Central Bank Digital Currency (CBDC) is an electronic form of sovereign currency issued by central banks world over and is perceived as the next big innovation in payment and settlement system (PSS) across the globe. Transformation of currency has been taking place since ages but the swift movement with which the shift has taken from fiat to electronic to CBDC is unprecedented and visible within a single generation of humankind. With the rise in e-commerce coupled with convenience and utility, the acceptance of electronic(e) and mobile(m) money has increased; consequently, there is a fall in the use of cash.
The mobile(m) / electronic (e)-money adoption behavior was probably at its peak during the COVID pandemic when users refrained from physical cash and turned to m/e money, cryptocurrencies, and other forms of payments systems. This shift to an extent created some concerns for central banks world over. However, what was also later witnessed by countries that too much reliance on a particular country-based card system (payments processing) could be determinantal during unprecedented situations and how private players could be pulled into international conflicts, just as the world witnessed how these card networks froze their services in Russia during the recent Russia-Ukraine war. That was another trigger for expediting the launch of CBDCs.
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Initially, as a response to this shift, the Distributed Ledger Technology (DLT) based private cryptocurrencies like Bitcoin, Ethereum, XRP, USD Coin etc. emerged as an acceptable payment method in global marketplace. However, shortly national governments across the world came up with CBDCs, as a safe and acceptable alternative with attractive features like programmability, low barriers to adoption, remunerative nature (interest bearing), easy and low-cost cross border remittances etc.
CBDCs are optimistically seen a next generation asset backed currency of the digitalized world. Functionality wise, CBDCs are of two types – retail CBDCs (CBDC-R) and wholesale CBDCs (CBDC-W). This article focusses on CBDC-R. Retail ones deal with day-to-day transactions by users, whereas CBDC-W are used by banks for interbank transactions. CBDCs are just like physical currency notes in a digital form, where liability for liquidity risk or currency failure risk rests with the central bank. In addition to many other countries, prominently Europe, USA and China are in the process of launching full-fledged digital Euro, US Dollar, and Yuan. India on the other hand has already launched pilot versions of wholesale and retail CBDCs.
Adoption of CBDCs
The idea of CBDC is not new, it has been there for many years. An American economist and Noble laurate Prof. James Tobin were perhaps the first person to come up with an idea of CBDCs in 1980s. Thus far, four central banks in the world viz Jamaica, Nigeria, Bahamas, and Eastern Caribbean Central Bank (ECCB) have already launched retail CBDCs into their respective jurisdictions. As per a recently published European Central Bank paper, a survey response from 81 central banks representing more than 94% of global GDP said that they were engaged in CBDCs at some level, this also shows at least two-thirds of central banks are likely to launch CBDC in the short to medium term. Atlantic Council CBDC tracker gives an updated status of CBDCs related developments across world.
India’s Digital Rupee (e-INR)
Back home, on 7th October 2022, the Reserve Bank of India (RBI) released a concept note on CBDCs and later announced pilot launch of CBDCs. In its note, RBI has mentioned about three design considerations for the launch CBDC – Direct, Indirect and the Hybrid model with their salient features and act of balancing with commercial banks.
Following are the four broad policy objectives which central banks globally intend to achieve through CBDCs:
(1) Accelerating financial inclusion,
(2) Strengthening monetary policy,
(3) Ensuring financial stability and
(4.) Innovating payments and remittance market.
However, each country has its own priority areas to focus upon. Not all jurisdictions focus on all four broad areas with equal interest.
CBDC Debate and Open Questions
While proponents of CBDCs argue that it will play a significant role in aiding stability of financial system and help in smooth transmission of monetary policy, but academic literature and detailed learnings on effects of CBDCs on the financial ecosystem are still evolving. When it comes to the turn for implementation of CBDCs, there is no substitute for experience and in this context we share case of Equador.
In their paper titled as ‘Dinero Electrónico: The rise and fall of Ecuador’s central bank digital currency’ co-authors Arauz, Garratt and Ramos in 2020 have clearly explained in detail how the world’s very first Central Bank Electronic Money came into existence in 2014 and ended in 2018. Although there were many reasons for the same but the immediate and prominent reason was low uptake of digital currency by users and not so healthy interactions among various financial actors (banks), policy makers and the Central Bank of Equador. These are relevant learnings to review.
A section of academicians, theorists and policy analysts ask questions about adoption of CBDCs-R by end users, its impact on monetary policy, and the friction between commercial banks versus retail CBDCs – competitor or a collaborator?
- Changes in the Financial Sector Market Structure: If CBDC-R is remunerative (interest bearing), they may act as a closely perfect substitute for commercial bank money. This may lead to capital flight from commercial bank accounts to CBDCs. Won’t this unleash a ripple effect on credit market by mopping away low-cost retail liquidity from commercial banking system, thus increasing cost of capital for commercial banks?
- Remunerative CBDC -R are most likely to catalyze disintermediation. This would adversely impact intermediation function of commercial banks, thus ultimately influence monetary policy. CBDCs can influence monetary policy implementation and interest rate control by changing the supply of reserves in the banking system.
- On the contrary, if CBDC-R are unremunerative and there are associated costs to balance disintermediation, it may decelerate CBDC uptake, in such a case, it could be a costly failure, as has been seen in case of Ecuadorian digital currency. Critical success factors for successful update of CBDCs is that it must maximize private benefits and minimize associated costs for end users.
At present answers to all these questions are not very clear; yet Central banks world over probably out of some fear of missing out (FOMO) or in a digital exuberance intend to roll-out the currency innovation in a competitive manner in the shortest possible time.
On the face of it, the idea of CBDC looks an impressive one, smart, and futuristic. In case of the direct model (tier one) the liability lies with the central bank of a country. A CBDC-R will offer customers a direct access to digital currency backed by the central bank. At present, merely commercial banks can have this kind of relationship with a central bank in the form of central bank reserves. Users hold bank notes and coins (fiat currency) issued by central bank, distributed by commercial banks in physical form. When account holders hold electronically money into their bank accounts , those funds only represent a claim on the commercial bank which holds customer’s account, not on the central bank. With CBDCs comes direct liability on central bank unlike the commercial bank case, that’s a huge incentive for savers to switch to CBDCs should there be a fear of bank run in an economy.
Conclusion:
As a policy, India has followed an omni-channel, omni-tech approach in accessing payments and financial inclusion services through commercial banks, payment apps , mobile-wallets etc. through platforms like Unified Payments Interface (UPI) , Immediate Payments System (IMPS) etc.
With probably one of the best digital payment ecosystems in the world with real-time transaction facilities like IMPS and UPI along with online settlement options like RTGS, does India really need an alternative payments system in the form of CBDC at this very juncture? Or should it further enhance capability and uptake of existing payments systems and wait for more learnings from other CBDC installations?
From Public policy stand point, decision to issue CBDC-R is an executive one and initial directions have already been issued by India’s finance minister during her budget speech in 2022. In this context and the broader background discussed in this article, the role of RBI becomes immensely important not just in launching CBDC pilots but also in educating policy makers about multiple dimensions including readiness and robustness of Indian universal and neo-banks to handle a situation which might arise once central bank launches especially full-fledged CBDC-R. Readiness and maturity of the banking system to absorb savings flight ,effect and ability to raise wholesale collection would be crucial to keep credit market balanced. At the same time it would be useful to evaluate short term effects and long term impacts on non-banks , fintech lenders and microfinance institutions which borrow heavily from commercial banks.
Should it decide to launch direct or tier one CBDCs with its existing mandate and responsibilities? Would RBI alone be able to manage issuance and back-end transactions related to CBDCs and universally available acceptance infrastructure for CBDCs in the field? This is probably a long haul and might need a lot of education among customers , merchants and other stakeholders, not just in promoting retail CBDCs but also educating users adequately about digital frauds and data privacy concerns. These are some of the considerations which make CBDCs not an easy choice for any central bank.
