Money either has intrinsic value or represents title to commodities that have intrinsic value or title to other debt instruments. In modern economies, currency is a form of money that is issued exclusively by the sovereign (or a central bank as its representative) and is legal tender. Paper currency is a representative money, and it is essentially a debt instrument, means a liability of the issuing central bank (and sovereign) and an asset of the holding public.
Irrespective of the form of money, in any economy, money performs three primary functions – medium of exchange, a unit of account and a store of value. Money as a medium of exchange may be used for any transactions wherein goods or services are purchased or sold. Money as a unit of account can be used to value goods or services and express it in monetary terms. Money can also be stored or conserved for future purposes.
Reserve Bank of India defines CBDC as the legal tender issued by a central bank in a digital form. It is the same as a sovereign currency and is exchangeable one-to-one at par (1:1) with the fiat currency. While money in digital form is predominant in India—for example in bank accounts recorded as book entries on commercial bank ledgers—a CBDC would differ from existing digital money available to the public because a CBDC would be a liability of the Reserve Bank, and not of a commercial bank.
A CBDC is the legal tender issued by a central bank in a digital form which is the same as a fiat currency and is exchangeable one-to-one with the fiat currency. Only its form is different.
CBDC is a digital or virtual currency but it is not comparable to the private virtual currencies that have mushroomed over the last decade. Private virtual currencies sit at substantial odds to the historical concept of money. They are not commodities or claims on commodities as they have no intrinsic value; some claims that they are akin to gold clearly seem opportunistic. Usually, certainly for the most popular ones now, they do not represent any person’s debt or liabilities. There is no ISSUER. They are not money (certainly not CURRENCY).
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.
The adoption of CBDC has been justified for the following reasons:-
- Central banks, faced with dwindling usage of paper currency, seek to popularize a more acceptable electronic form of currency (like Sweden);
- Jurisdictions with significant physical cash usage seeking to make issuance more efficient (like Denmark, Germany, or Japan or even the US);
- Central banks seek to meet the public’s need for digital currencies, manifested in the increasing use of private virtual currencies, and thereby avoid the more damaging consequences of such private currencies.
In addition, CBDCs have some clear advantages over other digital payments systems – payments using CBDCs are final and thus reduce settlement risk in the financial system. Thus, a UPI system where CBDC is transacted instead of bank balances, as if cash is handed over – the need for interbank settlement disappears.
CBDCs would also potentially enable a more real-time and cost-effective globalization of payment systems. It is possible for an Indian importer to pay its American exporter on a real time basis in digital Dollars, without the need of an intermediary. This transaction would be final, as if cash dollars are handed over, and would not even require that the US Federal Reserve system is open for settlement. Time zone difference would no longer matter in currency settlements – there would be no ‘Herstatt’ risk.
India’s high currency to GDP ratio holds out another benefit of CBDCs. Cash usage can be replaced significantly by CBDCs, and as a result the cost of printing, transporting, storing and distributing currency can be reduced significantly.
With the plethora of private virtual currencies (VCs), these VCs might gain recognition, and may cause national currencies with limited convertibility to come under threat. While the freely convertible currencies like the US Dollar may not be adversely affected as most of these VCs are denominated in US Dollar. CBDC could provide the public with uses that any private VC can provide and might retain public preference for the Rupee. Besides, it could also protect the public from the abnormal level of volatility caused by some of these private VCs.
Impact of CBDC on the Banking System
- CBDCs can cause a reduction in the transaction demand for bank deposits. Since transactions in CBDCs reduce settlement risk as well, they reduce the liquidity needs for settlement of transactions (such as intra-day liquidity). As a genuinely risk-free alternative to bank deposits, these could cause a shift away from bank deposits which in turn might reduce the need for government guarantees on deposits.
- If banks begin to lose deposits over time, their ability for credit creation gets constrained. Besides, as banks lose significant volume of low-cost transaction deposits their interest margin might come under stress leading to an increase in cost of credit. Thus, to minimise the costs of disintermediation it is important to design and implement CBDC in a way that makes the demand for CBDC, vis‑à‑vis bank deposits, manageable.
- Availability of CBDC makes it easy for depositors to withdraw balances if there is stress on any bank. Flight of deposits can be much faster compared to cash withdrawal. As such the banks would be motivated to hold a larger level of liquidity which could result in lower returns for commercial banks.
- CBDCs are currency and therefore do not pay interest, as such their impact on bank deposits may actually be limited.
Type of CBDC to be issued
CBDC can be classified into two broad types viz. general purpose or retail (CBDC-R) and wholesale (CBDC-W). Retail CBDC would be potentially available for use by all viz. private sector, non-financial consumers and businesses while wholesale CBDC is designed for restricted access to select financial institutions. While, Wholesale CBDC is intended for the settlement of inter-bank transfers and related wholesale transactions, Retail CBDC is an electronic version of cash primarily meant for retail transactions.
It is believed that Retail CBDC can provide access to safe money for payment and settlement as it is a direct liability of the Central Bank. Wholesale CBDC has the potential to transform the settlement systems for financial transactions and make them more efficient and secure. Going by the potential offered by each of them, there may be merit in introducing both CBDC-W and CBDC-R.
CBDC, being a sovereign currency, holds unique advantages of central bank money viz. trust, safety, liquidity, settlement finality and integrity. The key motivations for exploring the issuance of CBDC in India among others include reduction in operational costs involved in physical cash management, fostering financial inclusion, bringing resilience, efficiency, and innovation in payments system, adding efficiency to the settlement system, boosting innovation in cross-border payments space and providing public with uses that any private virtual currencies can provide, without the associated risks. The use of offline feature in CBDC would also be beneficial in remote locations and offer availability and resilience benefits when electrical power or mobile network is not available.
Model for issuance and management of CBDC
There are two models for issuance and management of CBDCs viz. Direct model (Single Tier model) and Indirect model (Two-Tier model). A Direct model would be the one where the central bank is responsible for managing all aspects of the CBDC system viz. issuance, account-keeping and transaction verification.
In an Indirect model, central bank and other intermediaries (banks and any other service providers), each play their respective role. In this model central bank issues CBDC to consumers indirectly through intermediaries and any claim by consumers is managed by the intermediary as the central bank only handles wholesale payments to intermediaries.
The Indirect model is akin to the current physical currency management system wherein banks manage activities like distribution of notes to public, account-keeping, adherence of requirement related to know-your-customer (KYC) and anti-money laundering and countering the terrorism of financing (AML/CFT) checks, transaction verification etc.
Forms of CBDC
CBDC can be structured as ‘token-based’ or ‘account-based’. A token-based CBDC is a bearer-instrument like banknotes, meaning whosoever holds the tokens at a given point in time would be presumed to own them. In contrast, an account-based system would require maintenance of record of balances and transactions of all holders of the CBDC and indicate the ownership of the monetary balances. Also, in a token-based CBDC, the person receiving a token will verify that his ownership of the token is genuine, whereas in an account-based CBDC, an intermediary verifies the identity of an account holder. Considering the features offered by both the forms of CBDCs, a token-based CBDC is viewed as a preferred mode for CBDC-R as it would be closer to physical cash, while account-based CBDC may be considered for CBDC-W.
Degree of Anonymity
For CBDC to play the role as a medium of exchange, it needs to incorporate all the features that physical currency represents including anonymity, universality, and finality. Ensuring anonymity for a digital currency particularly represents a challenge, as all digital transactions would leave some trail. Clearly, the degree of anonymity would be a key design decision for any CBDC. In this regard, reasonable anonymity for small value transactions akin to anonymity associated with physical cash may be a desirable option for CBDC-R.
Distinguishing e-Rupi from UPI
- e-Rupi is a currency in digital form enabling digital transactions, whereas UPI is a platform through which transactions happen digitally.
- UPI is a payment platform, where one can use debit or credit card, net-banking, mobile wallet etc. to make the payment, while e Rupi is like spending physical money in the digital form, using one’s mobile phone.
- The bank acts as an intermediary in every UPI transaction. In UPI app, the bank account is debited and money is sent to the bank of the recipient. User can withdraw the amount from the bank in paper money, retain it in your wallet, and use it to make a purchase at a store. In case of CBDC, the virtual money is drawn and retained in the wallet. When a payment is made at a store or remitted to someone else, the money is transferred from user’s wallet to their wallet. The bank does not route payments or act as a middleman and no settlement takes place unlike UPI payment. Thus, e-Rupi is operated and settled by the RBI and does not entail any individual handlers, as is the case of UPI transactions where account settlement takes place at the individual bank’s level..
- Transactions in digital rupee may offer the same anonymity as cash transactions. Banks shall not report low-value transactions made through the digital rupee. Once the e-Rupi is transferred to customer wallets, banks will not track or report these transactions. Currently, cash transactions above Rs. 50,000 require customers to disclose their permanent account number. While no limit has been set for digital rupee transactions for now, it is believed that retail transactions up to Rs 50,000 will not be reported. Transactions in excess of Rs 2 lakh will however have to be reported for tax purposes.
- Depending upon the banks and user platforms, the UPI handle or ID varies. Even linking two different platforms with the same bank account may generate different UPI IDs. Whereas, in the case of e-Rupi, the digital rupee is operated by RBI and would have a single User Public Key.
- e-rupi will allow offline transactions which can be carried out even on a feature phones, promoting its adoption in rural and remote areas as well. A e-rupi voucher will be shared with the beneficiary through an SMS or QR code which will enable its use in rural and remote areas as well where internet connectivity can be a problem.
Pilot project on CBDC
The RBI has launched its pilot project on the digital rupee on 1st November 2022, to use central bank digital currency (CBDC) in the wholesale market for secondary trade in government securities. Nine banks, namely SBI, HDFC, Kotak Mahindra, Bank of Baroda, Union Bank of India, ICICI Bank, Yes Bank, IDFC First bank and HSBC are participating in this pilot project.
As per RBI, this pilot project is expected to make the interbank market more efficient. Settlement in central bank money would reduce transaction costs by pre-empting the need for settlement guarantee infrastructure or for collateral to mitigate settlement risk”. Other wholesale transactions and cross-border payments will be the focus of future pilots, based on the learnings from this one.
Some key issues under examination are –
- The scope of CBDCs – whether they should be used in retail payments or also in wholesale payments;
- The underlying technology – whether it should be a distributed ledger or a centralized ledger, for instance, and whether the choice of technology should vary according to use cases;
- The validation mechanism – whether token based or account based,
- Distribution architecture – whether direct issuance by the RBI or through banks;
- The degree of anonymity etc.
The second pilot project for retail participation in the central bank digital currency (CBDC) commenced on December 1, in four cities and with four banks. The pilot project will cover select locations in a closed user group (CUG) comprising of participating customers and merchants. Digital rupee for the retail segment would be in the form of a digital token that represents legal tender, issued in the same denominations in which paper currency and coins are currently issued. The token will be distributed through the intermediary banks.
Users will be able to transact with e₹-R through a digital wallet offered by the participating banks and stored on mobile phones/devices. Transactions can be both person-to-person (P2P) and person-to-merchant (P2M).
Payments to merchants can be made using QR codes displayed at merchant locations. The e₹-R would offer features of physical cash like trust, safety and settlement finality.
Wholesale CBDC (e₹-W) and Retail CBDC (e₹-R)
- Wholesale CBDC is applicable to financial institutions that hold reserve deposits with a central bank – it includes institutions which can lend money and make cross-border payments. In case of cross-border agreements, the central bank acts as a counterparty.
- In contrast, the digital currency issued to the general public is known as Retail CBDC. RBI has said that it plans on introducing retail CBDC within a month in specific localities among closed user groups made of customers and merchants.
Currently, the banks have a rupee account and a bond account with the RBI. Under the pilot project, they will be opening an additional CBDC account which will be connected to RBI’s CBDC node/server. The banks can then transfer CBDCs to their CBDC accounts in exchange for cash. Thereafter, sales or purchases of bonds can be done between CBDC accounts through the CCIL platform without any intermediaries.
The pilot project will firmly put India on the list of countries who are in advanced stages of having their own digital currency. It will make the following changes in how banks operate in relation to the central bank and to each other:
- Currently, interbank transfers are made through the CCIL and settled through net settlement (i.e. at the end of the period, CCIL gives the figure of the amount of money to be paid/received by the bank for the overall quantum of transactions). However, with the CBDC, banks will transfer currency directly and thus, gross settlement will take place.
- Currently it takes one day under the T+1 system for money to be transferred. But under the CBDC regime, money can be transferred almost immediately between banks. The facility will most likely be available round-the clock throughout the year.