Banking and financial markets

What is a central bank digital currency?

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finger chartFrom bank hackers to a cashier giving you the wrong amount of change, the current financial system is wrought with both technical susceptibilities and human error. By using blockchain technology to build upon the current framework, a central bank digital currency (CBDC) could lead to improvements on the current payments system while reducing overall costs and complexity.

But what is a central bank? Simply put, “a central bank is a financial institution given privileged control over the production and distribution of money and credit for a nation or a group of nations.” A central bank digital currency is a digital extension of a central bank’s medium of exchange able to permanently settle transactions between parties. The central bank is able to remove credit risk and ensure stability by guaranteeing the value of the CBDC with blockchain, exactly like paper money.

Blockchain for financial services

A brief history of currency

In his book, A Primer of Money, Banking and Gold, Peter L. Bernstein says that despite the problems money causes, mankind invented it and sticks to it because it relieves us of the almost insurmountable difficulties of doing business through barter. For this reason, even the most primitive societies have tended to use some form of money, whether it be feathers, beads or giant stones buried under the sea. Commonly defined as any medium of exchange, a more concise definition of currency would be a widespread system of money common to a geographic location, like the US Dollar.

Originally used as a receipt for grain stores in ancient Egypt, currency evolved to represent value with different metals. These metals were able to store value as they were a standardized weight when they were stamped into coins. This standardization paved the way for banking whereby coins could be valued by the weight of the metal and stored in a secure location for credit.

As trade increased, merchants needed a medium of exchange that was more efficient than metal coins, which led to the introduction of paper money. While initially a gradual process beginning in the Chinese Tang dynasty, by the 1900s, most industrialized countries were using paper notes and coins to represent a gold standard.

A brief history of digital currency

Although the idea of a central bank digital currency seems to be relatively new, the concept of a digital currency has been around since 1983 when David Chaum introduced the idea of digital cash. While similar to a traditional currency, what differentiates it is the ability to instantaneously exchange value between parties across borders. A digital currency is any medium of exchange recorded electronically, including virtual currencies (think of V-Bucks in Fortnite) and cryptocurrencies such as Bitcoin.

While digital currencies took a step back in the 1990s due to the dot-com bubble and several services being shut down for money laundering, they made a major leap forward in 1997 when Coca-Cola introduced the first mobile payment vending machines where customers could pay via text. The following year, the founding of PayPal offered payment services online, signaling the beginning of a new era. Then, in 2008, the first cryptocurrency Bitcoin was introduced, allowing digital currencies to be sent directly from one party to another without going through financial institutions. Bitcoin paved the way for blockchain and distributed ledger technology in the financial services industry.

The future of central bank digital currency

From its humble beginnings as a receipt for grain in Egypt to present day internet transactions, digital currencies will continue to evolve. Sending money across borders today requires a series of intermediaries for both clearing and settlement, each adding time and cost to the process.

With blockchain for payments, clearing and settlement with finality happens in near real-time. The solution uses digital assets to settle transactions — serving as an agreed-upon store of value exchanged between parties — as well as integrating payment instruction messages. It all means funds can now be transferred at a fraction of the cost and time of traditional correspondent banking.

Read the full report on retail CBDC — the next payments frontier

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