RBI recently announced its intent to explore its own central bank digital currency (CBDC). As a further activity that may be related, the Government of India recently announced that it was coming up with a law on cryptocurrency. These announcements were only left at the statement of intent level, and no details were made available.
The announcements have on the one hand led to fright and fear in the eyes of those who have been dabbling into trading of cryptocurrencies, while on the other hand, this law and the RBI announcement may be seen as the first steps toward creating a positive central bank crypto currency – to be created, issued and managed by RBI.
A recent survey found that 80% of central banks are engaged in investigating CBDC, and half have progressed past conceptual research to experimenting and running pilots. China has already rolled out its own CBDC, and is testing it in a limited way. Central banks of England, Canada, Japan, Singapore, Hong Kong have been at advanced levels of designing and prototyping such systems, including working on collaborative projects like testing cross-border payments even in the early days.
RBI has not participated in any proof of concept or CBDC project that some of the other central banks have, or at least it has not been disclosed so far. It’s time, therefore, that they woke up to it, and not be left behind in understanding this new instrument and the enormous potential it carries.
We will try to understand the concept, context and characteristics of a central bank digital currency or CBDC.
Providing cash to use for general payments is the key task of a central bank. Payment instruments like cash must be inexpensive, accessible to all and available as required. Digital money is another form of cash that can made available by the central banks. However, unlike cash, digital money is controlled and is in the ‘custody’ of licensed banks.
Digital currency is a next generation instrument that allows for best of both worlds – it has the core characteristic of being cash, and like cash it gives the custody of the money to the one holding it. For the regulator, it provides certain features like being programmable (if designed for it), so the money itself can be made to follow certain characters or ‘rules’ and the regulation (at least in part) can be built into it.
Many private entities have been trying to issue their own money (or ‘coins’), not dissimilar in concept with the regular physical tokens or coupons we have been using since the good old days. Just that, this is more digital and technologically secure in terms of being recorded on the blockchain based system (that does not need reconciliation).
These digital currencies have been making the regulators uncomfortable. They have all been appreciative of the technology, but wary of what it can do when controlled by wrong people and deployed for wrong purposes. Of late, the regulators have been waking up to the potential of using this technology to issue legitimate currency as digital money, also called as central bank digital currency or CBDC. CBDCs might also offer opportunities not possible with cash while supporting innovation.
Aside of the main use case of providing another payment instrument for the sovereign currency in the form of digital cash, there are some very significant long-term goals that can be achieved through the adoption of CBDCs. Financial inclusion and cross-border payments are two such complex goals, and the introduction of CBDCs may just be a once-in-a-millennia opportunity to achieve them. However, a lot will depend on how the CBDC is designed.
CBDCs can also help in better transmission of monetary and fiscal policy. In fact, it can bring in more control over subsidies, grants and other government doleouts as well as in ensuing authenticity of tax submissions.
The Bureau of International Settlements has been working on this for some time and has outlined some principles to consider while designing a CBDC. These principles emphasise that: (i) a central bank should not compromise monetary or financial stability by issuing a CBDC; (ii) a CBDC would need to co-exist with and complement existing forms of money; and (iii) a CBDC should promote innovation and efficiency.
CBDCs cannot work in isolation. Just like Aadhar, it must have provisions for public and private partnership. The general purpose CBDC would require an underlying system to provide and distribute it conveniently to the public. This system would comprise the central bank, commercial banks, operator(s) and participating payment service providers.
Depending on the design, it may also include private players who may even be allowed (or licensed) to issue their own tokens or coins based on the reserves they may maintain in the CBDC (with appropriate limits and other controls). This privately issued money is called stable coins or synthetic digital currency (SDC). This SDC may be based or pegged to CBDC, but will not carry a guarantee to pay by the central bank, and thus, will not qualify to be called a CBDC or an extension of that.
CBDCs can be designed in multiple ways – each having their own sets of pros and cons. RBI will need to outline its policy objective towards CBDC first. It will also need some legal provisions to be enacted and maybe the central government law will be a step in that direction.
One of the risks associated with CBDCs is the threat to the banking system on large-scale adoption of CBDCs and the risks emanating out of it for the financial system. However, the flipside of the argument is that CBDCs will enable many fintech solutions and make the capital markets faster, more efficient and possibly independent of any dependence on the banking system.
CBDCs can enable a new range for contracting, also called ‘smart contracts’ that may replace regular contracts (with wet signatures), but carry the same equivalence in the digital world. Availability of CBDC means payments against purchases of regular items and services as well as even assets like cars or real estate may be not done online, and such payments will be accepted as legal tender by the courts.
Such contracts may also have reversal clauses with programmable money that automatically gets refunded if either party defaults on its part of execution. This has the potential of relieving a lot of court cases related to execution and enforceability.
Therefore, there is a very strong case of creating a robust CBDC architecture that is inclusive of the private ecosystem of blockchain-based products and services that can usher in a new wave of innovative products and solutions that people can use. These blockchain-based systems use smart contracts that the technology will execute. But such execution of transactions is not fully possible until both sides – the product, information or solution being sought as well as the money — are not available on the blockchain systems with access for the smart contract to execute. So far not having the money on blockchain or cryptocurrency has been hindering the evolution and acceptance of such products and solutions.
The CBDC system will gain more interest and acceptance if it will mimic the simplicity and effectiveness of cash payments. However, the regulator may not be interested in opening up another large-scale payments mechanism that has complete anonymity. Despite dropping the anonymity from the digital cash system that CBCD presents, it is possible to achieve near cash system benefits. Consider this: we all make all sorts of transactions through banking channels all the time. However, even after having these non-anonymous channels, it is difficult for the enforcement and tax authorities to find something suspicious and connect the transfers that they suspect.
The steps taken by the Government of India and the follow-on work at RBI will be eagerly awaited. If done well, it may turn out to be a big transformational driver for spurring growth at a massive scale that India needs.
Manish Kumar is Co-founder of GREX and RealX. Views are his own)