The surging popularity of Cryptocurrencies in the past couple of years has got central banks and regulatory bodies around the world thinking about how to best regulate them. On the other hand, Crypto advocates and fanatics have been pushing the narrative about Bitcoin as an alternative to fiat currency. Last year El Salvador became the first country to adopt Bitcoin as legal tender, albeit with not much success. Prices of Cryptocurrencies are highly volatile, we have seen this in past and have also witnessed it this year. Take for instance Bitcoin which has fallen to < $20000 from highs of around $68000. Any asset which is this volatile is no good as a store of value or for day-to-day transactions.
The alternative for this in the Crypto world is tokens like USDC, also branded as stablecoins. But these are anything but stable as we have seen from the recent blow-up of the Terra Luna UST.
As RBI put it in its Concept Note;
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. The rapid mushrooming of private cryptocurrencies in the last few years has attempted to challenge the fundamental notion of money as we know it. Claiming the benefits of de-centralisation, cryptocurrencies are being hailed as innovation that would usher in de-centralised finance and disrupt the traditional financial system. However, the inherent design of cryptocurrencies is more geared to bypass the established and regulated intermediation and control arrangements that play a crucial role of ensuring integrity and stability of monetary and financial eco-system.
In a bid to thwart the risks posed by these Cryptocurrencies and stablecoins and to not remain behind the technological advances, major central banks are already experimenting with issuing their own digital currency, known as CBDC (Central Bank Digital Currency).
The Reserve Bank of India yesterday published a Concept Note on CBDC (Digital Rupee (eâ‚ą)). This Concept Note explains the objectives, choices, benefits and risks of issuing CBDC in India, which when launched will provide an additional option to the currently available forms of money. Below are a few insights from the report.
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Why CBDC?
Money either has intrinsic value or represents title to commodities that have intrinsic value or title to other debt instruments. In modern economies, the currency is a form of money that is issued exclusively by the sovereign (or a central bank as its representative) and is legal tender. It is a liability of the issuing central bank (and sovereign) and an asset of the holding public.
Irrespective of the form of money, in any economy, money performs three primary functions - a medium of exchange, a unit of account and a store of value.
The Reserve Bank broadly defines CBDC as the legal tender issued by a central bank in a digital form. It is akin to sovereign paper currency but takes a different form, exchangeable at par with the existing currency and shall be accepted as a medium of payment, legal tender and a safe store of value. CBDCs would appear as a liability on a central bank’s balance sheet.
CBDC, being a sovereign currency, holds unique advantages of central bank money viz. trust, safety, liquidity, settlement finality and integrity. The key motivations for exploring the issuance of CBDC in India among others include reduction in operational costs involved in physical cash management, fostering financial inclusion, bringing resilience, efficiency, and innovation in the payments system, adding efficiency to the settlement system, boosting innovation in cross-border payments space and providing public with uses that any private virtual currencies can provide, without the associated risks.
The use of offline features in CBDC would also be beneficial in remote locations and offer availability and resilience benefits when electrical power or a mobile network is not available.
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Design Choices of CBDC
The design of CBDC is dependent on the functions it is expected to perform, and the design determines its implications for payment systems, monetary policy as well as the structure and stability of the financial system.
The key design choices considered for issuing CBDCs in India include
- Type of CBDC to be issued
- Models of issuance and management of CBDCs
- Forms of CBDC
- Instrument Design
- Degree of Anonymity
Type of CBDC to be issued
CBDCs and be classified into two types;
General purpose or retail (CBDC-R): This is an electronic version of cash primarily meant for retail transactions and would be available for use by all such as the private sector, non-financial consumers and businesses.
Wholesale (CBDC-W): Designed for restricted access to select financial institutions. The Wholesale CBDC is intended for the settlement of interbank transfers and related wholesale transactions.
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 the issuance and management of CBDCs;
Direct Model (Single Tier Model): In this model the central bank is responsible for managing all the aspects of the CBDC system such as issuance, account-keeping and transaction verification.
Indirect Model (Two-Tier Model): This model involves the central bank and other intermediaries like banks and other service providers. Where the 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.
This is similar to the current system where banks manage activities like the distribution of notes to the public, account-keeping, adherence to 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
CBDCs can be structured in two types;
Token-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 this mode, the person receiving a token himself will verify that his ownership of the token is genuine.
Account-Based: The account-based system would require maintenance of records of balances and transactions of all holders of the CBDC and indicate the ownership of the monetary balances. Also, in this mode, the 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.
Technology choice
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 a single point of failure.
The technology considerations underlying the deployment of CBDC need to be forward-looking and must have strong cybersecurity, technical stability, resilience and sound technical governance standards. While crystallizing 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.
Instrument Design
The payment of (positive) interest would likely enhance the attractiveness of CBDCs that also serves as a store of value. But, designing a CBDC that moves away from cash-like attributes to a “deposit-like” CBDC may have a potential for disintermediation in the financial system resulting from loss of deposits by banks, impeding their credit creation capacity in the economy. Also considering that physical cash does not carry any interest, it would be more logical to offer non-interest-bearing CBDCs.
Degree of Anonymity
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.
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.
If you want to dive deep on this topic, you can read the report published by the RBI here.