Reserve Bank Of India announced its Pilot Launch of the Digital Rupee in the Wholesale segment on 1st November
The use case for this pilot is the settlement of secondary market transactions in government securities. The use of e₹-W is expected to make the interbank market more efficient. RBI is planning to launch the first pilot in Digital Rupee – Retail segment (e₹-R) within a month in select locations in closed user groups comprising customers and merchants. The launch of the Digital Rupee is in line with the Finance Minister’s announcement of Central Bank Digital Currency (CBDC) in her Budget speech on 1st Feb 2022. The Finance Ministry expects that the CBDC will give a big boost to the digital economy and will lead to a more efficient and cheaper currency management system.
With the developments in the economy and the evolution of the payment system, the form and functions of money have changed over time, and it will continue to influence the future course of currency. The concept of money has experienced an evolution from Commodity to Metallic Currency to Paper Currency to Digital Currency. The changing features of money are defining the new financial landscape of the economy. Further, with the advent of cutting-edge technologies, the digitalization of money is the next milestone in monetary history. Advancement in technology has made it possible for the development of a new form of money viz. Central Bank Digital Currencies (CBDCs).
What is CBDC?
A CBDC is a legal tender issued by a central bank in digital form. It is the same as a fiat currency and is exchangeable one-to-one with the fiat currency. Only its form is different.
CBDC is a digital or virtual currency but it is not comparable to the private virtual currencies that have mushroomed over the last decade. Private virtual currencies sit at substantial odds to the historical concept of money. They are not commodities or claims on commodities as they have no intrinsic value.
Need for a CBDC :
Central banks, faced with dwindling usage of paper currency, seek to popularize a more acceptable electronic form of currency (like Sweden);
Jurisdictions with significant physical cash usage seeking to make issuance more efficient
Central banks seek to meet the public’s need for digital currencies, manifested in the increasing use of private virtual currencies.
CBDCs have some clear advantages over other digital payment systems – payments using CBDCs are final and thus reduce settlement risk in the financial system. Imagine a UPI system where CBDC is transacted instead of bank balances, as if cash is handed over – the need for interbank settlement disappears.
CBDCs would potentially enable a more real-time and cost-effective globalization of payment systems. It is conceivable for an Indian importer to pay its American exporter on a real time basis in digital Dollars, without the need of an intermediary. This transaction would be final, as if cash dollars are handed over, and would not even require that the US Federal Reserve system is open for settlement. Time zone difference would no longer matter in currency settlements – there would be no ‘Herstatt’ risk. Although to realize benefits of global settlements, it is important that both the countries in a currency transaction have CBDCs in place.
India’s high currency-to-GDP ratio holds out another benefit of CBDCs. To the extent large cash usage can be replaced by CBDCs, the cost of printing, transporting, storing and distributing currency can be reduced.
CBDCs are desirable not just for the benefits they create in payment systems, but also might be necessary to protect the general public in an environment of volatile private VCs.
Bank for International Settlement has laid down “foundational principles” and “core features” of a CBDC, to guide exploration and support public policy objectives, as per the need of existing mandate of Central Banks. The foundational principles emphasise that, authorities would first need to be confident that issuance would not compromise monetary or financial stability and that a CBDC could coexist with and complement existing forms of money, promoting innovation and efficiency.
Difference Between e₹-W(Wholesale) and e₹-R (Retail) :
CBDC can be classified into two broad types viz. general purpose or retail (CBDC-R) and wholesale (CBDC-W). Retail CBDC would be potentially available for use by all viz. private sector, non-financial consumers and businesses while wholesale CBDC is designed for restricted access to select financial institutions. While Wholesale CBDC is intended for the settlement of interbank transfers and related wholesale transactions, Retail CBDC is an electronic version of cash primarily meant for retail transactions. It is believed that Retail CBDC can provide access to safe money for payment and settlement as it is a direct liability of the Central Bank. Wholesale CBDC has the potential to transform settlement systems for financial transactions and make them more efficient and secure. Going by the potential offered by each of them, there may be merit in introducing both CBDC-W and CBDC-R.
Model for issuance and management of CBDC
There are two models for issuance and management of CBDCs viz. Direct model (Single Tier model) and Indirect model (Two-Tier model). A Direct model would be the one where the central bank is responsible for managing all aspects of the CBDC system viz. issuance, account-keeping and transaction verification.
In an Indirect model, central bank and other intermediaries (banks and any other service providers), each play their respective role. In this model central bank issues, CBDC to consumers indirectly through intermediaries and any claim by consumers is managed by the intermediary as the central bank only handles wholesale payments to intermediaries.
The Indirect model is akin to the current physical currency management system wherein banks manage activities like the distribution of notes to public, account-keeping, adherence of requirements related to know-your-customer (KYC) and anti-money laundering and countering the terrorism of financing (AML/CFT) checks, transaction verification etc.
Forms of CBDC
CBDC can be structured as ‘token-based’ or ‘account-based’. A token-based CBDC is a bearer-instrument like banknotes, meaning whosoever holds the tokens at a given point in time would be presumed to own them. In contrast, an account-based system would require maintenance of record of balances and transactions of all holders of the CBDC and indicate the ownership of the monetary balances. Also, in a token-based CBDC, the person receiving a token will verify that his ownership of the token is genuine, whereas in an account-based CBDC, an intermediary verifies the identity of an account holder. Considering the features offered by both the forms of CBDCs, a token-based CBDC is viewed as a preferred mode for CBDC-R as it would be closer to physical cash, while an account-based CBDC may be considered for CBDC-W.
CBDCs being digital in nature, technological consideration will always remain at its core. The infrastructure of CBDCs can be on a conventional centrally controlled database or on Distributed Ledger Technology. The two technologies differ in terms of efficiency and degree of protection from single point of failure. The technology considerations underlying the deployment of CBDC needs to be forward looking and must have strong cybersecurity, technical stability, resilience and sound technical governance standards. While crystallising the design choices in the initial stages, the technological considerations may be kept flexible and open-ended in order to incorporate the changing needs based on the evolution of the technological aspects of CBDCs.
For CBDC to play the role as a medium of exchange, it needs to incorporate all the features that physical currency represents including anonymity, universality, and finality. Ensuring anonymity for a digital currency particularly represents a challenge, as all digital transactions would leave some trail. Clearly, the degree of anonymity would be a key design decision for any CBDC. In this regard, reasonable anonymity for small value transactions akin to anonymity associated with physical cash may be a desirable option for CBDC-R.
While the intent of CBDC and the expected benefits are well understood, it is important that the issuance of CBDC needs to follow a calibrated and nuanced approach with adequate safeguards to address potential difficulties and risks in order to build a system which is inclusive, competitive and responsive to innovation and technological changes. CBDC, across the world, is mostly in conceptual, developmental, or at pilot stages. Therefore, in the absence of a precedence, extensive stakeholder consultation along with iterative technology design may be the requirement, to develop a solution that meets the requirements of all stakeholders.
CBDC and the Banking System
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. Since central banks cannot provide credit to the private sector, the impact on the role of bank credit needs to be well understood. Plus, as banks lose significant volume of low-cost transaction deposits their interest margin might come under stress leading to an increase in cost of credit. Thus, potential costs of disintermediation mean it is important to design and implement CBDC in a way that makes the demand for CBDC, vis‑à‑vis bank deposits, manageable.
In actual fact, notwithstanding the benefits of CBDCs vis-à-vis bank deposits, since CBDCs are currency and therefore do not pay interest, their impact on bank deposits may actually be rather limited. Depositors that require CBDCs for transactional purposes are likely to sweep day end balances to interest-earning deposit accounts.
RBI said CBDC is aimed to complement, rather than replace, current forms of money and is envisaged to provide an additional payment avenue to users, not to replace the existing payment systems. Supported by state-of-the-art payment systems of India that are affordable, accessible, convenient, efficient, safe and secure, the Digital Rupee (e₹) system will further bolster India’s digital economy, make the monetary and payment systems more efficient and contribute to furthering financial inclusion.