With the central bank ready to begin the process of introducing an official digital currency, seasoned financial advisor Shivanand Pandit evaluates the checks and balances needed to secure the process
TThe legality of cryptocurrencies in India remains unclear, but the Reserve Bank of India (RBI) is working on a “phased implementation strategy” for a central bank digital currency (CBDC). Four years after the recommendation of an inter-ministerial committee to issue fiat money in digital form, the RBI has signaled that preliminary plans to determine the feasibility will be initiated shortly.
The central bank’s deputy governor, Rabi Sankar, has mentioned that the RBI is working towards a step-by-step execution plan for its own digital currency and is about to roll it out in wholesale and retail. He said that central banks have increased their awareness of digital currencies and their introduction is supported by the state, which will help reduce the use of cash in the economy and reduce the risks to the public from the use of private currencies.
Sankar also said the RBI is studying its use with little or no disruption to the Indian banking and tax system. He has argued that legal changes are inevitable as contemporary provisions regarding currencies in physical form have been made under the Reserve Bank of India Act. He said significant changes were also needed within the Coin Act, the Foreign Exchange Administration Act (FEMA) and the Information Technology Act.
Sankar said that cryptocurrencies like Bitcoin certainly don’t fit the RBI’s definition of “currency”. This has been the main reason that the RBI, along with other central banks around the world, is considering CBDCs as a replacement for the volatile crypto-asset in the conventional economy, as the CBDC limits the damage and is not subject to the volatility of market instabilities.
Recognize risks
In 2017, the Ministry of Finance set up a high-level inter-ministerial committee to review virtual currency issues and recommend an action plan. The committee’s report for 2019 focused on numerous risks related to private parties and decentralized virtual currencies, including volatility risks, lack of regulation, technology-related risks – particularly phishing and ponzi schemes – illegal and criminal uses such as terrorist financing and money laundering, and exposure to the Energy resources of a country due to scarcity and processing requirements.
The committee report proposed the introduction of a CBDC as well as the criminalization of incidents related to cryptocurrencies. The creation of a law banning proposed cryptocurrencies is also included in this committee report.
The government has always believed that a digital currency would only be accepted in India if it was issued and controlled by the sovereign. A CBDC is intended to be a form of digital currency issued by the RBI and approved as legal tender by the central government. It is assumed that it is safe, effective and permanently valuable, rather than erratic changes in value like the private cryptocurrencies.
A CBDC is basically legal tender issued by a country’s central bank. It has similar functional capabilities to a fiat currency and is considered to be transferable with that fiat currency in a one-to-one form. The only major difference is the digital form it takes. Private crypto assets like Bitcoin and Ethereum have no legal issuers and cannot be judged as money or currency, while the CBDC can be considered as money or currency.
The CBDC is the equivalent of any other currency issued by a central bank – an independent currency, but it is issued in electronic form and reflects that type of currency as the currency in circulation on the central bank’s balance sheet.
India needs a digital rupee
The significant boom in private cryptocurrencies has scared central banks around the world and advocated official digital currencies. Many chief central banks have started experimenting with a digital currency. The eastern Caribbean islands – which share a central bank – including Grenada and St. Kitts and Nevis, have already launched their own versions. The US Federal Reserve and the Bank of England are exploring the possibilities, while China, which has already been involved in test missions for the digital renminbi, is planning a major roll-out soon. According to a study by the Bank for International Settlements (BIS), 86% of central banks worldwide are investigating and researching CBDCs, 60% are currently experimenting with them and 14% of central banks are in the first test phase with CBDCs.
There is no doubt that India wants a digital rupee. A CBDC can make all four functions of central banks in payment transactions more efficient. These four tasks are providing cash, providing final payment, providing liquidity to ensure smooth settlement, and providing systematic integrity and efficiency.
The introduction of a CBDC will drastically reduce the costs of printing, transporting and storing paper money. Executing with a CBDC would be an instant process and the need for interbank settlement would disappear as central bank accountability would be transferred from one person to another. The introduction of a CBDC could also speed up foreign trade transactions between nations.
A CBDC could enable an economical and timely globalization of payment methods. It enables an Indian exporter to pay their fees in real time with no intermediaries. In addition, the hurdles of dollar-rupee transactions, the time zone difference in such transactions, would almost disappear.
Go through the conversation carefully
Although the clarity given by the RBI on the introduction of a digital currency is to be welcomed, the highly anticipated law on cryptocurrency and regulation of the official digital currency has yet to be introduced in 2021. The central bank has to make important decisions about the design of the currency, such as the type of issuance, the level of secrecy, the type of technology to be used, and so on.
While the RBI is looking into whether the digital currency should be gross billing at the retail or wholesale level, the CBDC should be available for both wholesale and bulk payments. This will make a real difference. Even though China has proposed a hybrid model, the key question for RBI is whether the digital currency should be account-based or tokenized.
Deciding on the level of confidentiality is also quite a challenge. Some degree of secrecy can be built into the blockchain-centric pattern that recognizes transaction records. A CBDC could prevent private payment system providers from dominating transactional data through a self-reinforcing data loop, network externalities and activities, and thus attract more and more users.
The RBI should carefully weigh all the likely impacts of an official digital currency on people, monetary policy and the banking system. There are also other major threats that need to be considered, including those arising from cybercrime. More importantly, many laws need to be changed to make the digital rupee a reality.
The RBI should also consider other issues, such as whether CBDCs should be issued through a distributed ledger that is synchronized between the RBI and the scheduled banks, or whether a centralized ledger is managed by the RBI. Should each CBDC be validated and identified by a unique serial number or token, or how else would the validation be done? Should the distribution only take place via the RBI or via banks? And how will authorities take CBDCs into account in the money supply?
A CBDC can weigh on traditional banking by reducing the volume of deposits. It cannot be an interest-bearing instrument, as physical debt securities are not, and can have inferences about commercial banking. Bank loans are covered by deposit volume, and if a CBDC prevails, many people can turn away from deposits. This will reduce the availability of cash for bank loans and depress net interest margins, which can affect investment and growth.
Also, since CBDCs allow instant withdrawals, there is a likelihood that depositors will do so immediately in the event of reports of a troubled bank. The RBI should deal with such incidents with tact.
In conclusion, India has done remarkably well in digital payments in recent years. Interestingly, they have grown at a cumulative annual rate of 55% over the past five years. Nonetheless, the digital rupee will be something completely different.
Setting up a digital currency requires careful calibration and a knowledgeable approach to execution. Drawing board discussions and stakeholder consultations are important. Regardless of all the obstacles associated with the adoption of the digital rupee, the answer to the title of the Deputy Governor’s speech – Central Bank Digital Currency: Is This the Future of Money? – is a resounding yes.
Shivanand Pandit is an independent finance and tax advisor with 25 years of experience in finance, accounting, tax law, asset management, auditing, corporate and banking law. He can be reached at: [email protected]
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