The Indian economy has seen a digital transformation in the past few years. Digital payments have become common with different apps facilitating online transactions. The country’s demonetization also forced people to adopt digital payment methods instead of cash as the new Rs.500 and Rs.2,000 notes were not available in the market. With this increased adoption of digital payments, India has witnessed massive growth in its fintech industry.
In the wake of a financial crisis and fears of cyber attacks, central banks around the world are exploring ways to issue digital currencies as a new form of settlement. A growing body of research suggests that central bank digital currency could improve the efficiency and performance of the monetary policy transmission process. The country has also been named one of the top 10 Fintech hubs globally.
With such encouraging signs, the adoption of technology is only going to grow further. Central banks around the world have also begun exploring ways to issue their own digital currencies or central bank digital currency (CBDC).
In the financial ecosystem, central banks play an important role. Fundamentally, each of them has always provided efficient, quick, seamless, stable solutions for its respective economy. This includes payment systems and the issuance of currency. Technology advancements and the global economy have forced these apex bodies to reevaluate and adapt their basic functions.
RBI defines Central Bank Digital Currency (CBDC) as the legal tender issued by a central bank in a digital format. There is no difference between it and a fiat currency, and it can be exchanged one for one with a fiat currency.
As a concept, money has evolved over time, from barter systems where goods were exchanged for ‘money’, to metallic and paper currencies, banking instruments, and now to digital currencies.
As the name implies, currency is the ‘form’ of money which the central bank of any jurisdiction issues, accepts as legal tender, and assumes responsibility for.
Since digital money took many forms, was rapidly innovated, and was not issued by a sovereign government, its emergence was accompanied by a great deal of hesitation regarding its use. Additionally, there were concerns about its security and decentralised nature, which led to a volatile environment for cryptocurrency or stable coins. As these forms of digital money become increasingly popular, central banks across the world are being pushed to meet this demand, especially due to the growing preference for electronic payment methods and the increasing cost and operational difficulties associated with printing money.
Central bank digital currency (CBDC) is an electronic version of fiat money that is issued by a central bank. CBDC is only equivalent to cash in terms of usage (redeemable for traditional currency). It doesn’t have any functionality outside its dedicated use case as an alternative to cash and coins.
In order to facilitate issuance and distribution to the public in a convenient manner, a general-purpose CBDC must have an underlying system. In order for the entire ecosystem to function, various players will be required, including the RBI, public and private banks, payment service providers (PSPs) and operator(s). As part of the broader ecosystem, we can also consider other financial institutions and third-party service or application providers. In spite of the fact that the implementation of issuance models may not be inherently different from the current intermediary system of currency issuance, every central bank and commercial bank will need to adopt a parallel end-to-end blockchain-enabled issuance and circulation system for CBDCs.
Types of CBDC:
Based on their use within a country’s financial and monetary ecosystem, CBDC can be divided into two major categories:
1. Wholesale CBDC — CBDCs in this category are generally used for trade between the central bank and public or private banks within a given country. CBDC payments reduce the risks associated with liquidity and counterparty credit. As a result, CBDC plays a vital role in making the country’s financial system faster, safer, and more efficient. The RBI will be able to interface more efficiently with its intermediaries and improve the existing real-time gross settlement (RTGS) system that is currently in use.
Through the creation of a corridor network or ‘bridge’ between wholesale CBDC systems of multiple countries, wholesale CBDC can facilitate cross-border transactions between wholesale CBDC systems. The operator node is run jointly by the central banks of participating countries that issue depository receipts. As a result, cross-border settlements across participating central banks are expedited and made more secure.
2. Retail CBDC — This type of CBDC serves as a digital format for the fiat currency that is intended to be used by the general public for day-to-day transactions. Retail CBDC is generally based on distributed ledger technology (DLT), such as a private blockchain network managed by the government, which allows it to trace transactions while maintaining anonymity. Additionally, it helps mitigate the involvement of private parties, thus preventing any criminal activity, such as money laundering and fraud.
CBDC can be issued directly by the central bank to the general public. The process of direct issuance is referred to as direct issuance. As an alternative, retail CBDC can be issued to intermediaries (such as public or private banks) who will then issue it to the public. A method of distribution that forwards the counterparty risk to regulated intermediaries is known as indirect issuance. There is also a third issuance methodology, known as hybrid issuance, in which retail CBDC is issued to intermediaries, as in indirect issuance. Hybrid issuance, however, requires the central bank to update its own ledger periodically with retail balance records.
Retail CBDC & Monetary System
Key Principles for CBDC in India
Although CBDCs are issued by central banks across the globe in different formats based on the broad categories discussed above, it is still bound by three foundational or key principles or considerations that dictate its issuance across diverse geographies.
Prior to issuing a CBDC within the country, the government and RBI must consider these key principles as part of their common public and monetary objectives. CBDC ecosystems must become as trusted as fiat currencies in order to maintain financial and monetary stability in the current economic climate.
- Non-Disruption — When issued by the RBI as a new form of money, the CBDC should not interfere with the overall public policy objectives of the government, nor should it interfere with the RBI’s ability to fulfill its mandate in terms of monetary and financial stability. Consequently, it should maintain the integrity and uniformity of the Indian currency and enable the general public to use all forms of the currency interchangeably, which will reinforce the singleness of all forms of currency.
- Co-existence — The CBDC should coexist with other existing forms of currency, such as cash and settlement accounts. As well as coexisting with all commercial bank accounts, it should also function harmoniously with fiat currency. Rather than calling for a replacement, the CBDC should support all alternatives to cash, as long as there is a public demand for such currencies.
A country such as India, which had around 190 million unbanked citizens in 2017, needs a plan to allow all forms of currency to coexist, and CBDC should be used as a tool to include the underbanked and unbanked sections of our society. The CBDC is also expected to revolutionize the way citizens pay using digital payment modes in parallel with existing payment systems.
- Innovation & Competition — As soon as the CBDC ecosystem is introduced, it should continue to innovate and improve its efficiency by fostering healthy competition with the other existing digital payment systems, so that the average user in a country like India, which has a variety of instruments, some of which are less safe than CBDC, continues to use CBDC in their daily transactions.
Benefits of CBDC
By providing a safe and secure means of payment, CBDCs can support the government’s public policy objectives. Providing they are properly monitored and the risks involved are effectively mitigated, they promote efficient, inclusive and innovative payments.
As part of its report on currency and finance, the RBI also highlighted some of the advantages of the CBDC, including its ability to monitor transactions and the provision of ‘helicopter money’ during times of need. Additionally, CBDCs have been noted to have the potential to distribute funds for specific goods and services, as well as to administer aid and subsidies.
As highlighted by the Deputy Governor of the RBI, CBDC would not only create desirable benefits for the payment systems, but would also protect the general public from the risks associated with volatile virtual currencies.
Furthermore, CBDC contributes to the implementation of anti-money laundering (AML) and counter-financial terrorism (CFT) measures by serving as a highly secure means of transacting across international borders. In light of the existence of the DLT, it can facilitate the processing of high-value transactions by eliminating the need for post-reconciliation. As a tool for offline payments through digital tokens, it will also benefit many sections of society.
CBDC is not only a tool for the digital transformation of payments, but also has a variety of other uses. Across different geographies, it has multiple forms of usage. In the following paragraphs, we will discuss four major use cases relevant to the Indian context.
Let’s take some case of CBDC in Indian Context
1. Programmable Payments — Direct Benefit Transfer (DBT)
One possible use case for CBDC is the provision of ‘fit-for-purpose’ money for social benefits and other targeted payments in a country. As a result, the central bank may pay pre-programmed CBDC to the intended beneficiaries, which may be accepted only for the purpose intended. Pre-programmed CBDC, for example Direct benefit transfers (DBT) may be issued for LPG subsidies. CBDC would only be accepted at authorised LPG agencies and would not be accepted by other agencies. It is possible for LPG agencies to convert this CBDC into a general-purpose CBDC or fiat currency at any commercial bank, which would have the required authorization to alter the nature of the CBDC.
Besides fuel and telecom bills, programmable payments can also be utilized by other organizations for the expenses of their employees. Furthermore, programmable payments can also be used within industrial supply chains. The pre-programmed digital CBDC in this case could only be used for specific purposes, such as fuel expenses and state border taxes.
KEY PARTICIPANTS — RBI, Commercial Banks, Commercial Organisations Merchants, Software and Hardware providers, General Public
2. Cross-Border Remittances
In order to facilitate cross-border remittances, CBDCs could be used. Collaborative efforts between the major economies of the world, including India, could contribute to the creation of the necessary infrastructure and arrangements for the transfer and conversion of CBDCs. It is crucial that such an infrastructure ensures the interoperability of CBDCs across jurisdictions as well as the quick transfer of CBDCs for success. As a result, CBDC remittances could take place in real time, thereby reducing the time it takes for the payment to reach its intended recipient.
KEY PARTICIPANTS — RBI, other central banks, commercial banks, software providers, general public
3. Retail Payments
CBDCs may also be used for retail payments. CBDC may be able to offer payment instruments for use in payment transactions. In addition, the universal access attributes of a CBDC may also include the ability to make payments offline.
The RBI and commercial banks would distribute CBDC to retail customers via electronic wallets or accounts. As a result, the following payment methods would be available:
• Consumer to consumer: A method of exchanging CBDC between wallets
• Consumer to business: When consumers can buy products and services using CBDC
• Business to business: Businesses can exchange CBDC between their corporate accounts
Due to CBDCs’ instant settlement, they reduce counterparty risk in clearing and settling retail payments.
CBDC’s underlying technology and its digital nature make it superior to existing digital payments. Combined with ownership record transfers, its irrefutable nature can provide irrefutable proof of ownership.
KEY PARTICIPANTS — RBI, commercial banks, businesses, software and hardware providers, OEMs, general public
4. MSME Lending
It is possible to provide instant loans to micro, small and medium enterprises (MSMEs) in India with the assistance of CBDC. CBDC allows banks to develop a more accurate risk profile of borrowers as more MSMEs use the service. As a result, MSME financing requirements can be met promptly.
The central bank can also disburse stimulus to MSMEs quickly. During periods of uncertainty when cash is limited, this can assist businesses in growing and sustaining themselves. CBDC’s traceability can assist MSMEs in establishing their creditworthiness. In addition, it facilitates transparency and is very resistant to forgery.
KEY PARTICIPANTS — RBI, commercial banks, businesses, software and hardware providers, general public
5. Offline Payments
CBDC may also enable offline payment methods. In general, the offline wallet would be a separate wallet that uses near-field communication (NFC) technology. You can use the digital wallet/application on any NFC-enabled device, whether it is a feature phone or a smartphone. In areas with weak networks or without access to the internet, it will be a highly secure and convenient method of making peer-to-peer payments. Without the need for an internet connection, identity verification, confirmation of a transaction, and payment will be performed over the offline wallet in an account-agnostic manner.
KEY PARTICIPANTS — RBI, commercial banks, businesses, software and hardware providers, OEMs, general public
Possible Drawbacks of CBDC
1. Cyber Attacks & Threats
Apart from such cyber attacks, CBDC is also susceptible to other cyberthreats, which include distributed denial-of-service (DDoS) attacks that disrupt services, supply-side attacks on infrastructure, and side channel attacks on mobile devices and payment applications.
The CBDC systems based on DLT are vulnerable to DDoS attacks since all nodes in the network must interact with each other for a transaction to be completed. By overwhelming a server or network with a large amount of traffic in a very short period of time, a DDoS attack attempts to disrupt the traffic towards the server or network. In addition, if the government fails to deal with these cyberattacks, the integrity of the CBDC system will be compromised, and the public will lose confidence in the system.
2. Impact on Monetary Policy
An increase in CBDC adoption within a country’s financial system may adversely affect the country’s monetary policy, causing unnecessary instability in the economy without proper measures. Fiat currency flows and usage are curtailed by higher adoption rates, and in extreme circumstances the Indian rupee is substituted for foreign currencies such as the dollar.
A further method for reducing any negative impact would be to increase awareness about CBDC and to educate people about its use in order to build trust in its use.
3. Threat to Privacy
Due to the introduction of CBDC, all transactions will be validated and recorded in a distributed ledger, increasing their security and safety. Nevertheless, there is a small trade-off between the fight against AML and CFT and the protection of privacy, since the transactions of people and businesses will not be entirely anonymous.
Therefore, it is very important for the authorities to strike a balance between AML and other measures intended to curb illegal activity and maintain the confidentiality of citizens’ personal and financial information.
Why is India exploring the idea of a Central Bank Digital Currency?
Since almost three years ago, the Indian government has been exploring the possibility of a Central Bank Digital Currency (CBDC). The primary objective of the initiative is to explore the potential benefits of a digital fiat currency in enhancing the performance of the Indian monetary policy transmission mechanism. There is also a great deal of innovation potential in the Indian financial sector, with many fintech startups working on CBDC-related solutions. A CBDC could contribute to the improvement of the efficiency and speed of financial transactions. The use of CBDC will also reduce the risk of money laundering and other illegal activities, as it will be limited to financial transactions.
How could a Central Bank Digital Currency help the Indian economy?
Due to the absence of a digital economy, India’s monetary policy transmission mechanism is inefficient. In India, there is a significant portion of the population that lacks access to financial services due to a lack of financial inclusion. The lack of digital infrastructure and the absence of electricity in remote areas are major factors contributing to this situation.
As a result of expanding financial inclusion in the Indian economy, CBDC will contribute to the efficiency of monetary policy transmission. The organization accomplishes this by increasing the number of people who have access to digital financial services, as well as improving the speed at which such transactions can be conducted.
Thus, RBI monetary policy decisions will be translated into changes in interest rates for loans and deposits more quickly. The overall cost of financial transactions will also be reduced as a result.
Why does India need a CBDC?
Having a CBDC in India will enable the Reserve Bank of India to improve the transmission mechanism for monetary policy in the country. By creating a CBDC, we will be able to increase financial inclusion in the country, increase the number of people who have access to digital financial services, and improve the efficiency of financial transactions.
Despite working on a prototype for a CBDC since 2016, no official announcement has been made regarding the launch of a pilot program. By launching a pilot project, the RBI will be able to get a better understanding of the challenges and risks associated with launching a CBDC. Additionally, it will assist the central bank in understanding how CBDC can help improve the transmission of monetary policy, as well as finding ways to overcome potential challenges.
How will a CBDC benefit the Indian economy?
CBDCs will reduce transaction costs, increase transparency in the financial system, and reduce the risk of fraud. By eliminating the need to print and distribute physical currency, a CBDC will also help reduce the cost of cash.
In recent years, central bank digital currencies have become increasingly popular as financial institutions seek ways to adapt to the changing landscape posed by digitization. CBDCs are essentially digital versions of fiat money issued by central banks.
To put it simply, CBDC represents cash or its third-party equivalent. In addition to its dedicated function as an alternative to cash and coins, it does not offer any other functionality.
CBDCs will undoubtedly change the way people make payments in the future. A CBDC has been adopted by India in significant steps. By introducing a CBDC, the country will be able to improve the transmission mechanism of monetary policy, reduce the cost of financial transactions, and increase the speed of those transactions.