Central Bank Digital Currency (CBDC)

Context: Fourth edition of the G20 TechSprint, a global technology competition to promote innovative solutions for improving cross-border payments is jointly organised by the RBI and the Bank for International Settlements’ BIS Innovation Hub (BISIH). 

What is a Central Bank Digital Currency (CBDC)?

• Digital currency backed by the central bank of a country. Just like currency notes issued by the Central Bank, the CDBC is a legal tender and accepted for the payment of various transactions within a country. 
• It is akin to sovereign paper currency but takes a different form, exchangeable at par with the existing currency and shall be accepted as a medium of payment, legal tender and a safe store of value. CBDCs would appear as liability on a central bank’s balance sheet. That is, a central bank liability, denominated in an existing unit of account, which serves both as a medium of exchange and a store of value.
• It is substantially not different from banknotes, but being digital it is likely to be easier, faster and cheaper. It also has all the transactional benefits of other forms of digital money.
• CBDC, being a sovereign currency, holds unique advantages of central bank money viz. trust, safety, liquidity, settlement finality and integrity.

Features of CBDC

• CBDC is sovereign currency issued by Central Banks in alignment with their monetary policy
• It appears as a liability on the central bank’s balance sheet
• Must be accepted as a medium of payment, legal tender, and a safe store of value by all citizens, enterprises, and government agencies.
• Freely convertible against commercial bank money and cash
• Fungible legal tender for which holders need not have a bank account
• Expected to lower the cost of issuance of money and transactions

Types of CBDC

• Retail CBDC: CBDC that can be used for people for day-to-day transactions.
• Wholesale CBDC: CBDC that can be used only by financial institutions such as Banks, NBFCs etc.

Legal Framework For Issuance of CBDC

• Finance Act 2022 has amended the RBI Act, enabling it to introduce Central Bank Digital Currency. The definition of bank note was amended wherein RBI was allowed to issue both physical and digital currency by amending Section 2 of RBI Act, 1934.

Possible Designs of CBDC

• Direct Model: In case of Direct model, the Central Bank issues CBDC and enables customers to directly open accounts with itself. So, in this case, the Central Bank engages with the public for opening accounts, facilitating payments through CBDC etc. 
• Indirect/Two-tiered model: In this case, the Central Bank issues CBDC and customers would maintain with the Central Bank. But it would not directly engage with the customers. It would outsource activities such as opening accounts, facilitating payments etc. to other Banks.

Benefits of CBDC

Subhash Chandra Garg Committee (2019) has recommended a ban on private cryptocurrencies on account of concerns such as volatility, instability, security risk and risk of funding illegal activities. However, the committee has highlighted that an official digital currency can have number of advantages such as:

• Promote cashless economy by reducing Cash-to-GDP ratio. 
• Increase in Financial Inclusion
• Stability and Resilience of payment system since CBDC would promote competition in the payment system and ensures that no single company dominates the payment ecosystem
• Counter the Stable coins such as Diem which could be used for making payments.
• Increase in effectiveness of Monetary Policy
• Push to development of Fintech sector
• Provide a real time picture of economic activity and hence better GDP estimates and efficient monetary policy formulation.
• Traceability of transactions would crack down on corruption and money laundering.
• As it being a sovereign currency, ensures settlement finality and thus reduces settlement risk in the financial system. 
• CBDCs could also potentially enable a more real-time, cost-effective seamless integration of cross border payment systems. 
• The e₹ system will bolster India’s digital economy, cashless economy, enhance financial inclusion, and make the monetary and payment systems more efficient.
• Could ease current frictions in cross-border payments.
• Counter the monopoly of private sector issued cryptocurrencies.

Challenges and Concerns

• Potential Disintermediation of Banks as people may shift from depositing money in the bank to CBDC. This will lower the deposits with the banks which will force them to increase their deposit rates to attract customers. It may lead to an increase in the rate of interest on loans in the economy.
• Accelerate Bank runs: By providing depositors a safe and liquid alternative to bank deposits, CBDCs may accelerate bank runs during a period of financial stress.
• Security risks and financial system abuses: CBDC may be susceptible to cyber-attacks and other security breaches. Such attacks or breaches may be committed to misuse the CBDC for illicit activities.
• Competition to private payment service providers: Introduction of CBDC could lead to direct competition with private payment providers (such as Paytm, Google pay etc). This may reduce their incentives to invest in innovation.
• Higher Burden on the RBI: If the RBI adopts “Direct Model”, it will have to directly engage with the public for opening accounts and hence overall burden on the RBI could increase. This may in turn lead to neglect of its core activities.
• Reputation risk: Security breaches on the CBDC may dent public confidence in the RBI.
• Data privacy issues: Traceability feature of CBDC would have impact on Right to Privacy of the Individuals. Hence, the need for strong data regulation law in India.