Central Bank Digital Currency

FEB 28

Mains   > Economic Development   >   Indian Economy and issues   >   Digital technology

IN NEWS:

  • In the 2022-23 Budget, Finance Minister Nirmala Sitharaman had announced the introduction of India’s Central Bank Digital Currency (CBDC).

DIGITAL CURRENCY:

  • Digital Currency is the digital format of fiat currency. It is sovereign currency in an electronic form and will appear as liability (currency in circulation) on a central bank’s balance sheet.
  • It is backed by an authority, like the Reserve Bank of India, and can be used as a medium of exchange, store of value, standard of deferred payment and exchanged for physical currency.
  • The CBDC will be held in a digital wallet that is supervised by the Central bank. In India, it will be the RBI that supervises the digital rupee although it may delegate some power to banks.
  • RBI’s digital currency will not directly replace demand deposits held in banks. Physical cash will continue to be used by banks, and people who wish to withdraw cash from banks can still do so.

Prelims Bits:

  • The Bahamas launched the world’s first CBDC in October 2020 called the Sand Dollar.
  • China introduced the e-CNY, the digital form of the Chinese yuan, at the Winter Olympics in Beijing.

DIGITAL CURRENCY Vs CRYPTOCURRENCY:

Cryptocurrency is a decentralized digital currency transferred directly between peers and the transactions are confirmed in a public ledger – which is accessible to all the users. Technically, they are pieces of code created by ‘mining’ that are managed through a digital ledger called as blockchain. There are several differences between digital currency and cryptocurrency:

  • Centralisation:
    • In case of digital currency, control lies with the Central bank, like the Reserve Bank in India. But cryptocurrency follows a decentralized procedure and its value is independent of central banking control.
  • Encryption:
    • Cryptocurrencies rely on a blockchain and are stored in ‘wallets’ that offer a much higher degree of cyber security. However, Digital currencies are essentially e-cash that does not need necessarily need blockchain technology for storage and processing.
  • Transparency:
    • Every detail regarding cryptocurrency transactions is in the public domain thanks to the presence of a decentralised ledger that records all the blockchain details. With digital currency, only the banking authorities along with the sender and receiver are involved in the transaction involved.
  • Stability:
    • Due to their sovereign backing and wider acceptance, digital currency is stable and relatively easy to manage. Cryptocurrency lacks the backing, which hampers its stability and creates large price volatility.
  • Legality:
    • For now, countries around the world are firm in backing their own fiat currencies. As for cryptocurrencies, some countries like China and Bangladesh, have banned its use while some like El Salvador permit its use as legal tender.

RATIONALE BEHIND DIGITAL CURRENCY:

  • Advantages over paper currency:
    • Demonetisation and UPI based payment systems have reduced the usage of paper currency. Also, the cost of issuing digital currencies is far lower than the cost of printing and distributing physical cash. Hence, a CBDC can become a more acceptable electronic form of currency.
  • Financial inclusion:
    • RBI’s annual Financial Inclusion Index for the financial year ended March 2021 was 53.9, indicating that India has a long way to go in ensuring universal financial inclusion.
    • CBDCs can establish a more direct connection between consumers and central banks, thus eliminating the need of expensive infrastructure to bring financial access to the unbanked population.
  • Reduce transaction time:
    • CBDC will eliminate the need for interbank settlement. Also, payments using CBDCs are final and thus reduce settlement risk in the financial system.
  • Reduce transaction cost:
    • Cross-border payments suffer from transaction delays, multiple fees and several intermediaries resulting in high transaction cost. This can be lowered through CBDC, as it can be transferred peer-to-peer without going through the complex settlement system.
  • Meet public demand for digital currencies:
    • There is an increasing demand for digital currencies, like Bitcoin and Ethereum, in India. Central bank digital currencies are promised as reliable, sovereign-backed alternatives to private currencies which are volatile and unregulated.
  • Eliminate leakages:
    • Unlike physical cash, which is hard to trace, a digital currency can be more easily tracked and controlled by the Central bank. This has the potential to help reduce black money and terror financing. Also, programmable/targeted payments can be made through CBDC, which can reduce leakages in subsidies.
  • Becoming common across the world:
    • Several countries, including the United States and China, have been working towards issuing their own CBDC in recent years. India need its own CBDC or else would it stands to lose in the digital sphere of geopolitics.

CONCERNS:

  • Security:
    • CBDC ecosystems is at similar risk for cyber-attacks as the current payment systems are exposed to. Also, in countries with lower financial literacy levels like India, CBDC related frauds may also increase.
  • Privacy concerns:
    • CBDCs would require some amount of intrusion by authorities to monitor for financial crimes. However, this stands in violation of an individual’s privacy.
  • Technical glitches:
    • Recently, a digital currency that is being used by seven Carribean nations experienced glitches that have kept it offline for more than a month. The occurrence of such glitches can affect the financial security of the country.
  • Fear of bank run:
    • Since CBDC can provide a risk-free alternative to bank deposits, people may begin withdrawing their bank deposits and convert it into digital cash. This disintermediation of banks can potentially affect their ability of credit creation.
  • Impact on monetary policy:
    • CBDCs may bring about a change in the behaviour of the holding public. The nature of change this would bring on the effectiveness of monetary policy cannot be gauged a priori given that no central bank has launched CBDC.
  • Digital divide:
    • Based on National Sample Survey data, only 38% of households in India are digitally literate (61 % in urban areas and 25% in rural areas). Also, India has a gender gap of 40.4 percent in internet usage, with only 15 percent of women accessing the internet versus 25 percent of men.
    • Introducing a system like CBDC into this population can result in many missing out on the benefits of CBDC or being exploited by middlemen.

WAY FORWARD:

The move to introduce a CBDC is a progressive step for India. The Reserve Bank had, in July 2021, indicated that it would soon begin work on the ‘phased implementation’ of the CBDC.

 However, the central bank needs to make necessary preparations to allow all stakeholders to effectively utilise the digital currencies. This can include:

  • Strong cyber security: Efforts to prevent system penetration and theft of assets and information are needed.
  • Data protection regime: The data protection bill needs to be passed to ensure a balance between individual rights and tracking to CBDCs.
  • Efforts to enhance financial literacy.
  • Cap the amount of money that an individual can hold as CBDCs, in order to prevent the mass withdrawal of deposits from banks.
  • Develop plans to inject fresh money into banks, if needed, to ensure that the ability of banks to create loans is not affected once the currency is introduced.

PRACTICE QUESTION:

Q. Discuss the rationale behind the introduction of Central Bank Digital Currency (CBDC)? Also mention the challenges associated with its introduction?