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The Path to India’s Central Bank Digital Currency

The Path to India’s Central Bank Digital Currency

India is set to welcome its own digital currency in the near future. What are the building blocks of the Reserve Bank of India's Central Bank Digital Currency and what will the path to a CBDC look like?

What are the building blocks of the Reserve Bank of India's Central Bank Digital Currency? What are the building blocks of the Reserve Bank of India's Central Bank Digital Currency?

What if the government could transfer subsidies directly to beneficiaries, and no, we aren’t talking about direct benefit transfer (DBT). Say food subsidy was credited directly to the beneficiary’s mobile wallet and could only be used to buy pre-defined rations. This could soon be a reality with a central bank digital currency, or CBDC.

India has set a deadline of 2023 to launch its digital currency. A CBDC will be legal tender like paper currency with all the characteristics of the existing fiat currency. “Digital currency will lead to a more efficient and cheaper currency management system,” Finance Minister Nirmala Sitharaman said in her Budget speech for 2022-23.

A CBDC has other benefits. Now, account holders deposit their money in commercial banks. A customer’s deposit carries the liability of the bank to repay it on demand. The Reserve Bank of India (RBI) is under no obligation to compensate or reimburse any loss of value. But CBDC is supposed to be a central bank liability.

Why are central bankers so interested in cryptos? It’s because they sense likely collateral damage in terms of losing control over monetary policy thanks to the interest in such currencies among the young. “Cryptos are raising concerns on two fronts—monetary stability and financial stability. The RBI is more concerned about the monetary stability part,” says Subhash Chandra Garg, former finance secretary. “Cryptos might enable money laundering and getting around capital controls—essentially a digital hawala channel. During periods of financial stress, this might amplify market volatility,” says Saugata Bhattacharya, Senior VP & Chief Economist, Axis Bank.

Globally, players are ready with the technology to use crypto as a form of payment to buy goods and services. US-based crypto exchange Coinbase allows merchants to accept cryptos. Online payment solutions provider PayPal has an option for customers to pay with cryptos at checkout. Global card network player Mastercard also supports the instant settlement of cryptos. “Unlike other asset classes like equity, debt or gold, cryptos are very easily transferable digitally,” says Arpit Agrawal, Co-founder & Chief Engineering Officer, Cion Digital, a fintech solutions provider. Soon, there will be payment mechanisms where a person holding cryptos as investment can directly pay a merchant, he adds. “The merchant will have the option to immediately sell the cryptos or keep it as savings or investment.” Then there are stablecoins, which are fast emerging as the ideal way for merchants to accept crypto payments as they are pegged to a fiat currency with no fluctuation in value. Many apps allow for the conversion of crypto to stablecoins.

What has put cryptos on central banks’ radars are its growing numbers. In just five years, the total market cap of cryptos has touched a high of $3 trillion. For context, India has a GDP of around $2.7 trillion, while the BSE’s market cap is about $3.5 trillion. Cryptos, which have no boundaries, have the potential to make a significant impact on an emerging economy like India. “Private cryptocurrencies which have currency-like characteristics will jeopardise the RBI’s ability to deal with issues of financial stability,” RBI Governor Shaktikanta Das said recently, while reminding the public that these currencies have no underlying asset.

That brings us to another important point. The current currency circulation in the market is backed by physical money, while CBDC will have no such linkages. Simply put, every bit of electronic money that people use for day-to-day purposes today is backed by physical cash. Krishnamurthy Subramanian, former chief economic advisor, says that it is unlikely that CBDC will be a very large part of the broad money (bank money or deposits) in the economy. He explains that the CBDC will be part of narrow money (existing physical currency). He adds that CBDC won’t offer any interest rate. “It should be similar to the existing physical currency where you don’t earn interest,” says Subramanian.

Currently, cryptocurrencies are traded online without any central authority or regulated exchange monitoring it; the investors, too, are anonymous. But now, any transaction involving crypto or virtual asset will be taxed at 30 per cent. “But knowing how the world of blockchain and crypto works, they are going to bypass that,” says a player. For instance, if you have a non-custodial wallet (akin to cash), with complete control over the blockchain keys, you can send money from your wallet A to another non-custodial wallet B in your name or somebody else’s name, and nobody would be able to track it, says an expert. “The government is also aware of it and will do whatever it can to prevent it,” says the expert.

T he rbi has been researching CBDCs for the past two years. Sources say it is using the work done by the Bank of England as a test bed. In the past four years, blockchain (the technology on which cryptos are based) has proved that one can build transparent financial systems on top of it. “The technology has been proven to be versatile and it’s safe and secure, so large-scale financial systems can be built,” says Snehal Fulzele, Founder & CEO, Cion Digital. Agrees George Sam, Co-founder & Business Head, Mindgate Solutions, a fintech solutions provider. “I think from a CBDC perspective, blockchain will be the backbone for a digital currency.”

Currently, Bitcoin and Ethereum are on permissionless or public blockchains, where users can download a crypto wallet and carry out transactions without disclosing their identity. “It’s unlikely that any country will sign up for fully public blockchain as the foundation of a CBDC,” says Swapnil Pawar, Founder of financial advisory ASQI. Sources suggest that the RBI is likely to work on a “permissioned blockchain”, where the central bank and distribution partners like banks would be participants, and users (the merchants and public at large) could join the network after disclosing their identity via KYC.

Earlier, the RBI had said that a decision on whether CBDC would be issued directly by it or through commercial banks had to be weighed carefully. “When you do retail CBDC directly... It’s almost like you’re bypassing the banking system,” says Fulzele. In the US, the central bank is likely to go through existing banking channels, as is China. “This is a better system as the banks and other payment players have the infrastructure to undertake KYC,” says a banker. But in Eastern Caribbean nations, central banks have launched CBDCs directly. “The RBI doesn’t need a large network for the digital distribution of money as required in physical currency,” says Rajnish Kumar, former chairman, State Bank of India.

The RBI will also have to choose between account-based- or token-based modules. “The account-based module is easy to develop, whereas the token-based module takes longer time. Which model will be tested first will be decided in due course,” RBI Deputy Governor T. Rabi Sankar said recently. Account-based CBDCs work like a regular deposit accounts. For instance, UPI is an account-based module. Digital tokens, on the other hand, have to be issued by a central bank to distributing banks. There is no need to verify one’s identity and these tokens can change hands freely for P2P payments. “The token-based modules require ecosystem-wise adoption... This will be the eventual end goal for frictionless payments,” says Mindgate’s Sam.

There is an added benefit of introducing something like a CBDC. Whenever the government initiates innovation at a fundamental level, an entire ecosystem develops around it, like it happened in the case of UPI. “Currently, there are 12 digital nodes involved in the digital system of UPI. CBDC will be much faster,” adds Kumar. “CBDC could probably be the infrastructure that will solve the underwriting and credit issues [of digital payments] because of a transparent transaction record,” says Abhinav Sinha, Co-founder, Eko, a financial solutions provider.

Experts say that the CBDC will provide a tool for the government to manage the economy. “When you issue a retail CBDC in India, by definition, what that means is that every individual will have a wallet with the RBI,” says Fulzele. This means it will be possible to know how and where people are using the currency. “As the risk of intermediaries and their reconciliation process is minimal [on blockchain], the associated risk of settlement goes away,” adds Sam. And reduced cash and chain tracking will result in more money being available for the economy, says Vinshu Gupta, Founder and Director of Nonceblox, a blockchain firm.

The launch of a CBDC will involve significant investment, technology and a huge amount of focus, say experts. “I don’t think the RBI would want to own all of these pieces... they would work with multiple consortiums of technology providers,” says a banker. “There will be a huge amount of integration, a huge amount of surround capabilities, which will have to fall in place. The payment service providers will have to be enabled,” adds Harish Prasad, Head of Banking-India, FIS, a fintech solutions provider. According to Sam, the RBI will need partners “to create a CBDC system, manage it and continuously evolve, because there will be a lot of use cases”. Nonceblox’s Gupta says India could learn from the experience of the Bahamas, which launched the world’s first CBDC two years ago. The RBI has said that it is necessary to adopt basic models initially for the CBDC and test them comprehensively so that it has minimal impact on monetary policy and the banking system. “This is necessary because of the CBDC’s dynamic impact on macroeconomic policymaking,” it said in its ‘Report on Trend and Progress of Banking in India 2020-21’. “Most of the fintech players and banks will have to upgrade their systems to some degree to accommodate digital currency. Today, if you look at it fundamentally, banks and a lot of fintechs don’t work on blockchain,” says Eko’s Sinha. “The entire technology stack has to change to process currency transactions on a blockchain network. CBDC will fundamentally change most of the payments systems that are running in the country now,” says Fulzele.

Unlike in the West where corporates borrow funds in the bond market, the Indian credit system is dominated by banks. Under the CBDC regime, there is a possibility of bank deposits shifting to the RBI. “Any shift in deposits may impact the banks’ ability to dole out credit,” says Madan Sabnavis, Chief Economist at Bank of Baroda. “The RBI might choose to transfer some or all of these back to banks, using appropriate rules of allocation, including auctioning the funds,” says Axis Bank’s Bhattacharya. While CBDC will be aimed at reducing cash in the system, it is easier said than done. “Despite demonetisation and digital banking, the cash in the system is back,” says Sabnavis.

While more details about CBDC are yet to emerge, one thing is clear: a wide cross-section of the population is waiting with bated breath for India’s crypto.