Will CBDCs Replace Fiat Currencies?

Central banks have served as trusted institutions for providing money to the public since their inception. Fiat currency issued by a central bank is a vital public necessity and is one of the important components in the foundation of the modern financial system. The notion of Central Bank Digital Currency or CBDC replacing fiat currencies emerges from the digital transformation of different aspects of the financial systems.

On top of it, evidence also indicates that huge margins have recently reduced the use of fiat currencies or physical cash. For example, the COVID-19 pandemic fuelled the switch to digital payments within a short span of time. Therefore, central banks worldwide have started exploring the prospects for introducing digital versions of fiat currencies or CBDCs. 

While CBDCs are painted as promising alternatives to physical cash, it is important to review different factors before ensuring CBDC adoption. For example, it is important to identify the CBDC impact on fiat currencies and their associated limitations. In the following post, let us learn more about the fundamentals of Central Bank Digital Currencies and their advantages over fiat currencies.

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What are Central Bank Digital Currencies? 

Do you remember the last time you paid for something with physical cash? Fiat currency is still used in large numbers worldwide, although the frequency of use has reduced by huge margins. The COVID-19 pandemic spurred a change in customers’ behavior, particularly due to concerns about hygiene and cash shortages worldwide. Therefore, questions like “Will digital currency replace fiat currency?” have become notable headlines in finance.

Banks and financial institutions worldwide process more transactions in digital form than in physical branches. The recent examples of digital disruptions, such as the rise of cryptocurrencies and blockchain, have played a crucial role in transforming the financial services domain. 

Central Bank Digital Currencies are digital fiat currencies issued by central banks. The central bank issuing CBDC would have to back the digital form of fiat currency. Central banks are responsible for supporting the financial services of the government of a nation and the commercial banking system. In addition, the central bank also performs other notable functions, such as issuing currency and defining monetary policy. Some examples of central banks include the People’s Bank of China, the US Federal Reserve System, the Reserve Bank of India, the Deutsche Bundesbank in Germany, and the Bank of Japan.   

The review of responses to “Will digital currency be the future?” also sheds light on the working of CBDCs. Some people draw similarities between CBDCs and stablecoins. However, CBDCs are different from stablecoins in the fact that any physical commodity does not back them.

Stablecoins are cryptocurrencies that have the backing of a specific fiat currency, physical commodity, or other financial instruments. Generally, a private entity deploys a stablecoin on blockchain networks. On the other hand, Central Bank Digital Currencies are issued and operated by the Central Bank or the government of a nation.

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Variants of CBDCs 

The definition of Central Bank Digital Currencies implies that you could find one specific variant of CBDC. On the contrary, you would come across different approaches for CBDC implementation in different countries. If you want to find answers to “Are central bank digital currencies the future of cash?” you should pay attention to the different models for CBDC implementation.

How will nations embrace CBDCs over fiat currencies? First of all, you can find the account-based model for CBDC implementation with examples like DCash, used in the Eastern Caribbean region. DCash enables users to own deposit accounts directly affiliated with the central bank.

Another example of an account model for implementing Central Bank Digital Currency is the e-CNY in China. It is a CBDC pilot project that depends on different private-sector banks to distribute and maintain digital currency accounts. China promoted e-CNY during the Beijing Olympics in 2022 by enabling athletes and visitors to make purchases using e-CNY in the Olympic Village. 

The next example of the CBDC implementation model refers to the one being considered by the European Central Bank. According to the model, licensed financial institutions would run a permissioned or private blockchain node to distribute digital euro. The notion of CBDC replacing fiat currencies would find a better path forward with such models. Every bank could issue anonymous fungible tokens instead of fiat currency upon implementation. The anonymous tokens could help safeguard the privacy of users.

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Are There Any Countries That Have Implemented CBDCs?

The working of CBDCs and the two distinct models for implementing them in the financial system of a country prove their potential. However, the answers to “Will digital currency replace fiat currency?” would depend on the success of existing examples. Therefore, the interest in CBDC implementation examples has been soaring in recent times.

It is important to note that around 87 countries are exploring the possibilities of implementing CBDCs. Interestingly, the 87 countries represent over 90% of the global GDP. Here are some notable examples of countries that have adopted or plan to adopt CBDCs.  

• Nigeria launched its CBDC, i.e., eNaira, in October 2021 and became the first African country to implement a CBDC.
• The central banks of Saudi Arabia and the United Arab Emirates have collaborated to launch Project Aber, a CBDC-centric initiative. Project Aber aims to evaluate the effectiveness of a jointly-issued digital currency as a tool for domestic and cross-border financial transactions. 
• Another notable example of CBDC implementation points to Jamaica. The Caribbean country launched its own CBDC, JAM-DEX, in June 2022. Most importantly, JAM-DEX is the first CBDC to obtain formal recognition as a country’s legal tender. You can notice the CBDC impact on fiat currencies with the simple use cases of JAM-DEX, such as cross-border payments. The unique highlight of JAM-DEX is the fact that it does not use blockchain technology like DCash.
• The Sub-Saharan African region is also a promising candidate for the adoption of CBDCs. For example, M-PESA mobile money transfer service has emerged as a formidable tool for strengthening the social and financial infrastructure to encourage the adoption of CBDCs.

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Why Would Central Banks Pay Attention to CBDCs?

The examples of CBDC implementation in different countries showcase the possibilities for large-scale CBDC adoption in the future. On the other hand, it is also important to review why central banks worldwide would take an interest in CBDCs. Without any valid reason for introducing digital forms of fiat currencies, why would central banks go through the effort to introduce digital currency? Here are some reasons why central banks have been thinking about implementing Central Bank Digital Currencies.

The pandemic pushed people away from each other into the safety of their own homes. People could not visit supermarkets or the local farmer’s market. Therefore, digital payments became the norm of the day as online shopping gained momentum during the pandemic. For example, cash usage dropped by almost 33% between 2014 and 2021 in Europe. Another example of declining cash usage is Norway, where cash usage accounts for only 3% of payment transactions. As a result, central banks have started re-examining their role within the monetary system.

• Need for Innovation in Payment

Another prominent reason underlying responses to “What are the benefits of CBDC over fiat money?” points to the need for innovation. Central banks have to stand up to the challenge of encouraging innovation in payment systems. With the help of CBDCs, central banks could revolutionize conversations about the use cases of cash.

• Rise of Global Payment Systems

The growth of global payment systems also serves as another formidable reason for central banks to consider the adoption of CBDCs. Central Bank Digital Currencies could serve as a valuable tool for improving local governance over the global payment systems. On top of it, central banks could also leverage CBDCs as a tool for stabilizing local digital payment systems. 

• Growing Preference for Digital Assets

Digital assets have become one of the popular choices for consumers, especially after the booming popularity of cryptocurrencies and NFTs. Around 10% of adults in the UK have claimed they own or own digital assets such as cryptocurrency. Furthermore, the answers to “Will digital currency be the future?” point in favor of CBDCs, as 10% of families in large EU countries have ownership of digital assets. The growing usage of digital assets serves as a formidable challenge to fiat currencies.

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Advantages of CBDCs

Central banks have more than one reason to adopt CBDCs as an alternative to fiat currency. At the same time, it is also important to reflect on the necessity of such an initiative. Will the general public use CBDCs? How will central banks overcome resistance to the replacement of fiat currencies? The following advantages of CBDCs could provide some helpful pointers for encouraging the adoption of digital currencies.    

The foremost advantage for central banks with Central Bank Digital Currencies is cost reduction. By shifting towards digital finance, financial service providers could save almost $400 billion in direct costs every year. However, it is also important to measure the reduced costs against the significant initial investments required in technology for implementing CBDCs.

The responses to “What are the benefits of CBDC over fiat money?” also draw attention to the benefit of accessibility. Around 5% of adults in the US need bank accounts. The world has over 2 billion people without access to banking services. CBDCs could provide access to money issued by central banks through mobile phones, thereby powering the prospects for financial inclusion. On the other hand, digital financial service providers could use CBDCs to enter untapped markets.

The next additional advantage of CBDCs over fiat currency refers to a reduction of risks. CBDCs could improve payment security by ensuring the immutability of transactions. For example, regulated private-key cryptography applications could help digitally sign transactions. Therefore, the answers to “Are central bank digital currencies the future of cash?” weigh in favor of CBDCs, which could reduce wait time for transaction finalization and security risks. Faster finalization of payment transactions leaves little room for compromising the transactions.

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Do CBDCs Have Any Limitations? 

Before you think of the possibilities for the adoption of CBDCs, it is important to reflect on their limitations. Central banks must review the ‘good’ as well as the ‘bad’ of CBDCs before making decisions about implementing them. A critical review of the CBDC impact on fiat currencies suggests that CBDCs could increase surveillance of financial transactions. As a result, consumers would have to worry about the security and privacy of their financial information.

Another significant challenge with CBDCs is the cost and complexity of implementing digital currencies. Central banks would need the technical infrastructure and skilled professionals required for implementing and maintaining CBDCs. 

Furthermore, central banks must also deal with the requirements for the integration of CBDCs in existing payment networks and systems. The effect of CBDCs on fiat currency also points to the possibility of a negative influence on monetary policy. For example, the use of CBDCs could affect the ability of central banks for implementation of monetary policy.

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Final Words

The reasons for adopting Central Bank Digital Currencies show that CBDCs are an innovative financial instrument. CBDCs assure a state-issued digital currency, which could help speed up the transition to digital money. However, the responses to “Will digital currency replace fiat currency?” would depend on multiple factors other than the advantages of CBDCs. Central Bank Digital Currencies provide many advantages, such as reduced costs of processing payments and increased financial inclusion.

On the other hand, the implementation of CBDCs requires significant capital investments in technical infrastructure and personnel. Furthermore, CBDCs could also create concerns regarding the monitoring of financial transactions and sensitive financial information. Learn more about CBDCs and their working mechanisms to identify their potential.  

*Disclaimer: The article should not be taken as, and is not intended to provide any investment advice. Claims made in this article do not constitute investment advice and should not be taken as such. 101 Blockchains shall not be responsible for any loss sustained by any person who relies on this article. Do your own research!