The rise of digital transactions and the expanding usage of mobile devices for financial operations have completely changed the payments industry in recent years. Central banks worldwide are looking at the introduction of a central bank digital currency (CBDC) as we continue to shift towards a society that uses less cash.
The central bank’s digital currency is known as CBDC (Central Bank Digital Currency). It is an electronic obligation of the monetary regulator that is valued in the local unit of account and functions as a medium of exchange, a unit of measurement, and a store of value. CBDC may be used for a variety of transactions, including online purchases, peer-to-peer payments, and even overseas transfers, unlike actual cash because it is purely digital. Instead of replacing current forms of money like bank deposits and physical cash, CBDCs (central bank digital currencies) are intended to function in conjunction with them.
The two main types of CBDC are general purpose or retail (CBDC-R) and wholesale (CBDC-W). While wholesale CBDC is made for restricted access to certain financial institutions, retail CBDC may be used by everyone, including private sector, non-financial customers, businesses, and consumers. Unlike retail CBDC, which is primarily designed for retail transactions, wholesale CBDC is used to settle interbank transfers and other wholesale transactions.
In a direct CBDC system, the central bank would be overseeing all operations, including transaction verification, account maintenance, and issuance. Since the central bank controls the retail ledger under this approach, all payments are processed through the central bank server. In this paradigm, the central bank, which keeps track of all balances and updates it after each transaction, is directly sued by the CBDC. As the central bank has comprehensive knowledge of retail account balances, it offers the benefit of a very robust system and makes it simple for it to satisfy claims because all the information needed for verification is readily available. This model’s primary drawback is that it discourages payment system innovation by undervaluing private sector participation. The central bank would deal directly with the end users under this model’s disintermediation scenario. In addition to adding to the central banks’ workload in terms of administering client onboarding, KYC (Know Your Customer), and AML (Anti Money Laundering) checks, which might be challenging and expensive for the central bank, this model has the potential to upset the present financial system.
Two-Tier Model (Intermediate model) or Retail model or Indirect Model
In the indirect CBDC approach, customers would keep their CBDC in an account or wallet with a bank or service provider. The intermediary, not the central bank, would handle providing CBDC upon request. Only the intermediaries’ wholesale CBDC balances would be tracked by the central bank. The central bank must make sure that all the retail balances offered to retail clients are equal to the wholesale CBDC balances.
Hybrid or Synthetic model
In the hybrid approach, a private sector messaging layer is paired with a direct claim on the central bank. Other entities will receive CBDC from the central bank, which will make them accountable for all customer-related activity. In this arrangement, end users receive retail services via commercial intermediaries (payment service providers), yet the central bank keeps a record of retail transactions. The central bank keeps a central ledger of all transactions, manages retail payments through intermediaries, but also runs a backup technical infrastructure that enables it to restart the payment system if intermediaries become insolvent or experience technical difficulties. This architecture is powered by two engines.
Account Based CBDC
A trusted third party is often used in an account-based method to confirm a user’s identification as the account holder and check their account balance before allowing them to make a payment. The accounts are then appropriately debited and credited. While the requirement for added verification processes can replicate similar issues with current legacy systems, this could result in unnecessary overheads. The management of the network may also be affected by the requirement for a third party. Since the trade-off between accessibility and identification evidence is clearer cut in a wholesale CBDC (interbank transactions), an account-based method seems more proper.
Token Based CBDC
Token-based verification, on the other hand, makes use of blockchain technology to do away with the requirement that a customer’s balance be checked before approving a transaction. This is provided that the token holder can prove their ownership of the token by signing the transaction, for example, by using a private key, and by satisfying the necessary identity requirements. Although there is a danger involved when a private key is lost, there are ways to keep control of ownership in such situations. Without requiring an account, these methods can offer a more direct, cash-like approach. Features for account-based and multi-factor authentication can still be used on top. The same funds can be spent more than once or simultaneously spent and returned to the user, which is an issue that both real currency and blockchain technology, which uses a distributed ledger, must address. Both techniques are used to avoid double-spending.
Changes of CBDC
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