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Baba’s Explainer – Central Bank Digital Currency (CBDC)

  • IASbaba
  • October 19, 2022
  • 0
Economics, Governance
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Syllabus

  • GS-III- Economy – Banking and Monetary Policy
  • GS-II- Governance

Context: Digitalization is reshaping economic activity, shrinking the role of cash, and spurring new digital forms of money. Central banks have been pondering whether and how to adapt. One possibility is central bank digital currency (CBDC)—a widely accessible digital form of fiat money that could be legal tender.

What is money?
  • Money is defined as “anything which is widely accepted in payment for goods or in discharge of other kinds of business obligations.”

In economics, money is seen as having three functions:

  • A unit of account: As a unit of account, money serves as a measuring stick
    ideally linked to the same basket of goods over time.
  • A means of payment: As a means of payment, it facilitates transactions.
  • A store of value: It provides refuge from various sources of risk
How has money evolved over years?
  • Management of currency is one of the core central banking functions of the Reserve Bank for which it derives the necessary statutory powers from Section 22 of the RBI Act, 1934.
  • Along with the government of India, the RBI is responsible for the design, production and overall management of the nation’s currency, with the goal of ensuring an adequate supply of clean and genuine notes in the economy.
  • In its evolution till date, currency has taken several different forms. It has traversed its path from barter, to valuable metal coins made up of bronze and copper which later evolved to be made up of silver and gold.
  • Use of coins was a huge milestone in the history of money because they were one of the first currencies that allowed people to pay by count (number of coins) rather than weight.
  • Somewhere along the way, people improvised by using claims on goods and a bill of exchange (paper money).
  • In the beginning paper money, that is, paper notes were simple claims to metallic money. But with the passage of time paper money came to be regarded as money itself.
  • Paper money took the form of bank notes were not mere substitutes but were considered as an addition to the supply of money. In the starting, notes could be issued by all commercial banks but with the passage of time it became the monopoly of the Central Bank of a country.
  • In early times when notes were introduced they were backed by an exactly equal amount in gold or silver kept in reserve by the issuing authority. This paper currency system was called “Full Reserve System”.
    • These notes could be exchanged for gold or silver coins when demanded and did nothing more than representing metallic coins. This type of paper money or notes, therefore, were called representative paper money.
  • With the passage of time it was thought that a cent percent reserve of gold against paper currency issued was not needed and instead only proportion of 30 to 50 percent was enough to convert the notes presented for conversion into gold. Therefore, “Proportional Reserve System” was adopted.
    • It was based upon the fact that people found notes very convenient and they seldom thought of presenting them to the issuing authority. Therefore, full backing of gold was not required.
  • In India, this proportional reserve system was adopted in 1927 and continued till 1957.
  • So, now a days paper money is of inconvertible type, means it can’t be converted into gold or other precious metals. So, when paper money is inconvertible, the issuing authority is not responsible to convert the paper notes into gold.
  • The currency notes issued by the Central Bank of a country are ‘Fiat Paper Money’, that is, they are issued by the fiat means ‘order, of the government’. As they are legal tender, they are generally acceptable in exchange for goods and services.
  • But as time passed even proportional reserve system was thought inadequate for the monetary needs of the growing economy. It was abandoned in India in 1957 and was replaced by the ‘Minimum Reserve System’.
  • According to this, Reserve Bank was required to keep only a minimum amount of gold and other approved securities (such as dollar and pound sterling)
    • Out of these reserves it was required that gold must not be less than the value of 115 Crores Rupees. On the basis of these minimum reserves l, Reserve Bank of India could issue any number of notes or currency subject to the economic condition of the country.
  • The bank cheques, drafts and promissory notes came into use in addition of currency and now bank deposits are the entries in the bank ledgers, serves as the most important type of money.
  • More recently, Indian Union Government notified the necessary amendments in the Reserve Bank of India Act, 1934, paving the way for running a pilot programme and the subsequent issuance of CBDCs.
    • This amendment were moved after the Reserve Bank of India (RBI) in Oct 2021 floated a concept note enumerating the objectives, choices, benefits and risks of issuing Central Bank Digital Currencies (CBDC), or e₹ (digital rupee) in India.
What is a Central Bank Digital Currencies (CBDC)?
  • CBDC is a new form of money, issued digitally by the central bank and intended to
    serve as legal tender.
  • It would be similar to the sovereign paper currency— albeit digital. Further, e₹ would be accepted as a legal tender and serve as a medium of payment and a safe store of value and would move away from the competitive ‘mining’ of cryptocurrencies to an algorithm-based process.
  • It would appear as a liability on the central bank’s balance sheet.
What purpose would CBDC serve?
  • CBDC seems to be a natural next step in the evolution of official coinage (from metal- based money, to metal-backed banknotes, to physical fiat money)
  • The prime reasons for exploring CBDC’s use case entail
    • fostering financial inclusion
    • Reducing costs associated with physical cash management
    • Introducing a more resilient and innovative payments system.
  • More importantly, it would provide the general populace an alternative to unregulated cryptocurrencies and their associated risks.
  • The e₹ can be converted to any commercial bank money or cash. It would be a fungible legal tender for which holders need not have a bank account – hence, strengthening the cause of financial inclusion.
  • Issuing CBDC allow central banks to more effectively satisfy public policy goals, including operational efficiency, financial stability, monetary policy effectiveness, and financial integrity.
What is the prevailing perception about CBDCs outside India?
  • 105 countries representing 95% of the global GDP are exploring a CBDC.
  • In fact, the International Monetary Fund (IMF) says that the Asia-Pacific region is at the forefront of introducing digital currencies.
    • Countries like Bangladesh and Maldives, which have not done much research and development about CBDC adoption, are interested and learning from their peers, as per the IMF.
  • The rationale for introducing CBDCs vary across countries. However, much of national regulators’ interest stemmed from the surge in crypto uptake observed in 2020-21.
  • Thus, regulators now endeavour to exercise more caution in dealing with volatilities triggered by ‘crypto-busts’ and ‘crypto-winters’, or periods of depressed crypto prices.
  • Bahamas and Nigeria were the first countries to launch their own CBDCs.  
    • Launched in Oct 2020, the ‘Bahamian Sand Dollar’ is a case in point for financial inclusion.
    • Its primary objective was to serve the unbanked and the under-banked populations across more than thirty of its inhabited islands.
    • On similar lines, East Carribean Central Bank which is the central regulator for Anguilla, Antigua and Barbuda, Commonwealth of Dominica, Grenada, Montserrat, St Kitts and Nevis and St Vincent and the Grenadines became the first currency union central bank to have a CBDC.
    • Paper currencies need to physically travel and require certain logistics to be accessible to people. For these distant island nations, CBDCs as a currency would ensure wider geographical coverage with lower logistical challenges than paper currency.
  • Senegal and Ecuador, on the other hand, have opted out of launching CBDCs.
  • Separately, Asian countries sitting on certain crucial technological advancements would be helped in their CBDC plunge. For example, China’s CBDC project was initiated in 2014 with Singapore and Hong Kong SAR entering the frame in 2016 and 2017.
What are the varied forms of CBDCs?
  • Based on their usage and functions, CBDCs are categorised into retail (CBDC-R) and wholesale (CBDC-W).
  • CBDC-R
    • It is meant for retail consumption and can be availed by all including the private sector, non-financial consumers and businesses.
    • CBDC-R can be particularly useful for a regulator to ensure financial inclusion. Being digitally based, it can bolster payment mechanisms.
  • CBDC-W
    • It is meant for interbank transfers and wholesale transactions by financial institutions.
    • CBDC-W can help improve the efficiency of interbank payments or securities settlement, as has been observed in Project Jasper, Canada’s CBDC project, as well as Project Ubin— Singapore’s CBDC project.

 

Now coming to the question of accessibility; in other words— how the asset would flow in the supply chain. The two suggested model types are the

  • Account-based system.
    • It involves the transfer of a claim on an account. It requires maintaining a record of balances and transactions of all holders of the CBDC and indicate his/her ownership of monetary balances.
    • A transaction in account-based CBDC would resemble today’s transactions between commercial bank depositors, except accounts would be held with the central bank.
    • A payer would log in to an account at the central bank—for example, through a web page or an app on a handheld device—and request a transfer of funds to a recipient’s account, also at the central bank.
    • The central bank would ensure settlement by updating a master ledger, but only after verification of the payer’s authority to use the account, sufficient funds, and authenticity of the payee’s account. The exchange of information would therefore be substantial.
  • Token-based system
    • It involves the transfer of a token between wallets.
    • Token ownership is prima face verified— the possessor of e₹ is by default deemed as its owner, just like banknotes. Only the authenticity of the token is to be verified.
    • Transacting in token-based CBDC would involve more steps than exchanging cash but
      would offer the convenience of not having to meet in person.
    • Unlike cash—the prime example of a traditional token-based form of money—CBDC tokens would be too complex for the user and therefore settling a transaction using token- based CBDC would require external verification of the tokens.
    • As a result, transactions might not be entirely anonymous, like cash.
    • Verification of the tokens and settlement could be centralized or decentralized, depending on the technology used.
    • Decentralized settlement is possible via the use of distributed ledger technology (DLT). However, although the technology is evolving, it currently falls short in scalability, energy efficiency, and payment finality. DLT could be used over a closed (“permissioned”) network managed by the central bank.
    • But there are other types of centralized settlement technology that may prove more efficient. These would check the validity of the tokens’ serial numbers, then reassign numbers once tokens change wallets to avoid the risk of double spending.
What would the ‘supply chain’ be like?
  • The previously-illustrated distribution model could potentially be integrated to either the single-tier or the double-tier model. 
  • In the single-tier model as the name might suggest, in the Direct CBDC system the central bank manages the entire supply chain from issuing CBDCs, to maintaining accounts and verifying transactions. Its server is involved in all payments.
  • The double-tier model adds to the supply chain the role of an intermediary (or a service provider). This supply chain is further categorised into two, namely, the indirect model and the hybrid model. 
  • The indirect model entails consumers holding an account/wallet with a bank, or service provider. The obligation to provide CBDCs to retail customers would fall on the service provider and not the central bank.
    • Central Bank would only be involved in ensuring that the wholesale balance is identical to the retail balances of its retail customers; in other words, scrutinising whether the CBDCs being given to retail customers are equivalent to what the intermediaries have been allocated.
  • In contrast, while the intermediary handles retail payments in the hybrid model, the central bank provides CBDCs directly through intermediaries.
    • In other words, the central bank as well as the intermediaries maintain the ledger of all transactions and manage payments.
    • The regulator would operate a backup technical infrastructure allowing it to restart the payment system if intermediaries run into insolvency or technical outages.
What models does the RBI deem suitable?
  • The RBI deems the indirect model more suitable for India, with the central bank creating and issuing tokens to authorised entities called Token Service Providers (TSPs).
  • These TSPs would then distribute the tokens to end-users who undertake retail transactions.
  • The regulator acknowledges that it may not have a comparative and competitive advantage over banks in distribution, account-keeping and customer verification, among others. This is especially in an environment where technology is rapidly changing.
  • Further, it deems CBDC-W suitable for account-based transactions and CBDC-R for token-based transactions.
    • Issuing CBDC-R in a token-based system would help the regulator with its financial inclusion goals.
    • Additionally, CBDC-W in an account-based system would facilitate instant settlement with a well-established legal status as transactions would emanate from verified accounts.
What are the challenges regarding adoption of CBDC?
  • There are certain concerns pertaining to data collection and anonymity, cyber-security, dispute resolution and accountability.
  • About concerns pertaining to data collection and anonymity, RBI notes that there emerges a possibility that anonymous digital currency would facilitate a shadow economy and illegal transactions.
  • Regulators require insight to identify suspicious transactions, such as those pertaining to money laundering and terrorism financing, among others. Addressing this concern, the IMF recommends instituting a specific threshold (say $10,000) for regulatory oversight.
  • RBI recognises there is an increased probability of payment-related frauds in countries with lower financial literacy levels. It states the ecosystem would be a “high-value target” since it is important to maintain public trust. Ensuring financial literacy and cyber-security thus becomes very important.
  • CBDCs would also need infrastructure for facilitating offline transactions. The risk of ‘double spending’ is spurred when operations head offline. This is because a CBDC unit could potentially be used more than once with the ledger requiring an internet connection to update.
    • However, RBI believes it could be mitigated to a large extent by technical solutions and imposing limits on offline transactions.
    • It acknowledges the importance of enhancing offline capabilities for wider use, pointing to only 825 million of a total population of 1.40 billion having internet access in India.
  • RBI would also explore the possibility of cross-border payments using CBDCs. In a related context, the IMF has observed that fragmented international efforts to build CBDCs would likely result in interoperability challenges and cross-border security risks.
  • RBI highlights two broad concerns in the event of a financial crisis. There could either be a potential ‘bank run’, in other words, people withdraw their money rapidly from banks, or a financial disintermediation that would prompt banks to rely on more expensive and less stable sources of funding.

Main Practice Question: What do you think are the challenges in adoption of Central Bank Digital Currency?

Note: Write answer his question in the comment section.


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