By Suvir Davda
Digital assets and currencies from Central Bank Digital Currencies (CBDC) to cryptocurrencies are constantly in the headlines. For those not so clued about the new-age digital and traceable money and assets, hopefully, the below explanation will help decode the complex maze.
Let’s start with Central Bank Digital Currencies. CBDCs are a digital representation or form of sovereign/fiat currency (value) that is issued and backed by central banks. The natural question which may arise is how are the current forms of payments like wallets, local payment systems including NEFT, RTGS, Unified Payment Interfaces (UPIs) different from CBDC?
One of the main differences is the underlying technology used. CBDCs use distributed ledger technology (DLT), which is typically deployed in a hybrid architecture i.e. existing central bank and payment infrastructure + DLT for movement, transparency, workflow and audit trail or tracing of funds (value). This technology helps in efficiency (speed), security (encryptions) and also other aspects like smart contracts which execute buy and sell transactions based on a pre-defined criteria and opens up the possibility of ‘programmable’ money. CBDC can be in different forms like token or account/ digital wallet form.
The design and implementation of wholesale and retail CBDC is an important aspect of determining anonymity and the ultimate funds trail. What features a CBDC has, depends on how the central bank envisages the future of CBDCs and the resultant framework that is put in place.
As mentioned before, the underlying technology used for CBDCs can vary from DLT or a mix of existing payment rails and systems at one layer and DLT at the second layer. In order to keep track of money, banks need to store financial records, such as how much money a person has and what transactions they’ve made. While digitising the money supply chain from central banks to commercial banks to consumers of wholesale and retail CBDCs, complimenting the existing infrastructure and investment is important.
How are CBDCs different from private cryptocurrencies?
While both work on the DLT technology, the goals are different. Private crypto-currencies such as Bitcoin are decentralised digital currencies and use open source peer to peer networks to make trustless transactions possible. There is no central entity or group of entities in charge. That concept typically does not sit well with governments. Also, private cryptocurrencies could have certain limits. For example, Bitcoin has a hard limit of 21 million units built into the protocol. It is very hard to break/increase this limit. In contrast to CBDCs, the supply and demand can be controlled by central banks which are in charge of the money supply. They can choose when to remove or add money to the supply, such as to stimulate the economy in troubled times and set national interest rates, among other tasks.
Typical features for CBDC
- Central Bank Digital Currency (CBDC) will be legal tender
- CBDC must be complementary to cash and is not intended to replace cash
- CBDC must be accepted as a means of payment by all sizes of business and by the government;
- Must not introduce the risk of destabilising the financial sector & mechanisms to give effect to policy decisions regarding its supply & movement;
- Consumers must be able to own and transact in CBDC without the need for a bank account;
- Consumers and businesses must be provided with channels to obtain or return CBDC in exchange for cash & commercial bank money;
- It must enable instant peer-to-peer transfer of value without clearing and settlement in today’s terms;
- CBDCs could be traceable & auditable in terms of issuance and ownership
Another key area where CBDCs could play a role is cross border payments. Today’s cross border payments work mainly around the SWIFT framework and despite a lot of financial innovation, do involve travelling through a maze of bank nostros, vostros and ultimately local payment systems. With CBDCs, we could increase payment efficiency, improve on authentication (including AML risks) and finally also improve transaction costs thereby benefiting the full universe of retail users. For this to move ahead global central banks will have to coordinate amongst themselves to set up a global framework and protocol such that interoperability is achieved across new settlement systems.
Cross-border and wholesale uses for CBDC
- Subscription to mutual funds and also possibly other security transactions (equity and debt) using CBDCs, whereby instantaneous fund transfers will lead to more efficiency albeit missed cut offs, lengthening payment cut-offs etc.
- Trade Invoicing in INR and importer/exporter paying and receiving in CBDC
- Software developers being paid in CBDC
- Non-Resident Indians keeping CBDC INR accounts offshore/ fungible into NRE and NRO accounts
- GIFT City permitting CBDC Indian rupee (INR) accounts to be opened with IFSC banking units as authorised agents, the logic being that the central bank could keep aside a finite amount of rupee from the money supply, and issue a pool of CBDC through authorised dealer (AD) banks. This will enable a finite pool of Indian rupees in free float offshore with proper tracking and audit trails. This could be the initial baby steps to test the waters towards capital account convertibility.
While there are a lot of pros for CBDCs, one also needs to be careful that CBDCs do not disrupt well-functioning capital and credit markets. Liquidity is another key issue. For any asset class to be stable, there has to be a good balance of buyers and sellers. Depending on the laws in each jurisdiction, issuing a CBDC would require additional monitoring and compliance under Anti-Money Laundering and Countering Financing of Terrorism (AML/CFT) laws.
Finally, as the central bank will intermediate CBDCs through wholesale banks and financial institutions, its impact on savings and deposits needs to be carefully studied and analysed as they serve as a large savings pool for banks to lend to commercial and retail establishments. How the general public perceives CBDCs as a replacement for cash is also an important aspect to consider. Depending on the form of CBDC, the anonymity and audit trial of funds would vary.
To summarise, CBDCs provide opportunities and threats to the money supply chain that could disrupt the broader financial services ecosystem. Globally, a lot of central banks have been studying CBDCs in great detail and in some cases even running pilot test cases. India has been at the forefront of digital innovation over the last decade and it is important for us to start trial projects for CBDCs in controlled environments.
The typically used cases would be market participants who today don’t have access to UPI as they don’t want to actively access bank accounts. That’s the residual gap for India which CBDC can plug. To that extent, this can be a regulated alternative to a
wallet, with a central bank ‘promise to pay’ which is core to a fiat currency. Wallets enhance systemic risk. CBDC when combined with fintech wallets and other digital payment mediums, will help control those systematic risks.
Some pilot projects could be started in college canteens, large sporting or entertainment events etc. CBDCs could also be used to alter the lives of those living in tier 3 & 4 towns and villages. This could be in the form of financial inclusion — be it direct benefit transfer from the government, more formal savings opportunities and possibly easier and more cost effective access to loans which result in better monetary policy transmission.
Who are using CBDCs?
In a lot of countries, where CBDCs are being explored, there is a clear absence of countrywide real-time retail infrastructure like UPI. India has leapfrogged the world in this space and a lot of investments have been made by market participants towards this effect. We hence need the CBDC (proposed digital rupee) to be positioned in such a way that it complements UPI and India Stack rather than compete with it. The CBDCs framework should be such that it coexists with the private sector. For example, CBDC could be linked to the E-wallets, the UPI payment infrastructure and also possibly bank accounts thereby offering the end-user the best of both — security (sovereign issuance) and convenience offered by new age fintechs.
Recent news reports suggest that the government authorities are examining the need to introduce CBDC in India. One should watch out for the possibility of a bill being introduced for a digital rupee and the view taken on private cryptocurrencies.
The author is Director, Global Market, HSBC India.
