CBDC Development: Regulations and Future Considerations

The COVID-19 pandemic has created an urgent need for the digitalization of society, which would help improve the efficiency of public policy, eliminate problems in the traditional financial system, and so on. In addition, the crypto industry has become an area of life that does not lend itself to direct government oversight. In this context, CBDC (Central Bank Digital Currency) appeared.

Most countries are interested in CBDC, while 9 countries have already put the digital currency into circulation. The rest are still exploring the possibility of implementing this technology or are monitoring a pilot project. Our article discusses central bank digital currency opportunities, challenges, and design, as well as the CBDC development process.

Table of Content:

1. What is CBDC?
2. Central Bank Digital Currency Technology: How It Works?
3. Development Challenges and Considerations
4. The Future of CBDC Technology
5. Summary

What is CBDC?

CBDC (Central Bank Digital Currency) is the digital equivalent of fiat currency, pegged at a 1:1 ratio and issued and controlled by the central bank. This is the main difference between CBDC and cryptocurrencies, which exist in a decentralized and anonymous environment. Cryptocurrencies are subject to significant price fluctuations that depend on current supply and demand, whereas the value of CBDC is much more stable.

Reminiscent of stablecoins? Yes, there are similarities, but there is still a difference. Private entities issue stablecoins in exchange for fiat provided, while CBDCs are controlled by the government and are essentially a version of fiat on a digital platform.

CBDCs are also unlike the cashless money we use. When CBDCs are introduced, citizens will be directly connected to the central bank, bypassing the intermediaries of commercial banks. They will not need a bank account – just an electronic device. One of the options for implementing CBDC involves the creation of universal accounts in central banks.

Benefits of CBDC

States are going to develop central bank digital currency for many reasons:

• Efficiency. CBDCs will speed up transactions in a simplified financial infrastructure, making them cheaper and more convenient for the public. The cost of cross-border transfers will also go down.
• Accessibility. In some countries, a large proportion of the population still lacks access to the traditional financial system. For example, the figure reaches a third of all residents in Indonesia. CBDCs help to do without intermediaries, reduce costs for the population, and use financial services with only a mobile device.
• Security. CBDCs will be a significant step in the fight against various kinds of crime, from tax evasion to participation in illegal groups. Digital currencies will make governments more efficient in reporting and identifying suspicious transactions.
• Competitiveness. Private entities responsible for issuing cryptocurrencies are serious rivals (if not threats) to state regulators. In fact, private entities undermine the stability of the traditional financial system and, consequently, raise concerns among state actors. The essence of CBDC contradicts the principles of anonymity and ungovernability that states are fighting against.
• AML policy compliance. As transactions using CBDCs are characterized by their transparency and can be tracked and analyzed, the state can control the circulation of funds and track cash flows. Such measurements may help in terms of money laundering prevention and terrorism funding. 

This is why central bank digital currency development is a hot topic for different countries today. They strive to comply with CBDC requirements and get the most out of CBDC development to maximize the positive impact on the economy.

Central Bank Digital Currency Technology: How It Works?

CBDC leverages a secure and transparent blockchain network, harnessing cutting-edge technology to establish an unalterable record of every transaction. This ensures that all activities are meticulously documented on a decentralized ledger, guaranteeing the integrity and immutability of the data.

The blockchain’s distributed nature enhances the resilience of the CBDC system. In the event of a node failure or malicious attack, the decentralized network ensures that the data remains intact and accessible. This robustness adds an extra layer of security and reliability, crucial elements in the evolving landscape of digital currencies.

So, CBDCs are built through permissioned blockchains. Central bank digital currency development emphasizes robust security measures, transparency through an immutable ledger, and privacy features to create a digital currency system that is both secure and trustworthy.

CBDC Development Challenges and Considerations

A successful central bank digital currency design involves navigating complex economic, technological, and regulatory factors. Here are some key challenges and considerations of CBDCs:

• Security. Ensuring the security of CBDC transactions and data is paramount. Cybersecurity measures must be robust to prevent fraud, hacking, and unauthorized access.
• Scalability. The CBDC system needs to handle a potentially large volume of transactions efficiently to meet the demands of the entire economy.
• Legal and regulatory clarity. Countries must develop a clear legal framework for CBDC to define its status, regulatory oversight, and legal implications. By the way, MICA regulation will come into force in Europe in 2024. Thanks to it, it will be easier to regulate CBDCs, and consequently we can expect more projects to appear on the market.
• Cross-border regulatory coordination. It is important to address regulatory challenges arising when CBDC transactions cross borders, including money laundering and international cooperation issues.
• Interoperability with existing systems. Integrating CBDC with existing financial systems and payment infrastructure to ensure seamless transactions is essential.
• Global standards. Another big issue is collaborating with other countries and international organizations to establish common standards for CBDC transactions and interoperability. 

Addressing these challenges and considerations requires a multidisciplinary approach involving collaboration between central banks, technology experts, legal professionals, and policymakers. It’s essential to conduct thorough research, engage stakeholders, and pilot programs to test and refine the system before the wider implementation of CBDCs.

The Future of CBDC Technology

The place of traditional banking institutions is gradually being taken over by digital financial institutions that provide users with online banking services. In addition, the use of cryptocurrencies and blockchain technologies in general has been gaining momentum in recent years, which has led to significant changes in global FinTech regulation.

According to the latest data from the Atlantic Council’s Central Bank Digital Currency tracker, 130 countries, representing 98% of the world’s GDP, have already started conducting CBDC research. Some countries have even moved on to the next stages of CBDC implementation. Let’s take a look at some of them:

• In 2020, the Central Bank of the Bahamas launched the world’s first official digital currency, the Sand Dollar. It became a digital version of the Bahamian dollar, thus putting it ahead of China and other countries. The main purpose of the CBDC was to promote financial inclusion and provide greater access to financial services in the sparsely populated archipelago of 700 scattered islands. Residents can use digital currency through mobile applications or a physical payment card to access a digital wallet. The Sand Dollar is backed by the Central Bank’s foreign exchange reserves and is limited to domestic use.
• China also implemented a pilot project on the use of digital currency in April 2020 after 6 years of research. The main goal of this project was to protect China’s currency sovereignty and the legal status of the national currency. The digital yuan tests began in 4 cities and gradually expanded to other cities. According to the data released by the People’s Bank of China, at the end of August 2022, the number of transactions using the CBDC was 100 billion yuan ($14.5 billion), equivalent to an average of 3.6 billion yuan per month since the beginning of the trial. The number of digital yuan-enabled merchants has exceeded 5.6 million. The digital yuan was also actively used during the Beijing Winter Olympics.
• Jamaica’s digital currency, JAM-DEX, was launched in June 2022 and is the first CBDC officially recognized as legal tender. The Governor of the Central Bank of Jamaica, Richard Biles, noted that the digital Jamaican currency offers a safer and more convenient alternative to physical banknotes and coins. The Jamaican government expects to save about $7 million a year on the replacement, storage, and handling of cash.

One of the most promising aspects of CBDC technology is its potential to address longstanding challenges in the financial sector. CBDCs can enhance financial inclusion by providing a digital means of accessing and participating in the formal economy, particularly for those underserved by traditional banking infrastructure. 

Additionally, CBDCs promise to revolutionize cross-border payments, offering faster, cheaper, and more transparent transactions. From a monetary policy perspective, central banks may find new tools and levers, with CBDCs allowing for more precise control over the money supply and interest rates.

Looking ahead, the future of CBDC technology is likely to be shaped by ongoing technological advancements and innovations. As the digital currency landscape evolves, developments such as the integration of smart contracts, quantum-resistant cryptography, and improved consensus mechanisms could further enhance CBDC capabilities. These innovations hold the potential to streamline and automate complex financial processes, offering efficiency gains and increased security in CBDC transactions.

Ongoing tests of CBDCs in various countries open new opportunities within the WEB3 domain. I mean financial products that will empower the new financial (and banking) formula after CBDCs succeed in retail. Banks will be the first. It will enable them to offer new financial products to their existing customers. Infrastructure providers (like Mastercard) will be the second, as they are already preparing the new infra for the retail, cross-border payments, and AML.

Andrei Lazorenko, CEO at IdeaSoft

Summary

Central bank digital currency and the future of monetary policy are interconnected. Control and efficiency are words that perfectly explain the states’ desire to introduce CBDC. It is a response to the expanding digitalization processes, the proliferation of cryptocurrencies, and the financial instability of recent years. Will this cause tangible damage to cryptocurrencies? More likely, no than yes.

CBDC technology varies, with many central banks exploring permissioned blockchains and distributed ledger technology for secure and transparent transactions. Cryptographic techniques, such as public and private keys, ensure transaction security, while smart contracts may automate aspects of CBDC transactions. Consensus mechanisms, like Proof of Authority or Proof of Stake, validate transactions and maintain network integrity.