Our thoughts on the way forward for CBDC

It was announced in the budget that the RBI would launch a CBDC (Central Bank Digital Currency). 

What is a CBDC?

CBDC is an electronic form of a country's Fiat currency. Holding CBDC would be like holding currency notes in a digital form instead of a physical form. It represents a claim on the central bank i.e. it is a liability for the central bank.

How is it different/similar to Cryptocurrencies?

While the underlying technology is similar (i.e. blockchain), there are several differences, the most important being that, while cryptocurrencies are decentralized, CBDCs are centralized. While a CBDC would entail a claim on the central bank and are backed by Reserves, there are no assets backing Cryptocurrencies. 

While the actual launch could be months away, we explore various frameworks the RBI could possibly consider in introducing the CBDC and what would be the implications from an economic and policy-making standpoint. 

What are the frameworks RBI can consider for launching a CBDC?

The RBI could adopt one of three architectures for rolling out the CBDC i.e. direct, indirect, or hybrid. 

One can think of the direct architecture as hard cash being replaced by CBDC and being kept in wallets at the central bank. The holder would have a direct claim on the central bank. The central bank would have direct access to the data for each and every cash transaction. 

An indirect CBDC framework would be very similar to the two-tier architecture we have now (i.e. comprising of the RBI and commercial banks). The RBI would issue CBDCs to the banks who would, in turn, roll it out to customers. The customers would have a claim on the bank and not on the RBI. One can think of it as having a savings/current account with the bank and another cash account/wallet.  

A hybrid framework would be one where the central bank appoints intermediaries (different from banks) who provide only the technical support to set up and maintain the architecture. The transaction data is captured by them and relayed to the central bank periodically. The customer however has a direct claim on the RBI. Such a framework would reduce the operational burden on the central bank. 

In all of the above frameworks, there would be a distinction between a deposit and cash like there is even today. The difference would be that there would exist a record for every cash transaction, unlike today.

What would be the advantages of having a digital currency?

This advantage of having a digital currency and access to data of all cash transactions would be that it would bring about greater transparency, reduce tax evasion, make administering direct transfers more efficient (reduce leakages on account of corruption), enhance security (prevent theft), help clampdown on counterfeiting, terrorism financing, and money laundering. Since all data is centrally stored, ensuring that the technology and process are secure is of utmost importance to prevent cyberattacks.  

Eliminating the anonymity associated with cash transactions may itself reduce the incentive to hold cash. A drop in currency with the public would have major implications for the financial system and from the standpoint of implementation of monetary policy. 

Let us consider an extreme situation: One in which all of the currency with the public enters the banking system. If the currency in circulation goes down, banking system liquidity would increase. There would be downward pressure on rates. Asset prices would inflate. To curb this the RBI may have to perhaps hike the CRR or introduce another facility to mop up liquidity. Otherwise, it could be staring at a liquidity trap where monetary policy becomes impotent on account of hitting the Zero Lower Bound (Technically, the money multiplier would increase as the Currency to Deposit ratio decreases)

A move towards a more cashless ecosystem would weigh on the informal sector which would be compelled to integrate with the formal sector. Given that the rural economy is still largely cash-driven, penetration of technology and change in mindset would be important factors in the transition. Holding cash in a wallet introduced by RBI would inspire greater confidence compared to a wallet managed by a private company and could facilitate the transition. A sudden transition could impart a shock to the rural economy and therefore the transition is likely to progress in an extremely calibrated manner. The RBI would be encouraged by the success of UPI. The RBI would likely conduct pilot projects and assess the response. In the longer run, a transition towards a more digital economy would certainly increase productivity and enhance security.

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