Crypto and CBDC are not the same thing

Cryptocurrencies will be discouraged through taxation and capital gains provisions. This was the message of the Finance Minister during the budget discussion in Parliament. Will it slow down the growing use of crypto in India? Russian kleptocrats are using crypto to evade sanctions. Ukraine has been a center of crypto trading due to its lax regulations and is using them to raise funds for its war with Russia.

In February, the Governor of the Reserve Bank of India highlighted two things. Firstly, “Private cryptocurrencies are a major threat to our financial and macroeconomic stability”. Second, “there is no underlying (property) in these cryptocurrencies … not even a tulip”. Soon after, an RBI deputy governor called crypto worse than a Ponzi scheme and argued against “legalizing” them. Nevertheless, the RBI announced that it would issue a Central Bank Digital Currency (CBDC). How do we understand all this? The Supreme Court of India has also asked the government whether cryptocurrencies are legal or not.

The governor who called crypto as cryptocurrency has inadvertently identified them as currency. Clearly, RBI’s statements indicate growing concern as the proliferation of crypto threatens the RBI’s place in the financial system of the economy. This threat stems from the decentralized character of crypto based on blockchain technology that cannot be regulated by central banks and which enables enterprising private entities (such as Satoshi Nakamoto who introduced bitcoin in 2009) to float crypto that can provide assets and assets. Can act as money.

Cryptos that operate through the net can be banned only if all nations come together. Nevertheless, tax havens may allow crypto to function, defying global agreement. They have been facilitating the flight and illegality of capital despite pressure from powerful nations. The genie is out of the bottle. The total valuation of crypto was recently above $2 trillion – more than the value of gold held globally.

as crypto currency

A CBDC will not solve the RBI problem as it can only be a fiat currency, not crypto. However, cryptos can act as money. This difference needs to be understood.

Currency is a token used in market transactions. Historically, commodities (such as copper coins) have been used as tokens because they are valuable in themselves. But paper currency is useless until the government declares it as fiat currency. Only then does everyone accept it at the price printed on it.

Therefore, the value of paper currency is derived from the support of the state. Cryptos are a string of numbers in a computer program and are even more useless. And, there is no state support. So, how do they become acceptable as tokens for exchange? Well their acceptability enables them to act as money. Paintings with low use value tend to have higher valuations as the wealthy tend to agree. It is the same for crypto.

Bitcoin, the most prominent crypto, is designed to be expensive. Its total number is limited to 21 million and production requires progressively more and more computer power and energy (called mining, as for gold). As the cost of making bitcoin has increased, so has its price. This has led to speculative investment which pushes the price higher and attracts more investors. Hence, since 2009, despite the wildly fluctuating prices, they have given high returns making speculation a success.

Opposite of Tulip Frenzy

The RBI governor’s statement that crypto has no underlying asset, not even tulips, refers to a time when tulip prices rose dramatically before falling. But, tulips cannot be used as tokens whereas cryptos can be used through internet. Furthermore, the supply of tulips can rapidly increase as their price increases when the number of bitcoins is limited.

So, receive crypto value and can be transacted through the net. This enables them to act as money. True, bitcoin is difficult to use, but there are other simpler cryptos available.

The varying degrees of difficulties inherent in crypto are related to the problem of ‘double spending’. Fiat currency is an asset that, once spent, cannot be used again through counterfeiting, as it is not with the spender. But, the software on the computer can be used over and over again.

Blockchain and encryption have solved the problem by creating protocols like ‘Proof of Work’ and ‘Proof of Stake’. They enable the use of crypto for transactions. While the first protocol is difficult, the second is simpler but is prone to hacking and fraud. Today, thousands of different types of crypto exist; Cryptos like bitcoin, alt coins and stable coins.

CBDC, as opposed to crypto

Blockchain enables decentralization. That is, everyone has their own point of view on the crypto platform. But, the central banks would not like that. Furthermore, they want a fiat currency to be issued and controlled exclusively by them. But, theoretically everyone can ‘mine’ and create crypto. Therefore, for a CBDC to be under central control, solving the problem of ‘double spend’ and having a crypto (not just a digital version of the currency) seems impossible.

A centralized CBDC would require the RBI to validate every transaction – something it currently does not do. Once a currency note is issued, RBI does not monitor its use in transactions. Keeping track would be extremely complex which could render cryptos like CBDCs unusable until new secure protocols are created. No wonder, Kristalina Georgieva, managing director of the International Monetary Fund, said earlier this year: “All told, about 100 countries are exploring CBDCs at one level or another. Some research, some testing, and some earlier We have already been distributing CBDCs to the public… As you might expect, the IMF is deeply involved in this issue, including providing technical support to a number of members.”

Therefore, CBDCs may not currently be a substitute for cryptos that will soon start being used as money. This will have an impact on the functioning of central banks and commercial banks. Furthermore, banning crypto requires global coordination, which seems unlikely. Ms Georgieva has said, “The history of money is entering a new chapter”. RBI needs to heed this caution and not be defensive.

Arun Kumar is the Malcolm Adisheya Chair Professor, Institute of Social Sciences and author of ‘Indian Economy’s Greatest Crisis: Impact of the Coronavirus and the Road Ahead’, 2020.