CBDC – The Digital Currency from Central Banks

Central Bank Digital Currency or CBDC is the new kid on the block. This is a digital currency ( eg. Digital Rupee ) issued by the Central bank of a country whose value will typically be equal to the fiat currency ( Rupee ) that is in the form of paper currency and coins. It is to be understood that CBDC is also a fiat currency in the digital form.

Many countries ( at last count, 110 ) are developing CBDC and are mostly in the pilot phase. This is something we need to examine closely as this can have implications for the monetary system globally. There are positive parts for sure; but there are negative aspects as well that needs to be properly understood.

Good primer on CBDC –  https://www.investopedia.com/terms/c/central-bank-digital-currency-cbdc.asp

A bit more about CBDC

Online payments, Wallets and Crypto currencies are becoming common in the world today. India has travelled far in real time payment settlements.  RTGS and NEFT facilitate near real time payment settlement mechanism. IMPS and UPI are truly instant payment settlement systems, putting India far ahead of most countries.

In India, Unified Payments Interface (UPI) has revolutionized payments by connecting applications with UPI backend connect with bank accounts, enable payments to merchants, allows peer-to-peer transfers and more. The UPI is a part of India Stack, which is a set of APIs that allow various stakeholders to use digital infrastructure to deliver services anytime, anywhere digitally. Lot of innovations have taken place as products have been developed around UPI and India stack.

Go through these – 1, 2.

In many countries, this kind of digital infrastructure is not present. See this –  Indian Digital infra is 5 to 10 years ahead of the west. The older system of bank settlements is still used even today by most western countries.  Just now, US is introducing FedNow, which is on the lines of UPI, that is in pilot stages.

Over and above this, CBDC is also being considered for introduction. CBDC is a unique digital currency controlled by the Central Bank directly ( as opposed to the paper currency which goes through the banking system ), whose value is expected to be the same as the existing fiat paper currency. CBDC can be used for wholesale and retail payment settlements.

CBDC may be directly administered by the Central Bank or may be a tiered architecture where the Central Bank just issues the CBDC while the distribution and payment portions would be with the banks. CBDCs are not envisaged to infringe on the commercial and credit operations by banks and other financial entities.

CBDC and Crypto currencies

CBDC was conceived based on the success of Crypto currencies, among other reasons. It is seen by some as an alternative to Crypto currencies, though at a fundamental level, it can never be.

Crypto currencies have been created with the express intention of liberating the people from the tyranny of the government control and its systems. Also, Crypto currencies by design are made available in limited quantities due to which debasement of the currency is arrested. Debasement is a huge problem with fiat currencies due to the reckless money printing by governments across the globe.

However, Crypto currencies are not controlled by any government, sometimes without clear origins with idiosyncratic currency creation rules. They are very volatile and their creation is environment unfriendly.

Its runaway success is a worry for governments who see their grip on the financial system being chipped away. Most governments are restricting the use of crypto currencies and some do not even recognize them as they see them as a threat to their authority.

Central governments worry that the proliferation of Crypto currencies has the potential to diminish the monetary authority’s potential to administer and regulate the monetary policy and hence can pose a serious challenge to financial system itself.

Crypto currencies solve the problem of counterfeiting and use the blockchain technology making the transactions foolproof. They provide privacy and anonymity in transactions which is great for consumers but worrying for the governments due to the potential for misuse. In this connection, central banks are also concerned about the proliferation of illegal trade that happens due to the global reach of crypto currency.

Crypto currencies are very volatile to be a currency and is probably an alternative investment asset. There are stable coins which are supposed to solve this problem. They are crypto currencies whose value is pegged to a currency, commodity or a financial instrument. But still, it is a far cry from stable fiat currencies.

The case in favour of CBDC

CBDC is expected to bring down the usage of cash in the system and reduce currency printing, management and logistics costs.

Since CBDC is issued by the Central Bank, CBDC has lower risks as compared to dealing through the banking system, which could default on occasion when there is a huge run on the bank due to the fractional reserve system followed there. CBDC is hence free from Credit and liquidity risk.

Counterfeiting of currency can be curtailed in this system.

CBDC could be a wonderful mechanism to reduce costs, especially in international transactions and increase trust.

This can be a great way by which the central bank can bring in digital currency to consumers and build an entire alternate ecosystem to the existing cash and bank system. This is especially useful in countries where the digital payment and banking infrastructure is relatively underdeveloped.

Also, in many countries the logistics of transporting the currencies across the country is a challenge, which a CBDC can easily solve.

The negatives of CBDC

CBDC is essentially seen as a replacement for cash. In that sense, it may not yield any interest. However, there are proposals to consider interest payments on CBDCs too.

Unlike cash deposited with the bank, the digital cash with the Central Bank can potentially be locked and made out of use in certain situations. Such sweeping power is worrying especially with governments that want to exercise complete control.  This would be a deadly tool in their hands.

CBDC will expose the citizen transactions completely to the government and they would know what every citizen is doing with their money. Such data can be used to target whichever section as per their predilection, which could be a problem.

Many counter this saying that most transactions through card or through the bank are anyway known to the government. Only a small percentage of transactions made by cash are anonymous. Hence, according to them, CBDC is not going to be such a challenge.

If CBDC becomes prevalent, a secure digital infrastructure to support the transaction volume has to be in place. Safety of the money is a worry as even with blockchain technology ( which is supposed to be very secure ), instances of hacking have been there in respect of Crypto currencies. CBDC may face such challenges too, which it needs to be prepared for.

CBDC and the Indian situation

Many countries across the world do not have the robust and convenient digital payment settlement infrastructure. For such countries, including the USA, CBDC will be a big deal.

In India, we have Payment settlement mechanisms via the bank like NEFT, RTGS & IMPS and the latest UPI, which has payment apps and wallets linked to it as well as third party wallets, enabling smooth digital payments even at the consumer level. Hence, instantaneous payments is something Indians are used to, for over a decade.

CBDC would just be one more digital payment mechanism that will now become available. This may not make as much a splash in India as it would in other countries. Read this detailed note from RBI –

https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=1218#CP1

CBDC can also be used for Wholesale settlements among institutions, where this may find greater applicability. Also, when international settlements via the CBDC gets enabled and relevant infrastructure gets developed, this could prove useful.

For now CBDC is just an evolving concept. It may be very useful in certain countries, but could have limited impact in India. There are good parts to CBDC. Time will tell whether CBDC will be a gamechanger or would be just another player in the monetary space.

Authored by Suresh Sadagopan, MD & Principal Officer, Ladder7 Wealth Planners. P. Ltd