Baba’s Explainer – India’s Digital rupee: CBDC

  • IASbaba
  • December 1, 2022
  • 0
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  • GS-3: Money & Banking; RBI and its monetary Policy
  • GS-2: Government Policies and Interventions for Development in various sectors and Issues arising out of their Design and Implementation.

Context: Reserve Bank of India (RBI) has announced the launch of India’s much-awaited Central Bank Digital Currency (CBDC), a sort of official cryptocurrency, for retail users from December 1.

What is e-rupee?
  • Definition: RBI defines the CBDC as the digital form of currency notes issued by a central bank. It is a sovereign or entirely independent currency issued by the central bank (in this case, RBI), in accordance with the country’s monetary policy.
  • Legal Tender: Once officially issued, CBDC will be considered as a medium of payment and legal tender by all three parties – citizens, government bodies, and enterprises. Being government-recognised, it can be freely converted to any commercial bank’s money or notes.
    • RBI is not in favour of e-rupee with interest. Because people might withdraw money from banks and convert it to digital rupee – causing banks to fail.
  • Blockchain Technology: The underlying technology of cryptocurrency and the digital rupee system will be blockchain technology. However, cryptocurrencies like bitcoin or ethereum are ‘private’ in nature. Digital rupee on the other hand, will be issued and controlled by the RBI. E-rupee would move away from the competitive ‘mining’ of private cryptocurrencies to an algorithm-based process.
  • Global Scenario: As of July 2022, 105 countries were exploring CBDC. Ten countries have launched CBDC, the first of which was the Bahamian Sand Dollar in 2020 and the latest was Jamaica’s JAM-DEX.
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 RBI's Plan for CBDC?
  • On the basis of usage and the functions performed by the digital rupee and considering the different levels of accessibility, CBDC can be demarcated into two broad categories — general purpose (retail) (CBDC-R) and wholesale (CBDC-W).
    • Retail CBDC is an electronic version of cash primarily meant for retail transactions. It will be used by all — private sector, non-financial consumers and businesses.
    • Wholesale CBDC is designed for restricted access to select financial institutions. It has the potential to transform the settlement systems for financial transactions undertaken by banks into government securities (G-Sec) segment, inter-bank market and capital market more efficiently and securely in terms of operational costs, use of collateral and liquidity management.
  • On November 1, the RBI launched the digital rupee for the wholesale segment to settle secondary market transactions in government securities.
    • Wholesale CBDC is designed for restricted access to select financial institutions. It has the potential to transform the settlement systems for financial transactions undertaken by banks in the government securities (G-Sec) segment, inter-bank market and capital market more efficient and secure in terms of operational costs, use of collateral and liquidity management.
  • What will be launched on December 1 is the first phase of a pilot project of retail e-rupee that will cover select locations and banks in a closed user group (CUG) comprising participating customers and merchants.
    • The pilot will initially cover the four cities of Mumbai, New Delhi, Bengaluru, and Bhubaneswar, where customers and merchants will be able to use the digital rupee (e₹-R), or e-rupee.
    • Four banks will be involved in the controlled launch of the digital currency in these four cities: State Bank of India, ICICI Bank, Yes Bank, and IDFC First Bank.
    • The scope of the pilot may be expanded gradually to include more banks, users and locations as needed
And how will the retail digital rupee work?
  • The e₹-R would be in the form of a digital token that represents legal tender. It will be issued in the same denominations as paper currency and coins, and will be distributed through intermediaries, i.e., banks.
  • Users will be able to transact with e₹-R through a digital wallet offered by the participating banks and stored on mobile phones and devices, according to the RBI.
  • Transactions can be both person to person (P2P) and person to merchant (P2M).
    • Payments to merchants can be made using QR codes displayed at merchant locations.
  • The e₹-R would offer features of physical cash like trust, safety and settlement finality. As in the case of cash, it will not earn any interest and can be converted to other forms of money, like deposits with banks.
  • In effect, the retail e-rupee will be an electronic version of cash, and will be primarily meant for retail transactions. It will be potentially available for use by all — the private sector, non-financial consumers and businesses — and will be able to provide access to safe money for payment and settlement, as it will be the direct liability of the central bank.
So why do we need a pilot launch for the retail e-rupee?
  • According to the central bank, the pilot will test the robustness of the entire process of digital rupee creation, distribution and retail usage in real time.
  • Different features and applications of the e₹-R token and architecture will be tested in future pilots, based on the learnings from this pilot.
What are the advantages of the e-rupee?
  • The RBI had earlier said 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.
  • It will add efficiency to the settlement system and boost innovation in cross-border payments space and provide the public with uses that any private virtual currencies can provide, without the associated risks.
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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