A Central Bank Digital Currency (CBDC) is an electronic version of a country’s fiat currency created by the central bank. It is comparable to cryptocurrencies, but its value is set by the central bank and is equivalent to the country’s fiat currency. Many governments are developing and implementing CBDCs because they promote financial inclusion and make it easier to implement monetary and fiscal policy.

Fiat money is a government-issued currency that is not backed by any tangible substance. Technology has enabled governments and financial organizations to augment physical fiat currency with a credit-based currency model that digitally records balances and transactions. The arrival of cryptocurrencies and blockchain technologies has sparked renewed interest in cashless societies and digital currencies.

CBDCs are intended to give organizations and customers with privacy, transferability, convenience, accessibility, and financial security. They also lower the costs of maintenance, cross-border transaction fees, and the hazards involved with using digital currencies, such as cryptocurrency. CBDCs also give a country’s central bank the opportunity to undertake monetary policies that promote stability, limit growth, and impact inflation.

CBDCs are categorized into two types: wholesale and retail. Wholesale CBDCs function similarly to central bank reserves, however retail CBDCs eliminate the intermediary risk. Token-based retail CBDCs can be accessed via private keys, public keys, or both, whereas account-based CBDCs require digital identification.

The Federal Reserve has identified numerous concerns that CBDCs can help with, including financial structure changes, financial system stability, monetary policy influence, privacy and protection, and cybersecurity. CBDCs can minimize third-party risk, reduce cross-border payment costs, strengthen the dollar’s international position, promote financial inclusion, and increase public access. However, they also provide issues in terms of household costs, investments, banks reserves, interest rates, the financial services sector, and the economy.

Central banks must ensure that they have the instruments necessary to favorably impact the economy, as a shift to a CBDC may have unanticipated consequences for financial system stability. CBDCs are intended to reflect the value of fiat currency while also ensuring stability and safety. As of March 2024, three countries had functional CBDCs, and 36 CBDC pilots were in operation.

The United States is one among the countries considering whether a CBDC “could improve on an already safe and efficient U.S. domestic payments system.” CBDCs leverage blockchain or distributed ledger technology to provide access to financial services while lowering the maintenance costs of existing monetary systems. However, they should be used to supplement, not replace, current financial networks and fiat currencies.

To summarize, CBDCs seek to provide businesses and customers with privacy, transferability, ease, accessibility, and financial security. They could also minimize maintenance expenses, cross-border transaction costs, and provide cheaper options for individuals who use alternative money-transfer methods.