explained | RBI’s concept note on introduction of CBDC

the story So Far: Earlier in October, the Reserve Bank of India (RBI) issued a concept note enumerating the objectives, options, benefits and risks of issuing Central Bank Digital Currency (CBDC), or e₹ (Digital Rupee) in India. The central government notified necessary amendments to the Reserve Bank of India Act, 1934 in March, paving the way for a pilot program and subsequent issuance of CBDCs.

Broadly speaking, in addition to promoting financial inclusion and reducing the operating costs associated with managing physical cash, E₹ will attempt to tackle a “fast growing cryptocurrency”, which the regulator has said on several occasions as “decentralized finance”. could enter and disrupt the traditional financial system”.

What is CBDC? What purpose will it serve?

The apex regulator defines CBDC as legal tender issued by a central bank in digital form. It would be similar to sovereign paper currency – albeit digital. Furthermore, E ₹ will be accepted as a legal tender and will act as a medium of payment and a safe store of value and will move from competitive ‘mining’ of cryptocurrencies to an algorithm-based process. The other features mentioned will give it more utility than a crypto-asset.

It will appear as a liability on the balance sheet of the central bank. Key reasons for exploring a use case for CBDCs include promoting financial inclusion, reducing the costs associated with managing physical cash, and introducing more flexible and innovative payment systems. More importantly, it will provide the general public with an alternative to unregulated cryptocurrencies and the risks associated with them.

E₹ can be converted into any commercial bank money or cash. It will be a convertible legal tender for which holders do not have to have a bank account – hence, strengthening the cause of financial inclusion.

What is the prevailing perception about CBDCs outside India?

According to Washington think tank Atlantic Council, 105 countries representing 95% of global GDP are exploring CBDCs. Indeed, the International Monetary Fund (IMF) says that the Asia-Pacific region is at the forefront of introducing digital currencies. According to the IMF, countries such as Bangladesh and Maldives, which have not done much research and development on CBDC adoption, are interested and learning from their peers.

The rationale for introducing a CBDC varies from country to country. However, the interest of most national regulators stems from the increase in crypto uptake seen in 2020-21. Thus, regulators now try to be more careful in dealing with volatility resulting from periods of ‘crypto-busts’ and ‘crypto-winters’, or depressed crypto prices.

The Bahamas and Nigeria were the first countries to launch their own CBDCs.

Launched in October 2020, the ‘Bahamian Sand Dollar’ is an example for financial inclusion. Its primary purpose was to serve the unbanked and underbanked population of its over thirty inhabited islands. Similarly, the East Caribbean Central Bank, which is the central regulator for Anguilla, Antigua and Barbuda, Commonwealth of Dominica, Grenada, Montserrat, St. Kitts and Nevis and St. Vincent and the Grenadines, became the first currency consortium central bank to have a CBDC.

Paper currencies need to travel physically and require some logistics to be accessible to people. For these distant island nations, a CBDC as a currency will ensure broad geographic coverage. With certainly fewer logistical challenges than paper currency.

Senegal and Ecuador, on the other hand, have opted to launch CBDCs.

It is not just small countries that are exploring CBDCs. As the IMF pointed out, 19 G20 countries are also exploring the possibility. Separately, sitting on some significant technological advances will help Asian countries dip into their CBDCs. For example, China’s CBDC project was launched in 2014, with Singapore and Hong Kong SARs entering the frame in 2016 and 2017.

What are the Different Forms of CBDC?

Based on their uses and functions, CBDCs are classified into retail (CBDC-R) and wholesale (CBDC-W).

CBDC-R Retail is meant for consumption and can be availed by all, including the private sector, non-financial consumers and businesses. On the other hand, CBDC-W Interbank transfer and wholesale transactions by financial institutions.

CBDC-R can be particularly useful for regulators to ensure financial inclusion. Being digitally based, it can strengthen the payment mechanism. On the other hand, CBDC-W can help improve the efficiency of interbank payments or securities settlement, as seen in Project Jasper, a CBDC project in Canada, as well as Project Ubin – a CBDC project in Singapore.

Now coming to the question of access; In other words- how the asset will flow in the supply chain. There are two suggested model types: token based system And this account-based system,

The former will come into circulation like a banknote and can be transferred electronically from one entity to another. Token ownership is first-verified – the owner of E ₹ is treated as its owner by default, just like banknotes. Only the authenticity of the token is to be verified.

In contrast, an account-based system would require the payer to verify that he has the right to use the account and that he has a sufficient balance to transact – similar to existing digital transaction methods. This requires maintaining a record of the balances and transactions of all holders of the CBDC and indicating the ownership of the monetary balance.

What would the ‘supply chain’ be like?

The distribution models already illustrated can potentially be integrated into single-tier or double-tier models.

As the name suggests, in direct cbdc The central bank manages the entire supply chain from issuing CBDCs to maintaining accounts and verifying transactions. Its server is included in all payments.

The double-tier model adds an intermediary (or a service provider) role to the supply chain. This supply chain is further classified into two, namely the indirect model and the hybrid model.

indirect model Covers consumers maintaining an account/wallet with a bank, or service provider. The onus for providing CBDC to retail customers rests with the service provider, not the central bank. The latter will only be involved in ensuring that the wholesale balance is the same as the retail balance of its retail customers; In other words, checking whether CBDCs being offered to retail customers are identical to those allotted to intermediaries.

Conversely, while the intermediary handles retail payments hybrid modelThe central bank provides the CBDC directly through intermediaries. In other words, the central bank as well as the intermediaries maintain the ledger of all transactions and manage the payments. The regulator will operate a backup technical infrastructure, allowing it to restart the payment system if intermediaries run into bankruptcy or technical outages.

Which models does RBI consider suitable?

RBI considers the indirect model more suitable for India, the central bank creates and issues tokens to authorized entities called Token Service Providers (TSPs). These TSPs will then distribute the tokens to the end users who conduct retail transactions.

The regulator recognizes that it cannot have a comparative and competitive advantage over banks in distribution, account keeping and customer verification. This is especially so in an environment where technology is changing rapidly.

In addition, it considers CBDC-W suitable for account-based transactions and CBDC-R for token-based transactions. The issuance of CBDC-R in a token-based system will help the regulator achieve its financial inclusion goals. Additionally, CBDC-W in an account-based system with a well-established legal position will facilitate instant settlement as transactions will take place from verified accounts.

Does the concept note point to some challenges?

The concept note highlighted some of the concerns related to data collection and anonymity, cyber security, dispute resolution and accountability.

Regarding concerns regarding data collection and anonymity, the top regulator noted that a possibility emerges that anonymous digital currencies will facilitate a shadow economy and illegal transactions. Regulators need insight to identify suspicious transactions, such as those related to money laundering and terrorism financing, among others. Addressing this concern, the IMF recommends establishing a specific threshold (say $10,000) for regulatory oversight.

The apex regulator believes that the potential for payment-related fraud has increased in countries with low financial literacy levels. It added that the ecosystem will be a “high-value target” as it is important to maintain public trust. Thus ensuring financial literacy and cyber security becomes very important.

The CBDC will also need infrastructure to facilitate offline transactions. The risk of ‘double spend’ increases when operations are offline. This is because the CBDC unit can potentially be used more than once, requiring an internet connection to update the ledger. However, RBI believes that this can be mitigated to a great extent by introducing technical solutions and limits on offline transactions. It acknowledges the importance of scaling up offline capabilities for widespread use, pointing to only 825 million out of a total population of 1.40 billion using the Internet in India.

RBI will also explore the possibility of cross-border payments using CBDCs. In a related context, the IMF has observed that fragmented international efforts to create CBDCs can result in inter-operability challenges and cross-border security risks. “Countries are clearly focused on domestic use, with little consideration for cross-border regulation, interoperability and standard-setting,” it said.

And lastly, the financial implications will be difficult to ascertain, given that potential demand will be subject to the implementation framework. However, the RBI highlights two broad concerns in the event of a financial crisis. There could be either a potential ‘bank run’, in other words, people withdrawing their money from banks faster, or a financial intermediation that would lead banks to rely on more expensive and less stable sources of funding.

The change from cash to CBDC can only be a transition from one asset to another and cannot affect the balance sheet of the banking sector. Similarly, according to the RBI, switching from deposits to CBDCs will shrink the balance sheet similar to withdrawal of banknotes from an ATM or branch.

However, if a bank’s reserves fall short of its ability to meet supervisory liquidity measures, the central regulatory bank may need to inject some liquidity.