Understanding the nuances of central bank digital currency

Our economy is poised to become one of the leading advocates of the digital economy by putting all the pillars in place, even more so after the launch of “Digital India” in July 2015. The spread of mobile density, broadband connectivity coupled with the accumulation of digital banking infrastructure, cybersecurity measures and data privacy standards and many other supporting initiatives have formed a formidable digital ecosystem. Against the backdrop of the digital footprint across the trinity -jandhan, Adhaar and mobile (JAM), society is poised to embrace the debut of central bank digital currency (CBDC). This will be yet another strategic initiative to move towards a society with less cash. Any great change will have merits and challenges. It will take considerable time for stakeholders to join CBDC integration to strengthen digital transformation.

The way digital banking has been embraced in India over the past decade despite the low level of digital and financial literacy demonstrates society’s iron will to embrace new developments with open arms. It is exactly the differentiation of society’s entrepreneurial spirit to embrace the nuances of advancement that keeps us ahead of others. CBDC is a logical development from one stage of digital society to innovate yet another.

CBDC can be delayed but cannot be avoided if digital transformation is to be pursued in a sustainable manner. The 2022-2023 Union budget rightly announced the government’s intention to launch the CBDC. RBI is set to move forward to reduce the use of physical currency, thereby mitigating some of the operational risks of managing physical money when compatible tools – Information, Communication and Technology (ICT ) can be explored appropriately.

Among the nuances of ICT tools, blockchain technology is a tool to float a secure CBDC. It is a peer-to-peer decentralized distributed ledger technology that makes records of any digital asset transparent and immutable and works without involving a third-party intermediary serving the needs of the CBDC.

  1. What is the CBDC

It can be well understood in modern times that money is a form of money issued exclusively by the sovereign (or a central bank as its representative). It is a responsibility of the issuing central bank (and sovereign) to insure the value against the asset (underlying value) of the holder of this currency by the public. The currency is fiat and legal tender. Currency is usually issued in paper (or polymer) form, but the form of currency is not its defining characteristic. It can be coins and it was even previously in the form of leather/metal tokens embossed by the issuing authority. RBI issues legal tender – a currency that has a monetary value that can be exchanged for another product/service of equal value. Money is therefore a store of value.

Extending the same utility value of paper currency, it is easy to understand that CBDC will be issued by RBI but in digital form instead of paper currency. Physical currency needs a place to hold, can be in a wallet, bag, purse, cabinet, etc. For this purpose, a CBDC is legal tender issued by a central bank in a digital form that can be exchanged for value.

CBDC is identical to a fiat currency and is exchangeable on a one-to-one basis with fiat currency. Only its shape is different. Hence, money is usually issued by a sovereign – RBI in India which represents the government. Private issuance of currency – whether under sovereign license or otherwise – has existed in the past but has, over time, given way to sovereign issuance, for two reasons. First, being a debt issuance, private money is only as good as the issuer’s credit whereas the CBDC is state-backed.

It is a good development that RBI plans to release a digital currency using blockchain technology in 2022-23. It eliminates intermediaries in financial transactions – primarily banks – and allows transactions to move directly from person to person or from customer to supplier. This helps eliminate consumer risks, such as the collapse of a commercial bank, and creates a direct link between consumers and a central bank.

Many central banks have either launched digital currencies or are planning to do so with ongoing CBDC pilots. The Basel Committee on Banking Supervision (BCBS) published a joint report of its sub-committee – the Committee on Payments and Market Infrastructures and the Markets Committee of the Bank for International Settlements (BIS) in March 2018 which discussed various CBDC issues with their implications for payments, monetary policy, and financial stability. He highlighted points for reflection ahead of the launch of CBDCs.

Recently, after the Covid19 outbreak, the BIS proposed another set of guidelines on April 3, 2020, amid growing concerns that the virus could be transmitted through the manipulation of physical currency in circulation, although his chances are slim. Digital currencies are becoming popular after cryptocurrencies in circulation begin to catch up with growing fear of money laundering and illicit financing.

According to the IMF, around 100 countries are considering evaluating the CBDC while some have already rolled it out. The Bahamas was the first economy to launch its national CBDC – Sand Dollar. Nigeria is another country that rolled out eNaira in 2020 and in January 2021, it got 7,00,000 downloads. China became the first major economy in the world to pilot a digital currency in April 2020. The People’s Bank of China is targeting widespread household use of e-CNY, or digital yuan, in 2022. The Bank of Korea, Sweden, Jamaica, Ukraine, etc. are some of the countries that have also started testing their digital currency and many may soon follow. The European Central Bank and the US Federal Reserve are considering the CBDC issue.

Although the potential gains from the CBDC are huge, there are still many risks that need to be measured and mitigated. The CBDC will increase its reliance on technology too much, leading to increased operational risks that could be compounded due to faster technology obsolescence. The inevitable centralization of the CBDC will be vulnerable to point failures and cyberattacks and could also increase the surface and the attack vectors. Central banks should leverage the inherent cyber resilience of distributed systems, public blockchains along with a competitive free market for the movement of value across the internet provide a better long-term posture to overcome some of these risks.

With the increasing potential risks due to the expansion of businesses in society, complex systems and technological interconnection are failing in complex ways. The CBDC will call for the transition from a rapidly evolving blockchain-based business model to the public sector for something as fundamentally critical as money and monetary oversight, could outweigh the added value that comes with it unless digital literacy and the robustness of cybersecurity and data privacy standards are refined with the integration of a compatible macroprudential framework.

This will require accelerated public education and digital literacy to protect their CBDC possessions, as they may be more vulnerable to wholesale theft compared to physical cash and tracing will become difficult for law and order guardians. Despite the challenges, the CBDC will pave the way for a less liquid society and could reduce the operational risks associated with the movement of a huge volume of physical silver.



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