Understanding CBDCs

A report by the Bank for International Settlements states that, although the term "central bank
digital currency" is not well-defined but in a layman’s language, a CBDC can be described as a digital
form of fiat money. Instead of printing physical notes, the central bank issues electronic coins or
account backed by full credit and faith of the government. They differ from a credit card in a way
that CBDCs are the liability of the government, which means that the government will have to
maintain deposits and reserves to back it up rather than a private bank. There exist mainly 2 types of
CBDCs:
1) Retail CBDC: It is digital money meant for ordinary consumers and average people who will
use it to conduct transactions for their daily activities. Most governments are now looking at
developing Retail CBDCs only.
2) Wholesale CBDC: This type of CBDC can be exchanged and traded between central banks
and private banks and facilitates interbank transfers.

Let us now delve deeper into understanding why the Central bank should develop DCs for their
specific government:
1) Strengthening cross border payments: Cross Border payments are essentially more complex
than the domestic ones. They are high on regulations and jurisdictions and are often
dominated by time zones. With the introduction of an interoperable CBDC, the cross-border
payment scenario can be revolutionised.
2) Payments Diversity: Increase in the payment systems lead to more fragmentation of the
systems. This means that the users and merchants may face difficulties in paying users of
other systems. CBDC could provide a common means to transfer between fragmented
closed-loop systems.
3) Promoting Financial Inclusion: CBDCs will improve access to digital payments for unbanked
households.
4) Liquidity: CBDCs allow the Central Banks to provide short-term liquidity assistance, even on
bank holidays. This effectively lowers the risk of individual institutions systemically triggering
chain reactions.
5) Monetary policy transmission: CBDC could be used as a direct monetary policy tool if it is
interest bearing, which would allow for more direct control of the money supply.
6) Top of the League position: Acting swiftly on a CBDC could position a country as a pioneer in
defining monetary policy on CBDCs and setting applicable standards for the years to come.

Along with the optimistic side, lets assess the negative sides of a DC that the central banks need to
consider:
1) Lowers economic growth: As Central Banks become direct competitors to payment service
providers, banks might lose income. Likewise, a new form of investment opportunity may
reduce consumer deposit demand.
2) Competition for commercial banks: The introduction of a near substitute for bank deposits
may motivate banks to raise deposit rates and lead to a shift from deposit funding to
wholesale funding.
3) Lack of reliability: CBDCs are vulnerable to electricity outages and insufficient internet
connections. This might be a big challenge for the emerging economies.

Central banks serve jurisdictions with hugely differing financial systems, economies, societies, and
legal structures. The ups and downs balanced by different central banks will vary significantly.
However, given that central banks have common objectives, common principles, and requirements
for a CBDC are possible which should imperatively include – Do no harm, Coexistence and
Innovation and Efficiency. A CBDC robustly meeting these criteria and delivering the features could
be an important instrument for central banks to deliver their public policy objectives.