Central Bank Digital Currency: A Step towards digital age
What is CBDC?
Before doing a deep dive into the complexities of the topic, lets first try to understand what it really is.
A Central Bank Digital Currency (CBDC) is a digital form of central bank money, which is legal tender created and backed by a central bank that represents a claim against the central bank and not against a commercial bank or a Payment Service Provider (PSP). CBDC is actually a digital token, similar to cryptocurrency but issued by a central bank of a country and pegged to the value of the fiat currency of that country. In other words, CBDC represents claims against the central banks just like banknotes do. So the inventory of CBDC is fully governed by the central bank. The central bank also determines the business constraints for CBDC and acts towards the acceptance across the financial architecture of the given country.
The Idea
There are a several phenomenons that acted as catalysts and in turn initiated the thought process. Firstly, the overwhelming rise of cryptocurrency has shown that it is technically feasible to create digital means of payments separate from the traditional payment systems. Although, the conventional systems are widely being used but the sudden rise in adoption of digital solutions at the advent of COVID-19 triggered governments and central banks to explore possibilities for a govt. backed digital currency. Secondly, the big techs are rapidly showing interest into the payment markets which puts central banks in a very tricky situation and questions their role in the payments domain. Thirdly, the increasing Gen Z, Gen Y consumers who are tech savvy individuals, are fast moving away from cash and usually prefer digital cashless transaction offerings. There are other reasons as well. Central authorities want to promote financial inclusion by providing easy and safer access to money for unbanked and underbanked population. In that process, increasing transaction fairness, improve efficiency & transparency and lowering transaction cost are areas where central banks put tremendous amount of focus in their fiscal policy.
As a result, central banks across the globe have put their foot on the accelerator to analyze the potential of CBDC and maybe research on its ROI at a very low level. The image below talks about the overall statistics (as of May 2022) on how countries are moving towards CBDC solution.
The Complex Rationale
Today’s world is running on a dual monetary system involving privately-issued money — by banks , payment providers — built upon a foundation of publicly-issued money — by central banks — generally in the form of banknotes.
Confidence in private means of payment is determined by our ability to convert private money into safe public money simply because the public money is guaranteed by the state with its strength and credibility. Other types of money is a liability and their evaluation is based on the reliability of the issuer but moreover the one-to-one convertibility with the central bank money. In short, the option to redemption to central bank currency is essential for stability, interoperability, innovation and diversity of the private money.
So now, the question is eminent. Will the digital currencies issued by central banks be so enticing that they overshadow privately-issued money? Or will they still allow for private sector innovation? I think only time has the answer.
However, certain group of experts in the financial community are advocating in support of CBDC. They argue that everything looks perfectly alright until the mechanism to convert private money is being questioned. This would eventually undermine the singleness of central currency and impair the entire payment system while citing the free banking era of 19th century when bank issued notes often traded at variable prices in the absence of a sovereign currency promoting instability and risks across.
Use Cases of CBDC
CBDCs can be classified into two broad categories — i) Retail and ii) Wholesale. While a retail CBDC refers to a digital version of cash, a wholesale CBDC refers to a new infrastructure for inter-bank settlements. Central banks that have been trialing CBDC have been focusing especially on fast, low-cost payments.
Retail: Retail CBDC is used for payments between individuals and businesses or other individuals, akin to digital bank notes. The daily volume of retail CBDC is usually greater than 100,000,000 transactions.
Wholesale: Wholesale CBDC is used to facilitate inter-bank settlement, i.e., payments between the few banks and other entities that have accounts at the central bank. The daily volume of wholesale CBDC is usually less than 100,000 transactions.
The Benefits of CBDC
Expensive payment settlement to decreasing use of banknotes and lack of banking access for citizens — there are a several challenges in the current infrastructure. CBDC largely addresses these inefficiencies to provide a robust and reliable platform.
- Increase availability. Digital currency can be distributed through mobile devices and for obvious reasons, has a far reaching capability to attract a people who are far away from physical banking.
- Streamline reconciliation. CBDC is digital in nature and hence it does not require daily, weekly or monthly reconciliation processes which are overly time consuming.
- Foster competition. CBDC platform encourages new firms to join the mainstream in the payments sector by eliminating entry barriers and promotes healthy competition.
- Reduced counter-party risk. CBDC mitigates credit risk in cross-border payments by enabling payment-versus-payment settlement for transfers in different countries.
- Control monetary policy. CBDC platform provides central bank the direct influence over the money supply. So the tax control measures can be done in simple steps.
India Chapter
While the numerous benefits of CBDC is evident but still there are outstanding questions on how India could realize the most of this initiative. As per RBI, CBDC is not going to replace any existing payment system and it is being introduced for more inclusion driven approach, certain areas are still unclear and how already existing govt. policies like Jan Dhan Yojna will shape in future. Is there any thought process behind? While UPI draws a lot of attention from even developed economies, how UPI is going to co-exist with CBDC or will they be part of exclusive business paths that also is unanswered.
Nevertheless, even though CBDC has several offerings but in a country like India where we already have significant progress towards payment system and already policies in pipeline as BAU for years to come, it seems like CBDC will not make much of an impact right away. However, amid the rising innovation in the digitization journey across sectors and businesses there could be opportunities hidden under the carpet waiting to be discovered.
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