In the Union Budget 2022–23, the finance minister, Nirmala Sitharaman, announced the introduction of a Central Bank Digital Currency (CBDC) that will boost the digital economy. She proposed to introduce the digital rupee, using blockchain and other technologies, to be issued by the Reserve Bank of India (RBI) starting financial year (FY) 2022–23. In July 2021 itself, the RBI had indicated that it would soon be starting work on the ‘phased implementation’ of the CBDC.
It was felt that the issue of a CBDC had become important amidst the rapid surge of blockchain-based private cryptocurrencies in the market and the interest these private cryptocurrencies have generated among the investor community.
More than 90 countries, including China, Japan, Sweden, and Singapore, are currently exploring the viability, usefulness, and value of launching their own CBDC, according to the Atlantic Council. In 2020, the central bank of Bahamas issued the ‘Sand Dollar’, a digital currency, the first country to issue such a currency nationwide. In 2021, Nigeria became the first country in Africa to issue a CBDC, the eNaira.
What is Digital Currency?
A digital currency is the digital form of a fiat currency that can be used for undertaking contactless transactions. It is the same fiat currency but in an electronic form. What differentiates digital currency from the money held in bank account as deposits is the fact that the former never takes physical form.
For undertaking transactions using digital currency, one can make, say, purchases at a grocery store, by transferring digital currency to retailers using hand-held devices like mobile phones or tablets. Functionally, this may be similar to how one makes purchases using digital wallets such as Paytm or Google Pay.
What is CBDC?
According to the RBI, the digital rupee will be a legal tender in digital form. Rabi Sankar, Deputy Governor of the RBI, has defined a CBDC as a “legal tender issued by a central bank in a digital form,” which “is the same as fiat currency and is exchangeable one-to-one with the fiat currency” – which, in India, is the Indian National Rupee (INR). The Bank of England, the central bank of the United Kingdom, defines CBDC as “an electronic form of central bank money that could be used by households and businesses to make payments and store value”.
The CBDC will fulfil the basic functions as a medium of exchange, unit of account, store of value, and standard of deferred payment. As per the RBI website, CBDC is sovereign currency in an electronic form and will appear as liability (currency in circulation) on a central bank’s balance sheet.
Different from Cryptocurrencies Unlike cryptocurrencies such as Bitcoin and others run by private players, a CBDC would be issued and backed by the central bank. It may also be pointed out that bank deposits differ from private virtual currencies which do not have an issuer and are not convertible one-to-one into the sovereign currency. Thus, the volatility associated with private virtual currencies would be avoided.
CBDC and Cryptocurrencies: Differences
| CBDC | Cryptocurrencies |
| 1. It will be the digital version of the fiat currency issued by the RBI. As a result, CBDC is sovereign-backed. | 1. These are not backed by the government or the central bank of a country. They can be called an asset class or a payment mechanism. |
| 2. It carries an intrinsic value on account of government backing. In this sense, a digital rupee will be equivalent to a physical rupee. | 2. These have no underlying asset. In other words, they are not backed by any commodity. As such, they have no intrinsic value. They derive their purchasing power from the community of their users. In a sense, their acceptability to the well-off enables them to act as money.
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| 3. Being exclusively issued and controlled by the central banking authority of a country, it will be centralised. | 3. These are based on blockchain technology which enables decentralisation. As a result, cryptocurrencies are decentralised in nature, immune from the regulation of the sovereign. Everyone on the crypto platform has a say.
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| 4. Its holders have a direct claim on the central bank of a country. | 4. There is no fallback option in case of these cryptocurrencies since people use them as a speculative investment. |
| 5. It is money as ‘money’ is historically understood. | 5. They are not money (certainly not currency) as the word has come to be understood historically. |
| 6. Being managed by the central banking authority, it is stable in value; there is no element of fluctuation involved in its value. | 6. There is an inherent instability in their value. Their prices fluctuate rapidly, and swing wildly in value. |
Different from Electronic Transactions through Banks Consumers and businesses have long been conducting transactions using digital means – through net banking, payment wallets, online transactions. The forms of money used in such transactions are liabilities of the commercial bank concerned, the underlying entity. In the case of a CBDC, the liability would be that of the RBI.
It may not be quite correct to see the CBDC as a legalised replacement of private digital currencies or cryptocurrencies; the CBDC is really a digital form of the physical cash in circulation in the country.
Why a CBDC?
According to Rabi Sankar, the main reasons for adopting a CBDC are as follows:
(i) Central banks face dwindling usage of paper currency and seek to popularise a more acceptable electronic form of currency.
(ii) Jurisdictions with significant physical cash usage seek to make issuance more efficient.
(iii) Central banks seek to meet the public’s need for digital currencies, manifested in the increasing use of private virtual currencies, and thereby avoid the more damaging consequences of such private currencies.
Amendments to RBI Act Required
To provide a legal sanctity to the introduction of the CBDC, the Finance Bill, 2022 made provisions for amending the RBI Act, 1934. An amendment needs to made to Sections 2 (Definitions) and 22 (concerned with the right to issue bank notes) of the Act. A new clause needs to be added under Section 2 stating that ‘bank note’ means a note issued by the bank, whether in physical or in digital form. The clarification regarding a bank note has to be made in Section 22 as well. It is proposed to add a new Section 22A relating to the non-applicability of Sections 24 (denomination of notes), 25 (form of bank notes), 27 (re-issue of notes), 28 (recovery of notes lost, stolen, mutilated or imperfect) and 39 (obligation to supply different forms of currency) of the Act to the digital version of the legal tender.
Questions Around a Digital Rupee
(i) What kind of technology architecture will lie behind the CBDC? Should the CBDC be based on the decentralised mechanism, i.e., distributed ledger technology (as in the case of Bitcoin or other cryptocurrencies) or should it be a centralised ledger mechanism with the RBI at the helm of affairs? Experts have suggested that the RBI may opt for a centralised mechanism due to the inherent limitations of the blockchain-based platform to handle a large number of transactions (say, millions) per hour.
(ii) What would be the validation mechanism of a CBDC? Will the digital currency be account-based or token-based? Account-based framework, as in the case of demand deposits or checking deposits, links the ownership of the account with an identity (the accountholder). Token-based framework, on the other hand, like cash, provides anonymity to its holder.
(iii) What will determine the quantum of supply of CBDCs? Will the RBI issue the CBDCs over and above the incremental physical currency it injects every year into the economy? Or will the RBI, initially, choose to limit the supply of digital currency by substituting it for some portion of the incremental physical currency that it injects annually. If the RBI chooses the latter option, the result would a capping of the digital currency in circulation and limiting its usage.
(iv) An important question relates to whether CBDCs in circulation will be interest-bearing. If it is interest-bearing, there will be repercussions for the financial system and monetary policy.
(v) It is to be noted that the Indian economy is still characterised by widespread use of cash. In fact, as a percentage of the gross domestic product (GDP), currency in circulation is higher than before demonetisation of high-value currency notes on November 8, 2016. As per RBI annual report (May 27, 2021, the value and volume of banknotes in circulation increased by 16.8 per cent and 7.2 per cent, respectively, during 2020–21 as against an increase of 14.7 per cent and 6.6 per cent, respectively, witnessed during 2019–20.) The large informal economy in India, especially agriculture, is largely dependent on cash as a medium of exchange. If the physical currency in circulation is limited (with the introduction of CBDC), it could have an adverse effect on the informal economy.
Potential Benefits of a CBDC
The State Bank of India says in a note that the CBDC has potential benefits in terms of liquidity, scalability, acceptance, ease of transactions, and faster settlement in comparison with existing forms of money.
Some of the advantages and benefits of CBDCs are as follows:
Safe option CBDCs, being direct liabilities of the central bank, are a safer form of digital money. It is like every person using it has a checking account (an account that allows one to easily deposit and withdraw money for daily transactions) directly with the central bank.
A CBDC would reduce the need for banks, and enable direct transaction between person and person or customer and vendor. With commercial banks not being required for such transactions, as the consumer is directly connected to the central bank, the risk to the consumer posed by the collapse of the bank would be eliminated.
Move towards low paper cash economy A CBDC unit is not convertible to paper money but is actually an alternative, i.e., it is equivalent to paper money. So, it would reduce the importance or necessity of paper cash, if not make paper cash obsolete. The requirement of cash outlets would be reduced. The CBDC could be used for subsidies paid on welfare programmes as well as by financial institutions for lending and payments. A gradual but steady shift towards a low cash economy would thus become possible.
Savings in costs of currency management A digital currency is likely to save operational costs of currency management: there would be savings on costs of printing, distributing, or storing currency notes if a portion of fiat currency in circulation is replaced with a digital rupee. According to a market estimate, for every Rs 100 currency note, the operational cost works out to be Rs 15–17 for a four-year life cycle. Physical currency gets damaged over time and needs to be replaced with new notes that have to be printed. The CBDC would be out of this cycle. Thus, the cost saving with the introduction of a digital currency could be significant.
Greater financial inclusion The introduction of a CBDC is likely to accelerate financial inclusion in the country. A large number of people in the country do not have access to traditional finance though most have mobile internet access. As transactions with CBDC do not need bank accounts, such people who had been left out of the system can be included. The existing alternatives to physical currency, namely, debit cards or credit cards, are not accessible to all citizens, but the CBDC will be available to all. The CBDC will also lower the costs of financial transactions.
Ease in international transactions It may seem as if e-payments and money transfers occur in real time (i.e., at the same time as something actually happens), but this is not so; there is some delay between initiating a transaction and the completion of it. At some point down the line, the money has to be physically moved between the banks (in what is known as ‘inter-bank’ settlement). The CBDC would not require inter-bank settlement, and the digital payments will be the final transactions, as if the transaction is in paper cash. With CBDC, real time transactions and a globalised cost-effective payment settlement system would, thus, become possible. As Rabi Shankar points out, time zone difference would also no longer matter in currency settlements.
As the payments using CBDCs are final, there is little chance of a settlement risk or Herstatt risk (so called after the failure of the German bank Herstatt to settle currency transactions and going into bankruptcy in 1974) in the financial system. (This is the risk of loss in foreign exchange trading that one party will deliver foreign exchange but the counterparty financial-institution will fail to complete its end of the contract.)
Concerns about CBDCs
Cash transactions are anonymous (unless they are made through banks). Indeed, the need for privacy is one reason why many have turned to private digital currencies. In the case of CBDC, this anonymity is not likely (unless a false name is used). If all payment transactions related to CBDC are recorded and visible, there will be issues of informational privacy and surveillance. Maintaining anonymity of the users will require that the RBI does not keep a record of users on the basis of a particular series of currency. There needs to be a mechanism in place to maintain the privacy of CBDC users. The concern for privacy arises on the ground that since the central bank cannot handle the customer onboarding, know your customer (KYC) compliance, maintaining record of transactions undertaken using CBDCs, and addressing complaints, it will have to rely on intermediaries such as banks or payment service providers for these activities. In the absence of a data regulation framework in place, giving personal details as well as the details of transactions is fraught with risk. Despite the fact that financial transactions through banks or digital payments are visible, and it would be the same with CBDCs, a customer always prefers to remain anonymous while making transactions through digital means. Alas, privacy could well remain a distant dream.
The CBDC would require the use of sophisticated computing devices, such as smartphones or tablets. Thus, a certain cost is involved in obtaining the device with a reasonable processing power to hold the currency and transact with it. How far this will impede financial inclusiveness remains to be seen.
If the RBI chooses to have interest-bearing CBDCs, the digital currency will become a perfect substitute for bank deposits. There may be a threat of bank deposits shifting to the CBDC, in turn, depriving banks of their prime source of funding. Banks may be forced to raise funds at higher costs, which might get reflected in higher lending rates. That will increase the cost of credit, which would lead to a lower demand for credit in the economy. All this will have adverse implications for the banking system and may even cause financial upheaval.
It has been pointed out by several economists that while some benefits of the CBDC may accrue in the wholesale segment (of payments) of CBDC, the real challenge as well as transformation potential of CBDC lies at the retail level.
There are concerns related to whether the CBDC will offer the same degree of autonomy as cash does. A digital currency, unlike physical cash, will be much easier and cheaper to track and regulate.
The Federal Reserve has cautioned that a poorly designed CBDC could weaken banks, destabilise the financial system and create privacy issues.
Conclusion
Nandan Nilekani, cofounder of Infosys, has observed that the country will notch up a global first with the launch of its CBDC. Existing technologies and infrastructure platforms such as Aadhaar, Unified Payment Interface (UPI) will help to accelerate its launch. However, it needs to be asked, to what extent the potential benefits of issuing CBDCs will materialise in India. The country already has a robust payment infrastructure in place, characterised by low cost of transactions as well as quick turnaround time. Consumers and businesses have long held and transferred money in digital forms, via bank accounts, online transactions, or payment apps.
The efficacy of the introduction of a CBDC in further accelerating financial inclusion in the country or facilitating low-cost transactions remains to be seen.
Furthermore, concerns regarding loss of anonymity associated with the CBDC need to be addressed through a proper mechanism in place in the form of robust data governance and privacy safeguards in law as the Right to Privacy is a fundamental right of the users.
As pointed out by experts, the benefits provided by the CBDC to various sectors of the economy and the overall economy should exceed the costs and risks, and the yield of such benefits should be more effective compared to other methods. Most importantly, the CBDC should protect against criminal activity. It is necessary that regulatory processes are updated and made robust enough before the technology is adopted.
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