Decoding India’s Central Bank Digital Currency (CBDC)

In her budget speech presented in the Parliament on 1 February 2022, the Finance Minister of India – Nirmala Sitharaman – announced that India will launch its own Central Bank Digital Currency (CBDC) from the financial year 2022–23. The lack of information regarding the Indian CBDC project has resulted in limited discussions in the public sphere. This article is an attempt to briefly discuss the basics of CBDCs such as the definition, necessity, risks, models, and associated technologies so as to shed more light on India’s CBDC project.

1. What is a CBDC?

Before delving into the various aspects of a CBDC, we must first define it. A CBDC in its simplest form has been described by the RBI as “the same as currency issued by a central bank but [which] takes a different form than paper (or polymer). It is sovereign currency in an electronic form and it would appear as liability (currency in circulation) on a central bank’s balance sheet. The underlying technology, form and use of a CBDC can be moulded for specific requirements. CBDCs should be exchangeable at par with cash.”

2. Policy Goals

Launching any CBDC involves the setting up of infrastructure, which comes with notable costs. It is therefore imperative that the CBDC provides significant advantages that can justify the investment it entails. Some of the major arguments in favour of CBDCs and their relevance in the Indian context are as follows.

Financial Inclusion: In countries with underdeveloped banking and payment systems, proponents believe that CBDCs can boost financial inclusion through the provision of basic accounts and an electronic payment system operated by the central bank. However, financial inclusion may not be a powerful motive in India, where at least one member in 99% of rural and urban households have a bank account, according to some surveys. Even the US Federal Reserve recognises that further research is needed to assess the potential of CBDCs to expand financial inclusion, especially among underserved and lower-income households.

Access to Payments: – It is claimed that CBDCs provide scope for improving the existing payments landscape by offering fast and efficient payment services to users. Further, supporters claim that a well-designed, robust, open CBDC platform could enable a wide variety of firms to compete to offer payment services. It could also enable them to innovate and generate new capabilities to meet the evolving needs of an increasingly digitalised economy. However, it is not yet clear exactly how CBDCs would achieve this objective and whether there would be any noticeable improvements in the payment systems space in India, which already boasts of a fairly advanced and well-developed payment systems market.

Increased System Resilience: Countries with a highly developed digital payments landscape are aware of their reliance on electronic payment systems. The operational resilience of these systems is of critical importance to the entire payments landscape. The CBDC would not only act as a backup to existing payment systems in case of an emergency but also reduce the credit risk and liquidity risk, i.e., the risk that payment system providers will turn insolvent and run out of liquidity. Such risks can also be mitigated through robust regulatory supervision of the entities in the payment systems space.

Increasing Competition: A CBDC has the potential to increase competition in the country’s payments sector in two main ways, (i) directly – by providing an alternative payment system that competes with existing private players, and (ii) by providing an open platform for private players, thereby reducing entry barriers for newer players offering more innovative services at lower costs.

Addressing Illicit Transactions: Cash offers a level of anonymity that is not always available with existing payment systems. If a CBDC offers the same level of anonymity as cash then it would pose a greater CFT/AML (Combating Financial Terrorism/ Anti-Money Laundering) risk. However, if appropriate CFT/AML requirements are built into the design of the CBDC, it could address some of the concerns regarding its usage in illegal transactions. Such CFT/AML requirements are already being followed by existing banks and payment systems providers.

Reduced Costs: If a CBDC is adopted to the extent that it begins to act as a substitute for cash, it could allow the central bank to print lesser currency, thereby saving costs on printing, transporting, storing, and distributing currency. Such a cost reduction is not exclusive to only CBDTs but can also be achieved through the widespread adoption of existing payment systems.

Reduction in Private Virtual Currencies (VCs): Central banks are of the view that a widely used CBDC will provide users with an alternative toexisting private cryptocurrencies and thereby limit various risks including credit risks, volatility risks, risk of fraud, etc. However if a CBDC does not offer the same level of anonymity or potential for high return on investment that is available with existing VCs, it may not be considered an attractive alternative.

Serving Future Needs: Several central banks see the potential for “programmable money” that can be used to conduct transactions automatically on the fulfilment of certain conditions, rules, or events. Such a feature may be used for automatic routing of tax payments to authorities at the point of sale, shares programmed to pay dividends directly to shareholders, etc. Specific programmable CBDCs can also be issued for certain types of payments such as toward subway fees, shared bike fees, or bus fares. This characteristic of CBDCs has huge potential in India in terms of delivery of various subsidies.

3. Potential Risks

As with most things, CBDCs have certain drawbacks and risks that need to be considered and mitigated in the designing phase itself. A successful and widely adopted CBDC could change the structure and functions of various stakeholders and institutions in the economy.

Both private and public sector banks rely on bank deposits to fund their loan activities. Since bank deposits offer a safe and risk-freeway to park one’s savings, a large number of people utilise this facility, thereby providing banks with a large pool of funds that is utilised for lending activities. A CBDC could offer the public a safer alternative to bank deposits since it eradicates even the minute risk of the bank becoming insolvent making it more secure than regular bank deposits. A widely accepted CBDC could adversely affect bank deposits, thereby reducing the availability of funds for lending by banks and adversely affecting credit facilities in the economy. Further, since a CBDC is a safer form of money, in times of stress, people may opt to convert funds stored in banks into safer CBDCs, which might cause a bank run. However, these issues can be mitigated by making the CBDC deposits non-interest-bearing, thus reducing their attractiveness as an alternative to bank deposits. Further, in times of monetary stress, the central bank could impose restrictions on the amount of bank money that can be converted into the CBDC, just as it has done in the case of cash withdrawals from specific banks when it finds that such banks are undergoing extreme financial stress.

If a significantly large portion of a country’s population adopts a private digital currency, it could seriously hamper the ability of the central bank to carry out several crucial functions, such as implementing the monetary policy, controlling inflation, etc.

It may be safe to say that the question of how CBDCs may affect the economy in general and more specifically, the central bank’s ability to implement monetary policy, seigniorage, financial stability, etc. requires further research and widespread consultation to mitigate any potential risk factors.

4. The Role of the Central Bank in a CBDC

The next issue that requires attention when dealing with CBDCs is the role and level of involvement of the central bank. This would depend not only on the number of additional functions that the central bank is comfortable adopting but also on the maturity of the fintech ecosystem in the country. Broadly speaking, there are three basic models concerning the role of the central bank in CBDCs:

(i)  Unilateral CBDCs: Where the central bank performs all the functions right from issuing the CBDC to carrying out and verifying transactions and also dealing with the users by maintaining their accounts.

(ii)  Hybrid or Intermediate Model: In this model, the CBDCs are issued by the central bank, but private firms carry out some of the other functions such as providing wallets to end users, verifying transactions, updating ledgers, etc. These private entities will be regulated by the central bank to ensure that there is sufficient supervision.

(iii)  Synthetic CBDCs: In this model, the CBDC itself is not issued by the central bank but by private players. However, these CBDCs are backed by central bank liabilities, thus providing the sovereign stability that is the hallmark of a CBDC.

The mentioned models could also be modified to suit the needs of the economy; e.g., the second model could be modified by not only allowing private players to perform the user-facing functions, but also offering the same functions either by the central bank or even some other public sector enterprise. Such a scenario has the potential to offer services at a reduced price (perhaps with reduced functionalities) thereby fulfilling the financial inclusion and cost reduction policy goals mentioned above.

5. Role of Blockchain Technology

While it is true that the entire concept of a CBDC evolved from cryptocurrencies and that popular cryptocurrencies like Bitcoin and Ether are based on blockchain technology, recent research seems to suggest that blockchain may not necessarily be the default technology for a CBDC. Additionally, different jurisdictions have their own views on the merits and demerits of this technology, for example, the Bahamas and the Eastern Caribbean Central Bank have DLT-based systems; however, China has decided that DLT-based systems do not have adequate capacity to process transactions and store data to meet its system requirements.

Similarly, a project by the Massachusetts Institute of Technology (MIT) Currency Initiative and the Federal Reserve Bank of Boston titled “Project Hamilton” to explore the CBDC design space and its technical challenges and opportunities has surmised that a distributed ledger operating under the jurisdiction of different actors is not necessarily crucial. It was found that even if controlled by a single actor, the DLT architecture has downsides such as performance bottlenecks and significantly reduced transaction throughput scalability compared to other options.

6. Conclusion

Although a CBDC potentially offers some advantages, launching one is an expensive and complicated proposition, requiring in-depth research and detailed analyses of a large number of issues, only some of which have been highlighted here. Therefore, before launching a CBDC, central banks issue white papers and consult with the public in addition to major stakeholders, conduct pilot projects, etc. to ensure that the issue is analysed from all possible angles. Although the Reserve Bank of India is examining various issues such as whether the CBDC would be retail or wholesale, the validation mechanism, the underlying technology to be used, distribution architecture, degree of anonymity, etc., it has not yet released any consultation papers or confirmed the completion of any pilot programmes for the CBDC project.

It is, therefore, unclear whether there has been any detailed cost–benefit analysis by the government or the RBI regarding its feasibility and benefits over existing payment systems and whether such benefits justify the costs of investing in a CBDC. For example, several of the potential advantages discussed here, such as financial inclusion and improved payment systems may not be relevant in the Indian context, while others such as reduced costs and a reduction in illegal transactions may be achieved by improving the existing systems. It must be noted that the current system of distribution of central bank money has worked well over the years, and any systemic changes should be made only if the potential upside justifies such fundamental changes.

The Government of India has already announced the launch of the Indian CBDC in early 2023, but the lack of public consultation on such an important project is a matter of concern. The last time the RBI took a major decision in the crypto space without consulting stakeholders was when it banned financial institutions from having any dealings with crypto entities. On that occasion, the circular imposing the ban was struck down by the Supreme Court as violating the fundamental right to trade and profession. It is, therefore, imperative that the government and the Reserve Bank conduct wide-ranging consultations with experts and the public to conduct a detailed and thorough cost–benefit analysis to determine the feasibility of such a project before deciding on the launch of an Indian CBDC.