anshul gupta

anshul gupta

30-10-2022

03:00

RBI is planning to launch its own digital currency. How does it work and why is it important? What is a CBDC?

If you have noticed any currency note, each currency note is basically a promise by the RBI to pay whoever is the bearer of the note, sum of ₹x. It is legal tender i.e. can be used to pay for any transaction in India.

Each currency note is essentially a claim on the RBI (your asset, RBI’s liability). CBDC (Central Bank Digital Currency) has this same claim in digital form. It is legal tender, a medium of payment and a store of value.

It has all these properties of the ₹ but simply exists in digital form (e₹). You can exchange this digital rupee (e₹) for regular currency (₹) at a rate of 1:1.

Then what is the point? Why are we bothering with this? There are multiple reasons on how CBDC can be helpful for the Indian economy.

1. After Russia’s invasion of Ukraine, there were multiple sanctions placed on Russia - Russian participants were removed from SWIFT, dollar payments network, etc. Purchase of Russian debt was also restricted which cuts Russia off from the financial markets.

Russia had built up over $600 billion worth of reserves held in gold, dollars, and other currencies. Half of these reserves were frozen by the USA, UK and the EU under these sanctions. A significant chunk of our own reserves ($ and gold) are held overseas.

This creates a very uncomfortable situation where if some country like China or even India does something that the West does not approve of, the financial system can collapse. CBDC offers an alternative to western payment systems.

Cryptocurrencies have proven that it is possible to create a system which can’t be blocked off easily. CBDC can be used to create a system where Central banks, commercial banks and international companies can interact with each other without interference.

Why not just use cryptocurrencies? Cryptocurrency, unlike CBDC, does not come with any underlying claim to any asset. Its value is based on public perception. The value fluctuates every second which makes it unsuitable as a store of value.

And given how it can be used to carry out illegal transactions, and multiple instances of fraud, a currency with backing of a central bank like RBI is much safer. e₹ can also be exchanged for ₹.

2. Since this currency is programmable, end-use of CBDC can also be fixed and it can be a great way to distribute subsidies. E.g. If the government issues a fertiliser subsidy, it can ensure that money is only used to purchase fertiliser.

3. Conditional payments can be another game-changer. In this, the payment settlement only happens when certain conditions are met. E.g. Once the supplier sends the goods, invoice payment happens automatically after 90 days.

Why CBDC when there is UPI? 4. When you deposit your money with a bank, your cash which was a liability of the RBI becomes a liability of the bank on which it pays some small interest. UPI makes use of this balance held with banks.

Even though deposits upto 5 lakhs are insured, there is a chance that the bank might default or delay in paying your money. CBDC carries lower risks since you directly deal with the Central Bank and it doesn't require an intermediary to settle transactions.

Central bank money is the only asset in a domestic economy without credit and liquidity risk. Cash and now CBDC meet this criteria.

Being a unique asset, there can also be other use cases like CBDC being directly convertible into RBI/government bonds. It can also act as a backup protocol if UPI fails. There are many possibilities..

So how will this work? Will it be like cash? Compared to bank balances, cash has 1 more advantage - anonymity. Still a lot of transactions happen in cash because cash doesn't leave a digital trail and provides anonymity.

It is hard to say if CBDC will have the same anonymity but if it aims to replace cash it should have some. It is difficult to accomplish this in a digital currency since all digital transactions would leave some trail.

And it should not be possible to carry out illegal transactions on the network. So there might be some distinction there - higher degree of anonymity for small transactions, less for large value transactions.

Another point of discussion is should these CBDC pay interest to bearers? RBI believes that if these pay interest, many people would shift their balances to CBDC and banks would struggle to raise deposits. Deposit rates would increase, banks margins would shrink.

Banks would ultimately pass these costs to consumers. RBI wants to avoid this disruption. CBDC should complement the existing financial system. Not to mention, due to the money multiplier, even low amounts of liquidity leaving can cause serious issues.

However some nominal interest can be paid or there might be very little adoption if there is no incentive. And in case of crisis (slowdown or hyperinflation), these can be used as tools of pushing monetary policy by directly changing rates for customers.

Will this be built on the blockchain like cryptocurrencies? RBI has clarified that CBDC can be built on a centrally controlled database or on Distributed Ledger Technology (DLT). But due to how “mining” works, DLT is energy intensive and works best in small jurisdictions.

The number of transactions that can take place on the network would also be limited. Take bitcoin for example. Even after all the energy that is consumed by the network, theoretically only 867,000 transactions can take place in a day.

That means even if ~931 banks settle their balances in bitcoin with each other at the end of day, this limit would be exhausted. Compare this to the 6.78 billion transactions that took place on UPI in September alone (~226 million daily).

There are many open points regarding the design, but the need for CBDC is real and the potential for a country like India is huge. What are your thoughts on CBDC?



Follow us on Twitter

to be informed of the latest developments and updates!


You can easily use to @tivitikothread bot for create more readable thread!
Donate 💲

You can keep this app free of charge by supporting 😊

for server charges...