Special Content

Issue no 23, 03-09 September 2022


Central Bank Digital Currency - Is this

The Future of Money?


Today, we are living in a digital era. Digital banking, digital payments, and fintech innovations are growing at a rapid pace across the globe. Except currency notes, all other use of paper in the modern financial system - bonds, securities, transactions, communications, correspondences or messaging - has now been replaced by their corresponding digital and electronic versions. The Government of India is continuously making efforts to ensure that the benefits of digital banking reach every nook and corner of the country in a consumer-friendly manner. Taking forward this agenda, it has been proposed to introduce 'Digital Rupee', using blockchain and other technologies, to be issued by the Reserve Bank of India (RBI) starting 2022-23.


What is Digital Rupee?

It is an Indian moniker for Central Bank Digital Currency (CBDC). The High Level Inter-Ministerial Committee (November 2017) constituted by the Ministry of Finance, Government of India to examine the policy and legal framework for regulation of virtual/ crypto currencies had recommended the introduction of CBDCs as a digital form of fiat money in India. A CBDC is the legal tender issued by a central bank in a digital form. It is the same as currency issued by a central bank but takes a different form than paper and is exchangeable one-to-one with the fiat currency. It is sovereign currency in an electronic form which should be exchangeable at par with cash. Money nowadays is predominantly held in digital form (bank accounts, payment apps or through online transactions). However, a CBDC differs from existing digital money available to the general public as a CBDC is a liability of the Central bank, not of a commercial bank. The idea of CBDC is not a recent development. Some attribute the origins of CBDCs to Nobel laureate James Tobin, an American economist, who in the 1980s suggested that Federal Reserve Banks in the United States could make available to the public a widely accessible 'medium with the convenience of deposits and the safety of currency'. It is only in the last decade, however, that the concept of digital currency has picked up and is now being extensively discussed by central banks, economists, and governments. Many central banks and Governments are stepping up efforts towards exploring a digital version of fiat currency. Some of this interest among central banks has been indigenous in nature for pursuing specific policy objectives - for example, facilitating negative interest rate monetary policy. Another driver is to provide the public with virtual currencies that carry the legitimate benefits of private virtual currencies while avoiding the damaging social and economic consequences of private currencies.


How is it Different from Cryptocurrency?

CBDCs are digital versions of cash that are more secure and less volatile than cryptocurrency (also known as crypto assets) because they are issued and regulated by central banks. Cryptocurrencies are issued privately and their value can move up and down very quickly and involve a lot of risk. On the other hand, if a central bank issues digital currency, it is bound to be reliable and retain its value over time as it mirrors the value of the fiat currency.


What are the Benefits of CBDC?

According to the Managing Director of the International Monetary Fund (IMF), Ms. Kristalina Georgieva, "If CBDCs are designed prudently; they can potentially offer more resilience, more safety, greater availability, and lower costs than private forms of digital money. That is clearly the case when compared to unbacked crypto assets that are inherently volatile.


According to IMF, the potential benefits of CBDC include:

 ·         Cost of cash: In some countries, the cost of managing cash is very high due to an especially vast territory, or particularly remote areas including small islands. CBDC could lower costs associated with providing a national means of payment.

·         Financial inclusion: CBDC may provide a safe and liquid governmentbacked means of payment to the public that does not require individuals to even hold a bank account. Some central banks view this as essential in a digital world in which cash use is progressively diminishing, especially in countries where banking sector penetration is low

·         Stability of the payment system: Some central banks are concerned by the increasing concentration of the payment system in the hands of few very large companies (some of which are foreign). In this context, some central banks view CBDC as a means to enhance the resilience of their payment system.

·         Market contestability and discipline: Relatedly, some central banks view CBDC as potentially offering competition for large firms involved in payments, and thus as a means to cap the rents they can extract.

·         Countering new digital currencies: Some central banks view CBDC as healthy - potentially necessary-competition against privately issued digital currencies, some of which may be denominated in foreign currencies. These central banks believe a domestically issued digital currency backed by the government, denominated in the domestic unit of account, would help reduce or prevent the adoption of privately issued currencies, which may be difficult to regulate

·         Support Distributed Ledger Technology (DLT): Some central banks see the virtue of DLT-based CBDC to pay for DLT-based assets. If these assets proliferate, DLT-based currency would facilitate automatic payments when assets are delivered (so-called "payment-versus-delivery," or "payment-versus-payment," which could be automated using smart contracts). Some central banks are considering the option of providing CBDC only to institutional market participants in order to develop DLTbased asset markets.

·         Monetary policy: Some academic scholars view CBDC as a means to enhance the transmission of monetary policy. They argue that an interestbearing CBDC would increase the economy's response to changes in the policy rate. They also suggest that CBDC could be used to charge negative interest rates in times of prolonged crisis (thus breaking the "zero lower bound" constraint), to the extent that cash was made costly.


What is RBI's approach on CBDC?

Central banks across the globe are engaged in exploring CBDCs. Generally, countries have implemented specific purpose CBDCs in the wholesale and retail segments. Going forward, after studying the impact of these models, launch of general purpose CBDCs shall be evaluated. RBI is currently working towards a phased implementation strategy and examining use cases which could be implemented with little or no disruption. Although there is no doubt that CBDC will give a big boost to the digital economy and will also lead to a more efficient and cheaper currency management system, there are some key issues under examination by the RBI. The first is the scope of CBDCs - whether they should be used in retail payments or also in wholesale payments. The second is the underlying technology - whether it should be a distributed ledger or a centralized ledger, for instance, and whether the choice of technology should vary according to use cases. Other issues include the validation mechanism - whether token based or account based, distribution architecture - whether direct issuance by the RBI or through banks; and degree of anonymity, etc. However, conducting pilots in wholesale and retail segments may be a possibility in near future.


Do we need CBDC in India?

India is leading the world in terms of digital payments innovations. Its payment systems are available 24X7, available to both retail and wholesale customers, they are largely real-time, the cost of transaction is perhaps the lowest in the world, users have an impressive menu of options for doing transactions and digital payments have grown at an impressive CAGR of 55% (over the last five years). There is a unique scenario of increasing proliferation of digital payments in the country coupled with sustained interest in cash usage, especially for small value transactions. To the extent the preference for cash represents a discomfort for digital modes of payment, CBDC is unlikely to replace such cash usage. But preference for cash for its anonymity, for instance, can be redirected to acceptance of CBDC, as long as anonymity is assured. CBDCs are desirable not just for the benefits they create in payments systems, but also might be necessary to protect the general public in an environment of volatile private virtual currencies.


CBDC and the Banking System

Depending on the extent of its use, CBDCs can cause a reduction in the transaction demand for bank deposits. Since transactions in CBDCs reduce settlement risk as well, they reduce the liquidity needs for settlement of transactions (such as intra-day liquidity). In addition, by providing a genuinely riskfree alternative to bank deposits, they could cause a shift away from bank deposits which in turn might reduce the need for government guarantees on deposits. At the same time, reduced disintermediation of banks carries its own risks. If banks begin to lose deposits over time, their ability for credit creation gets constrained. Thus, it is important to design and implement CBDC in a way that makes the demand for CBDC, vis-àvis bank deposits, manageable. Additionally, availability of CBDC makes it easy for depositors to withdraw balances if there is stress on any bank. Flight of deposits can be much faster compared to cash withdrawal. On the other hand, just the availability of CBDCs might reduce panic 'runs' since depositors have knowledge that they can withdraw quickly. One consequence could be that banks would be motivated to hold a larger level of liquidity which could result in lower returns for commercial banks.


CBDC and Technology Risk

CBDC ecosystems may be at similar risk for cyber-attacks as the current payment systems are exposed to. Further, in areas with lower financial literacy levels, the increase in digital payment related frauds may also spread to CBDCs. Ensuring high standards of cybersecurity and parallel efforts on financial literacy is therefore essential for any country dealing with CBDC. Absorption of CBDCs in the economy is also subject to technology preparedness. The creation of a population scale digital currency system is contingent upon evolution of high speed internet and telecommunication networks and ensuring the wider reach of appropriate technology to the general public for storing and transacting in CBDCs. While improved inter-bank payment systems will bring many of the potential benefits discussed above, CBDC could be complementary, especially in some jurisdictions. Therefore, Central Banks should remain engaged in examining the full range of issues associated with CBDC, and deepen their familiarity with new technologies.


Compiled by EN Team