based retail CBDCs (requires digital identity verification).
• Wholesale CBDCs: Used for interbank settlements and financial infrastructure. In this model, commercial banks and financial institutions hold CBDCs by having accounts at the central bank. These digital reserves can be used for large-scale transfers, clearing, and settlement. They also serve as a tool for implementing monetary policy by influencing interest rates, liquidity, and lending conditions between institutions.

These types of currency are being deployed around the world, with more than 130 countries (representing over 98% of the global GDP) expressing interest in exploring the potential of CBDCs. This new financial outlook will allow countries to modernize outdated payment systems, by facilitating real-time and cost-efficient transactions, while still maintaining control over monetary and fiscal policies. CBDCs will also create direct competition with stablecoins.

Projects already deployed

As with any new technology and innovation, some countries are more prone to be early adopters of a new era of the financial system. There are several levels of commitment and implementation of CBDCs across the world:

1. Live Deployments

The first fully launched CBDC is the Sand Dollar in The Bahamas, a retail digital currency deployed in October 2020. Due to its decentralized structure, with more than 700 islands, banks were having trouble with physical subsidiaries, ATMs, and even coins and bills. As the Central Bank launched its CBDC, a blockchain-backed digital token pegged one-to-one to the Bahamian dollar, people and businesses in the Bahamas can now buy and sell goods and services with this new digital currency.

In Africa, Nigeria was the first country to launch a retail CBDC called eNaira, deployed in October 2021. Unfortunately, this action had a low adoption rate, with less than 0,5% of the population adhering to it.

Jamaica has launched Jam-Dex, designed for unbanked citizens, covering a usually outcasted part of the population, by integrating with mobile wallets.

2. Advanced Pilots

China is currently testing the Digital Yuan / e-CNY, which is considered the most advanced CBDC pilot program. It is used for transport, salary payments, and shopping across several provinces. Sweden is testing e-Krona, currently in a multi-phase trial with commercial banks and payment providers. Simultaneously, countries like France, Switzerland, and the Hong Kong province, are running wholesale CBDC experiments with interbank applications.

‍3. Under research or development

The United States is cautiously researching a digital dollar, with privacy and systemic impact under review. Meanwhile, the FedNow service enables real-time payments, with privacy and banking system impact top concerns. The European Union is simultaneously exploring the Digital Euro, which is expected to launch around 2026, with pilot testing currently underway.

Main advantages & challenges of CBDCs

As a growing trend, CBDCs offer significant benefits to both issuers and users. As it is modernizing the payment infrastructure, banks, governments, and financial institutions are both excited about the opportunity but also concerned about the challenges that this newly deployed technology still faces.

The most obvious advantages are:

1. Modernizing the current financial system

The new CBDCs are modernizing the way banks handle payments and transactions globally. This is a new real-time, programmable, and cost-effective solution that outdated traditional banking rails.

2. Creating an alternative to private stablecoins

As Web3 progresses, with more private solutions being developed and gaining traction from customers and more embedded adopters, such as PayPal USD, USDC, USDT, etc., banks and traditional infrastructures are becoming more overlooked. As governments seek to retain control over monetary systems, CBDCs have become an evident option for digital currencies that are still centralized.

3. Increasing financial inclusion

As demonstrated by the Jamaican CBDC example, a significant percentage of individuals in developing economies are still unbanked, but have access to mobile payments. This solution enables more people to access financial services without having to create a traditional bank account.

4. Diminishing banking risks

Traditional structures have the risk of bank failures, bankruptcy, human errors, etc. By eliminating the third-party risk and focusing solely on the central bank infrastructure, users can rest assured that their financial position is solid.

5. Lowering cross-border transaction costs

With less physical infrastructure costs, the fees of transactions and payments decrease significantly. This allows for a more efficient digital system.

6. Eliminating the shadow economies

Since it is based on blockchain technology, CBDC offers traceable and transparent transactions, which are registered on-chain, allowing for illicit money movements to be eliminated and tax compliance to increase.

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However, there are still a few challenges that need to be addressed:

1. Privacy & Surveillance

As web3 financial applications need to deploy Anti-Money Laundering (AML) and Know-Your-Customer (KYC) policies and compliance, concerns have been raised about the balance between user privacy and regulation in place. Additionally, there is an increasing fear that “programmable money” could be the first step toward a more authoritarian regime capable of controlling citizens and promoting censorship.

2. Impact on the financial system

There is no denying that a new financial system will create a cut on the current state of the entities now running the ecosystem. If citizens can hold funds directly with central banks, commercial banks could lose deposits, affecting lending and credit creation.

3. Interoperability

As more and more countries invest in creating CBDCs, cross–border compatibility for transactions and payments will become a priority necessity that must be addressed. There are ongoing projects, such as mBridge (China, UAE, Thailand, HK), tackling this issue, but no real worldwide results so far.

4. Cybersecurity

As the financial system becomes more dependent on technology and digital access, cybersecurity becomes critical to countries’ financial health. CBDCs must be resilient to fraud and cyberattacks to avoid endangering the whole economic ecosystem and users’ assets.

Conclusion

At this moment, we are witnessing the growing trend of CBDCs, as well as the widespread adoption of stablecoins, embedded wallets, and tokenized assets. These will become all different moving pieces of the financial system in the future. 

This will allow for:

• Payments to become programmable, automated, conditional, and instant.
• Digital wallets to integrate CBDCs with crypto, rewards, and other assets.
• Offline transactions to be possible through mobile and NFC technology.

Businesses will be able to pay employees with CBDCs, receive international payments, design DeFi, and fintech products within a new economic system, and manage liquidity and compliance digitally.

At Skyline Digital, we’re monitoring this evolution of digital payments very closely and helping clients prepare for the ongoing transformation. If you’d like to join the web3 financial revolution, reach out to our team via Telegram to learn more about how your business can integrate with tomorrow’s digital economy.