Central Bank Digital Currency

A Central Bank Digital Currency (CBDC) is a digital form of a country's official currency issued and backed directly by the central bank. Unlike commercial bank deposits, which represent a liability of a private institution, CBDC represents a direct liability of the central bank — the same entity that issues physical banknotes. Unlike cryptocurrencies, CBDC is centrally controlled, government-backed, and does not rely on decentralized consensus mechanisms.

## Why Central Banks Are Exploring CBDCs

Several converging trends have pushed CBDC from academic discussion to active development in most major economies:

**Declining cash use**: In Sweden, cash transactions fell below 10% of retail payments by the early 2020s. As physical cash becomes marginal, central banks face a scenario where all digital payments are routed through commercial banks — concentrating systemic risk and reducing central bank visibility into monetary transmission.

**Financial inclusion**: 1.4 billion adults worldwide remain unbanked. A CBDC accessible via a basic smartphone without a bank account could extend financial services to populations currently excluded from the formal economy.

**Payment system competition**: The success of private payment systems (Alipay, WeChat Pay, UPI, Pix) and the stated ambitions of technology companies to issue private currencies (most visibly Facebook's Diem/Libra proposal in 2019, since abandoned) prompted central banks to evaluate whether public digital money was necessary to preserve monetary sovereignty.

**Geopolitical dimension**: China's e-CNY (digital yuan) pilot, the largest in the world, has been interpreted partly as a strategic move to internationalize the renminbi and reduce dependence on the dollar-dominated SWIFT messaging system.

## Retail vs Wholesale CBDC

| Feature | Retail CBDC | Wholesale CBDC |
|---------|-------------|----------------|
| Who holds it | General public | Financial institutions |
| Current analogue | Physical cash | Central bank reserves |
| Primary use | Payments, savings | Interbank settlement |
| Design complexity | High | Lower |
| Privacy concern | High | Lower |

**Retail CBDC** is the version that attracts the most public attention and debate. It would allow citizens to hold digital currency directly at the central bank, bypassing commercial banks.

**Wholesale CBDC** is a more technically straightforward upgrade to existing central bank settlement systems, primarily of interest to financial institutions for cross-border transactions and interbank settlement.

## Design Choices and Trade-offs

### Account-Based vs Token-Based

An account-based CBDC links to verified identities (like bank accounts). A token-based CBDC is more like digital cash — the token itself represents value and can be transferred without authentication. Most central bank proposals use tiered approaches: anonymous up to small limits, identity-verified above thresholds.

### Direct vs Indirect (Two-Tier)

In a **direct CBDC** model, the central bank maintains accounts for all citizens. In a **two-tier model**, commercial banks distribute CBDC to customers while the central bank maintains only wholesale balances. Most serious designs favor two-tier to avoid overwhelming central bank infrastructure and displacing commercial banking.

### Programmability

CBDCs can be designed with programmable features: automatic tax collection, spending restrictions (welfare payments usable only for specified goods), time-limited stimulus that expires if unspent. These features raise both efficiency arguments and significant civil liberties concerns.

## Major Deployments and Pilots

**e-CNY (China)**: The most advanced large-economy CBDC. Distributed through major state banks, used in controlled pilots at the 2022 Beijing Winter Olympics, and expanded across dozens of cities. As of 2024, reported wallets exceed 120 million. E-CNY is designed with "controllable anonymity" — transactions are opaque to other users but traceable by authorities.

**Digital Euro (European Central Bank)**: The ECB completed its investigation phase in 2023 and entered a preparation phase. Design principles emphasize privacy (equivalent to cash for small transactions), no interest payment to prevent disintermediation of commercial banks, and holding limits.

**FedNow (United States)**: The US Federal Reserve launched a real-time payment settlement system (FedNow) in 2023. This is not a CBDC — it moves commercial bank money, not central bank liabilities — but it addresses many of the payment efficiency arguments for CBDC without creating new digital sovereign money.

**Project mBridge**: A multi-CBDC platform for cross-border payments involving the central banks of China, Hong Kong, Thailand, UAE, and Saudi Arabia. Designed to reduce reliance on correspondent banking and the dollar-based SWIFT system.

## Key Concerns

### Financial Disintermediation

If retail CBDC pays interest or is perceived as safer than commercial bank deposits, citizens may shift deposits from commercial banks to CBDC, especially during bank runs. This would reduce the deposits available for bank lending, potentially contracting credit availability. Most central bank designs address this with holding limits or zero interest rates on CBDC.

### Privacy and Surveillance

Physical cash is the only truly anonymous payment method. A CBDC that is traceable by the issuing government creates infrastructure for financial surveillance at a level previously impossible. The e-CNY's "controllable anonymity" explicitly preserves state access. Even in democracies, the existence of such infrastructure creates risks that persist beyond current governments.

### Monetary Policy and Control

Programmable CBDC creates new monetary policy tools: negative interest rates become enforceable on digital cash (currently people simply hold physical bills to avoid negative rates), helicopter money distributions become instantaneous, and stimulus can be precisely targeted. Whether these capabilities would be used appropriately is a governance question that technical design cannot answer.

### Cybersecurity

Concentrating the entire monetary system into a single digital infrastructure creates catastrophic failure modes. A successful attack on CBDC infrastructure could freeze transactions for an entire economy in ways that a system with distributed commercial bank intermediaries would not.

## Relationship to Cryptocurrencies

CBDCs and cryptocurrencies are often mentioned together but represent opposite design philosophies. Cryptocurrencies (especially Bitcoin) were created explicitly to remove central bank control, provide censorship resistance, and enable permissionless transactions. CBDCs extend central bank control into digital money, are fully permissioned, and are censorship-enabling by design. The two can coexist, but they serve fundamentally different values.

The more relevant comparison is between CBDCs and stablecoins (privately-issued tokens pegged to fiat currencies like USDC or USDT). CBDCs would compete directly with stablecoins for use in digital payments, with the advantage of central bank backing but the disadvantage of direct government control over every transaction.

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