Currency Demonetization: Why it didn’t really work and why it was a missed opportunity
Note 1: This was written before NPCI launched a rebranded consumer version of UPI — Bharat interface for money (BHIM). BHIM tries to incorporate some suggestions mentioned below at the outset — but probably a little too late and looks likes a postmortem reaction for what could have been a catapulting moment. Nonetheless, a step in the right direction.
Note 2: This was meant to be published as a paper before I decided to convert into a blog post. The main objective was to highlight the inefficacy of currency demonetization , given the forces that were at play and also explore ways in which it could have been setup. In no way I am advocating any of the suggestions mentioned below.
Introduction
The current demonetization program of the GoI is creating an economic turbulence of unprecedented proportions. While the intent of the policy —
a) Removal of black money
b) Removal of counterfeit currency
c) Blocking terrorist funding
— is laudable, its efficacy in achieving any of its stated objectives is debatable.
Emerging technology like cryptocurrencies and alternate currency have been available in the market for a while now. Bitcoin, in particular, has been around for 7 years now and has shown the world how it might function without artificial geographical borders or federal currency. It has pulled in a core audience devising a clever mechanism to artificially create value to compensate for lack of its intrinsic value or the legitimacy to be backed by any institution or federal agency. As the network of such cryptocurrencies grow, existing models pave way to accommodate them — just the way you have Bitcoin exchanges like Forex exchanges.
These cryptocurrencies traditionally are adopted by developers in the early days. But over time, as the network grows and as fungibility of the cryptocurrency increases, it attracts varied participants — non miners in Bitcoin for instance. Some purely come into it as investment instruments by exchanging with legal banknotes — and reinforcing the viability of the network every time.
Why a secondary market could come into existence?
With the recent demonetization push in India, about Rs 14.5 lakh crore (plus about 3 lakh crore of illegal money) worth of 500 and 1000 rupee notes were annulled in a single night. While there are estimates in recovering about 94% into legal and taxable bracket, a significant portion of the black money is unlikely to feed back into the system due to questionable sources. This could be ripe for a secondary market to even transact at a discount with so much value being locked up. The value here is not anymore determined by the federal institution but rather as promissory notes amongst the network.
While there could be many siloed pockets of hawala markets (quite rampant already like in here, that we would not be talking about it here), technology like blockchain could possibly help enable a decentralized secondary market just like how the world has seen it with Bitcoin, Ether (of Ethereum), Lite coin and many more. These cryptocurrencies can emerge naturally due to economic compulsions and can both subvert the overarching goal of demonetisation program or mitigate its positive effects. Due to the decentralized property of the network there is nothing that could be done to prevent it. The network could keep transacting internally as long as the network bears fruit and realizes value by finding channels to fuse into the legal system. Described below is a framework that could theoretically work well at scale. At best it could be controlled by proactively removing loopholes where the black money could possibly be converted into legal money. It is also imperative for the government to follow up with measures quickly before giving a chance for a such a network to thrive and get subsumed into the legal network. Such an event would be catastrophic in comparison to the travails that the common man had to endure since the ban.
Even the originally targeted hoarders of black money, due to questionable sources and with the penalty being high (non-taxed cash) to be deposited in banks — and with no intention of throwing it away — there is an inherent compulsion to look for channels to give value to those otherwise valueless notes. People do not mind even a non-sophisticated hawala network even if it means to trade at a huge discount. With a concerted and scalable decentralized network as described below, the discounts are nominal as it works at scale and creates ready fungibility for both the participants as well for the network — unlike the siloed hawala chains.
How does it work — Concept Note
With a significant pool of demonetized notes left behind — with difficulty in converting into legal tender via normal banking channels, there is an inherent need to give them a value — not anymore by the federal bank but a notional value like any other commodity or even Bitcoin.
An alternate system could be created by backing every such demonetized tender(from physical asset) into the blockchain(as digital identity). As part of on-boarding process, the owner(s) of the network gives an identity to every such demonetized note at a cost — say each Rs. 500 demonetized note is worth ‘x’ bitcoins and each Rs. 1000 demonetized note is worth ‘y’ bitcoins. Leveraging the pseudo anonymity (no body controls it anyway) of blockchain network, the decentralized autonomous organization (DAO) owning the secondary network gets more and more bitcoins for every old note that comes into the network. Bitcoins are readily fungible into US dollars and we now have a system that could convert the demonetized notes into legitimate currency, completely subverting the demonetization process.
The idea here is that a decentralized model could work where in every such note participating in the network needs to be captured into the system properly and also kept track of the transactions as it gets exchanged within the network. This is important to make sure the non-participating notes don’t get fused into the system, since the health of the network is in making sure only recognized and digitally asserted demonetized notes participate in the system and where the inherent business model of the decentralized network is making sure only such captured demonetized notes are being owned and transacted — equivalent of mining or proof of work in a Bitcoin network.
While the contract of any transaction ends as soon as federal banknote exchange hands in the case of cash payments — due to its value guaranteed by the Reserve Bank of India — the decentralized(or permissioned) network takes the onus of making sure that any exchange of demonetized note is duly validated for its authenticity in the secondary market. The contract here consists of 2 parts:
Tokenization — Capturing demonetized notes in the network
Proof of work — Verifying transaction whenever notes are exchanged
Tokenization
This process gives a digital identity for every unique banknote. There could be simple mobile app client that helps register notes — by scanning and extracting the unique identifier of the note; or there could be nodal points (operated by DAO) to do the scanning in case there is possibility of uploading fake notes. One could expect people to do it on ad-hoc basis (not converting all at one go) as long as the network keeps functioning.
Proof of Work
When the actual transaction happens with the payer handing over the tokenized demonetized notes, the payee scans to capture the unique identifier of the notes. This process validates by querying the network to check for capturement of the tokenized notes. Any non-tokenized note is flagged right away to the payee.
Like in the bitcoin network where miners get some bitcoins for every successful block that they add to the blockchain, the DAO could incentivize the miners to receive some share of the DAO (or even actual bitcoin from DAO) for every validation that they do — giving an intrinsic drive for miners.
Parallel Currency at Scale
With the availability of a system as described above, the demonetized notes could function just as well as normal currency — only now that the DAO gives value instead of the federal bank. With stashed bundles of cash, participants would want to keep their value alive nonetheless. People who have evaded tax all along with a significant portion by volume of cash, would be the key promoters of this network. It wouldn’t be a mainstream channel but could certainly be a significant parallel currency mainly by function of stocked up notes — which is now demonetized and with no way to convert them into equivalent legal notes devoid of penalties, either monetarily or imprisonment or both. The DAO serves an lucrative channel with only a marginal discounted price compared to other options. The scale and frictionless experience only reinforces the network to grow and hit sustainability.
Solving problems for the common man
While the intentions are great for demonetization, it wouldn’t be wrong to claim that the government is not capitalizing the cash crunch(which is going to last a while) with the right tools, to nudge people to adopt digital modes of transactions and instead falling back to dependency of cash as before. If the bigger goal is to make India a less cash economy and eventually a cashless economy, this is a wasted opportunity to not equip the common man with streamlined adoption of digital means.
There is a clear need for all the people to transact and keep their lives going; and with constrained cash flows — the economy is taking a big hit. People are hoarding the little cash that they have restricting the money flow in the market. What if everyone had the tools to transact digitally, people would be willing to go beyond their inhibitions to adopt digital means with the cash crunch literally forcing them to look for alternate options.
While Aadhaar, Jan Dhan Yojana and UPI are brilliant solutions for the society at large and are already working in order, it is irresponsible for the government to be not capitalizing them at this juncture of demonetization.
With the need across the spectrum of people (from digital adopters; digitally equipped but not so incentivized folks to use digital modes; to even lesser privileged folks without digital tools) to transact and participate in the economy, it is disastrous to not provide a streamlined way to get them on-boarded into the digital framework.
People could have been brought to a state where anybody could be transacting just by knowing the phone number of other party. Imagine somebody being able to pay an auto rickshaw person at the end of the trip or paying a street food vendor, buying from the nearby kirana store who couldn’t afford a Point of Sale device, to even making the merchants to make digital payments to his/her suppliers. There couldn’t have been a better time to boost and create a snowballing effect for people to adopt the framework that is already available but was just simply not provided or pushed for the masses.
The common man would have hardly needed to go through the hardships and more importantly reducing the dependency on cash for his daily needs and installing the behavior shift to reach the cashless economy sooner than later. Instead, everyone is hoarding cash and falling back to cash. This demonetization process simply becomes a painful reset process for the common man and it is even more saddening when the loopholes to convert the black money are wide open and accessible by the same people who was meant to have been impacted.
Coupling cash crunch with demonetized note exchange process
Besides the solving problems for the common man to freely participate in the economy and possibly accelerating the digital adoption by people — from creating bank accounts to getting them signed up with UPI, there is an ubiquitous need for everyone from the rich to the lesser privileged folks to exchange their demonetized notes.
The case today is that a good portion of the demonetized notes are only getting converted into new banknotes and getting locked up again, particularly as far as the hoarders are concerned. Even if this is achieved at a discount it destroys the overarching goal of destroying those black money or at least getting them back into the economy. Only the common man ends up on the receiving end for an ineffective cause.
With the limited banks as trusted sources and acting as gatekeepers to convert the notes, it stifles and puts pressure on both the bankers and the people to get them converted. A more decentralized(permissioned blockchain though) and distributed trust solution as described below could possibly alleviate the travails for the common man significantly. And more importantly, the process also gets them equipped into a state to participate in the digital economy be default.
Permissioned Blockchain Network
With the need clearly established for people to convert their demonetized notes, it would be helpful in having more trusted touch points beyond what is available today (i.e limited bank branches). These are essentially trusted entities to make sure they do the following 3 things:
1. Convert your demonetized note into legal currency
2. Link your legal currency into bank accounts and/or banknotes(limited)
3. Collect old demonetized notes
The blockchain network decouples the above the components and empowers individuals or more trusted entities with decentralized trusted framework and it works in the following way
1. Authentication and Authorization
We have about 1 billion registered Aadhaar people in the country also having a digital biometric fingerprint linked with it. If there was a simple app in the play store where people could download freely, provide all the details to establish their identities with Aadhaar, fingerprints or IRIS scanner, etc — as part of the registration process to go about converting their demonetized notes; and if we get them on-boarded onto the Jan Dhan Yojana, UPI and India Stack simultaneously, they are ready to participate in the digital economy going forward. Once the identity is established and having gotten them to an end state where they could transact just with their phone numbers without any restrictions. A maid in city for the first time gets a bank account created and also registered with the UPI network. With the cash crunch her employee could pay her salary just knowing her phone number — and without having to know her net bank account details. Having enabled her, she could again use the same way in purchasing the groceries or food supplies and all without being dependent on cash. The cycle goes on and the network grows slowly driving change the behavior. This could be a momentous point to get traction with the above said initiatives accelerating into the future sooner.
2. Tokenizing Demonetized Notes
The mobile client connects to the blockchain network with the identity established above. The notes are scanned, the legitimacy of the note is established in capacity available on digital medium, unique identifier is captured from the image which is then fed into the network for proof of work. The first step in the proof of work matches up with a list of known identifiers printed by the federal reserve bank to prove its legitimacy. The network also makes sure there it is the first time the notes are being tokenized and prevents duplication so as to avoid double spending. Once the proof of work is complete, the digital equivalent is attached to the identity of the person (and therefore the bank account and therefore UPI) and is only a step away from being able to use those digital tenders. The digital money is now put on hold and completing the third step would help release it to be able to participate in the economy.
Leveraging the possibility of smartphones and play store distribution, a democratized solution is made available to the masses directly to convert their demonetized notes (even if it is a single note) into digital tenders and also enabling them to participate in the digital economy. For the people without smartphones, other people with could pitch in — like the employer getting the maid on-boarded — or even dedicated touch points for the same. It is to be noted that the trust here is drastically reduced here with the network doing the chunk of work and the touch points merely facilitating access to the network, something similar to how people got themselves registered with Aadhaar.
In the process, every physical demonetized note gets a digital footprint to be able to track down the cash supply in the market and also determine the percentage of notes that would not be recovered.
3. Capturing Demonetized Notes
It is important for the federal bank to retrieve the demonetized note and this completes the process of converting old notes and releasing digital money that was captured earlier. These need more trust bearing a physical aspect and have to be restricted to banks nonetheless. This is perfectly fine as still the workload is significantly reduced at scale, with merely needing to collect the notes and verifying the identity of the depositor from the decentralized network and unblocking their linked digital money. It is magnitude better again as the trust of the identity and tax implications are by default taken care by the network and the trust of the banks are restricted to collect the demonetized notes from the right person (the identity that they used while capturing those same notes).
With the money being released now, people could freely transact just using the phone numbers. People with smartphones have a better experience with the fingerprint and other metadata to the 2 factor authentication; while those with feature phone would have to work with USSD and SMS along with OTP for transaction. Nonetheless, every person would have gotten to a state where they have been enabled with the tools to transact digitally and obliterating the need for cash for most parts. Going forward, with all the people having been on-boarded into the different systems like JAM, UPI, etc, they would be in position to enjoy the benefits going forward and rapidly bringing efficiency in the way economy would work.
Setting up such touch-points even post demonetization date is quite a reasonable expectation and one that is quite scalable. Only the blockchain need to have been thought out well beforehand and that could have possibly been done as proof of concept internally prior to demonetisation insinuating for other needs.
Conclusion
The demonetisation process meant to target the black and counterfeit notes is turning into a short blip with the passage of time. It is a gross mistake to call it a success by alluding to short term reduction in the illegal/fake money transactions. With the loopholes wide open it eventually gets fused into the system. The demonetisation event becomes more questionable when the target group — constituting a mere 3% of the entire cash circulation — has the means to subvert the process by colluding with centralized agents (bank officials), while the common man seems to take the hit for no apparent reason.
From such a standpoint, a decentralized blockchain network helps achieve couple of things — a democratized framework for people to convert their demonetized notes into digital tenders while at the same time equipping them with the tools to freely participate in the economy without hardships. People also reduce their dependency on cash and are on-boarded into initiatives for future benefits.
Such a ready tool helps convert old notes and also ties up the digital tenders with the right identity, and the entire process gets a digital footprint to avoid subverting the system — with the distributed trust framework (between consumer, bank and the fed) not allowing centralized bank agents to game the system.
It would be gross mistake to miss such an opportune moment and more so, when the hardships faced by the common man doesn’t see the benefits while the hawala channels and secondary markets flourish in parallel. A permissioned blockchain network as described above could have be an ideal solution and one that could have been quickly executed post demonetization event had it been thought through beforehand. A holistic and momentous opportunity to accelerate into a better India is not being capitalized and lapses in closing the loopholes has only exacerbated the event all the more. Left the way they are, things go back to functioning with same old cash modalities and people continue to keep hoarding black money as they leverage secondary markets to replenish their value. These demonetization events are merely reduced to minor blips in the long run with only the common man having to endure the pain for most parts.
A well thought-out and a decentralized demonetizing process could have had so much more to offer for the country and lot more things could have been achieved in catapulting the society to adopt digital identity, digital transactions and even bringing in a behavior shift in feeding them to adopt digital assets — reducing corruption and intermediaries beyond the just the short term goals of removing black money.
With the status quo, where people simply default to new currency — the demonetizing announcement is turning into a mere event instead of kick-starting a process — and in that regard, it looks like a lost opportunity. If you happened to notice, the tone gradually started focusing on digital payments — which obviously would show growth with such a momentous event. A better question would be —’ Is this a Pyrrhic Victory?’
