Why RBI wants a digital currency

Apparently, the Government of India and the RBI are preparing to launch a central bank digital currency (CBDC). A survey conducted by the Bank for International Settlements earlier this year found that 60% of the world’s central banks are experimenting with CBDC technology and 14% have started pilot projects.

Given this, it is important to understand what exactly is a CBDC and what is not; what it hopes to achieve; Opportunities for change are likely to arise and problems that are likely to be solved.

What is CBDC?

In a speech in July, RBI deputy governor T. Rabi Shankar defined a CBDC as “a fiat currency issued by a central bank in a digital form” that is “similar to fiat currency and exchangeable – two-to-one with fiat currency”.

The Bank of England, the United Kingdom’s central bank, defines a CBDC as “an electronic form of central bank money” that can be used by households and businesses to make payments and store value.

Now, what does this mean in simple English? There are two types of central bank money- one is made of paper/polymer notes (physical cash) which we use in our daily life and the other is the reserves maintained by the commercial banks with the central bank. These reserves are in digital form and are used by banks for managing interbank payments. Banks can also exchange these reserves for cash at the central bank.

In that sense, at the wholesale level, there is not much difference, as money is already digital in this segment. As Ishwar S. Prasad wrote in The Future of Money—How the Digital Revolution is Transforming Currency and Finance: “New technology does not fundamentally change the nature of an asset, as it is already digital, but allows banks to make more of it.” Enables us to use it efficiently and cheaply.”

If experts are to be believed, the retail segment—where a major chunk of money is still in cash—is the real ground for near-term innovation. A retail CBDC would essentially be a central bank-issued digital currency that would co-exist with physical cash. A discussion paper by the Bank of England states that retail CBDCs will be “denominated in pounds sterling, like banknotes.”

This digital currency would require an entirely new ecosystem, with a central bank—in the Indian case RBI—managing the centralized payment system. This centralized payment system, as Prasad writes, would be “linked to an electronic ‘wallet’ that resides on prepaid cards, smartphones or other electronic devices. Of course, money in these digital wallets can be spent in the same way as physical cash.”

The system seems similar to those who use payment apps that already exist in India and all over the world. How is CBDC different then? For one, the payment infrastructure is created and managed by the central bank. Two, payments are made using central bank money and not money created by the banking system.

But why do we need a central bank-issued CBDC, especially given how the market is already saturated with fintech innovation? Let us try to understand it with the examples of Sweden and China. Data from the Swedish central bank, the Riksbank, shows that between 2010 and 2020, the percentage of those who paid cash for their previous purchases declined from 39% to 9%. Also, a large part of this new digital payments infrastructure is managed by a few private companies.

China has gone the same way. As D Priyadarshini and Sabyasachi Kar explain in a working paper titled Central Bank Digital Currency: Critical Issues and the Indian Perspective: “China, for example, has seen near universal adoption of digital payments, with about 94% mobile The transaction is backed by Tencent. or Alibaba. Both entities have also linked several other financial services with their social media apps.”

Such integration increases the overall risk in the financial system, in which the entire digital payments infrastructure is dependent on a few private companies. As Priyadarshini and Kar write, this poses risks of “monopoly, high entry barriers, potential misuse of data, security and protection of technology”.

Thus, central banks need to create a new digital payments infrastructure through CBDCs. The Riksbank, which is experimenting with e-krona, states that “in the event of a serious setback to the systems of banks or card companies, e-krona may be an alternative form of payment”. Furthermore, in China, the Chinese Communist Party is also forced to put an end to the growing clout of the private sector.

Indian context

in India, unified payment interface (UPI) has been very successful in the field of digital payments. it is run by National Payments Corporation of India (NPCI), an umbrella organization for operating retail payment and settlement systems, is an initiative of RBI and Indian Banks’ Association (IBA).

NPCI is majorly owned by public sector banks, but given that it was formed at the initiative of RBI, it is safe to say that the government has some control over it. Also, the stake of each individual private company in NPCI is limited to a few percentage points.

UPI has proved to be a game changer in the field of digital payments. Instant money transfer can now be done between two bank accounts using a mobile phone. In October, 4.21 billion transactions were done through it.

In that sense, the presence of UPI has ensured that India will not go down the Chinese or Swedish route, where some private companies can monopolize the digital payment system.

But despite this advantage, there are two reasons why India can still go ahead with building a well-functioning CBDC system. There is a complex cross-border payment system as it is prevalent. As Prasad writes: “They include multiple currencies, which often must be remitted through multiple institutions, and conform to country-specific financial regulations. The net result of such constraints is that cross-border payments are often Slow, expensive and difficult to track.”

CBDCs can handle these issues well. As RBI’s Shankar puts it: “It is possible for an Indian importer to make payments to his US exporter on a real-time basis in digital dollars without the need for any middleman. This transaction will be final, as if the cash dollar is handed over.” Of course, for this to happen, India needs a sovereign-backed CBDC that “will be trusted in a global system”.

Another reason is that China is betting big on its CBDCs. In fact, China wants the digital yuan to play the same role in the international economy as the US dollar does today. Therefore, and as Priyadarshini and Kar put it, “once the digital yuan gains acceptance as a global currency, it is only a matter of time before it flows into the Indian economy”.

Given India’s contentious relationship with China, work needs to be done to limit this possibility, which would only be possible through the development of global protocols for cross-border use of CBDCs and “a say in their development”. For “International Standards… It would be very useful for India to have a reliable and working CBDC.”

more use cases

after the spread of covid-19 pandemicWestern governments spent a lot of money to prop up their domestic economy. This involved depositing money directly into individual bank accounts. But governments did not have bank account information of all citizens. So, he also sent checks and debit cards filled with money.

As Prasad writes of the American case: “Checks and debit cards were mailed … delayed or lost. Scammers found ways to intercept some payments, while many recipients mistook debit cards as junk mail.” “If there was a CBDC system, governments could put money directly into people’s wallets. In fact, in order for people to spend that money immediately, they could consider it to be expiring within a certain period of time.

On the other hand, this would mean that fiscal policy and monetary policy would become further mixed, blurring the line between the independence of the central bank and the government.

Other benefits of CBDCs include no counterfeiting of currency (unless innovators understand how to do it digitally), greater financial inclusion and promoting the war against black money and corruption.

The onset of negative interest rates is another possibility that could emerge with the widespread adoption of CBDCs. The only reason most central banks cannot impose negative interest rates is because people can easily withdraw their money from banks and other financial institutions and keep it in the form of cash.

But in the world of 100% digital currency, negative interest rates are possible. This has excited central bankers. In tough economic times, central banks may mandate negative interest rates on CBDCs stored in wallets, encouraging people to spend. Of course, people still can’t spend, but a negative interest rate is an idea central banks can use when they have exhausted all other considerations.

To do this, the CBDC would need the functionality of a savings bank account, where the central bank pays a fixed amount of interest to depositors to keep their money in a wallet. Only when you pay interest can you incur negative interest. As Shankar said in his speech: “Such steps may need to be taken with caution as any instrument paying interest (positive or negative) is not purely currency.”

CBDC and bank moves

A bank run is basically a situation where many depositors want to withdraw money from the bank if they feel it is fragile. In fact, this could be an unintended consequence of CBDCs.

As the Report on Currency and Finance 2020-21 explains: “CBDCs … pose a risk of disruption of the banking system, especially if the commercial banking system is considered fragile.” People can transfer money from their commercial bank accounts. Their CBDC accounts if they believe a bank is in trouble or if there is macro financial instability.

Therefore, the design of the CBDC becomes very important. As stated in the Bank of England discussion paper: “Limiting individual holdings of CBDCs can help ensure that CBDCs are primarily used for payments and not for large savings, thereby The extent of disruption of the banking system is reduced.”

Also, it is appropriate that a central bank, an institution that controls commercial banks, should not compete directly with them. It is, therefore, important that the RBI follows a two-pronged approach to CBDCs, where the central bank “creates a digital version of its currency”, yet, it also allows “the distribution of that currency and the maintenance of CBDC wallets on existing financial institutions”. Leaves. Intermediaries”. In fact, this is exactly how Chinese CBDCs are being developed.

Finally, there are two points to note. One, CBDCs are different from crypto. While the original idea behind bitcoin, the first cryptocurrency, was to challenge fiat money and emerge as a medium of exchange, this has not happened. At the same time, cryptocurrencies have become a subject of speculation. So, as Shankar puts it: “They are not money (certainly not currency) as the term has been understood historically. CBDCs, however, are money as it is understood historically. It is managed by a central bank.” is issued and it is backed by the sovereign, as is fiat money.

Two, if CBDCs operate over the long term, it would mean the end of liquidity. While this solves some problems, it will also create others.

(Vivek Kaul is the author of Bad Money.)