CBDCs in India and the Role of Banks
Background of private digital currencies
In the last decade, cryptocurrencies have gained popularity exponentially. The price of bitcoin has increased by more than 300000000 times to a current price of about $28000, since its inception in 2009. This makes bitcoin and the overall cryptocurrency sector highly lucrative to invest in.
They are also by consequence among the most volatile asset class and their value is solely determined by their supply and demand in market.
What is the tech behind cryptocurrencies?
Cryptocurrencies are based on blockchain technologies which by design are very secure and allows transparency in transactions. Blockchain is basically a distributed ledger, where the database is maintained by a network of computers, rather than a central authority. Each block in the blockchain is a record of a set of transactions and are linked to the previous and the next block. Once a block is added, they cannot be altered or deleted, making them tamper proof. Bitcoin transactions are validated through a process which occur through solving complex mathematical problems requiring significant computational power. This kind of computation is done by individuals or organizations, called miners, who have the necessary hardware and software to carry out the calculations. As an incentive to carry out the computations, the miners are rewarded with bitcoins to those who are able to solve the problems first.
Problems/risks with private currencies
There are a lot of problems associated with using private digital currencies. Besides the mining process being very computationally expensive, an inherent problem being the highly volatile nature of their prices. As their prices are ascertained by market sentiment, they are not regulated in any way. Cryptocurrencies value are not tied to any good or commodity, hence the owners of cryptocurrencies have limited recourse in case the technology fails and are vulnerable to loss of funds and value. As these work without the intermediation of any financial institutions, they present a congenial medium for frauds, scams and money laundering activities, and a medium for criminals to siphon money off for illegal activities.
Call for CBDCs
In such a scenario, for a central Bank, a Central Bank Digital Currency (CBDC) is a solution to derive the advantages of a digital currency, while eliminating the risks of using private digital currencies. A CBDC will be the digital equivalent of the physical currency currently in use in an economy, with added advantages of enabling faster transactions, minimizing transaction costs, deter criminal activities, among a lot of others. One of the points to be addressed in the existing physical currencies is the costs associated with printing and circulating the physical notes, which are borne mainly by the general public, businesses, banks and the Central Bank. A pivotal role of CBDCs is boosting financial inclusion by bringing services and government schemes to the underbanked and unbanked.
Design factors of CBDCs
RBI has choices in this regard as to whether issue CBDCs directly to the general public as legal tenders or issue CBDCs to commercial banks who in turn distribute to their customers. The former is called the direct model, while the latter is called the intermediate model based on the role of middle financial institutions. RBI has decided to go forth with the intermediate model, with RBI issuing the CBDCs and the intermediaries responsible for catering to demand for CBDCs of their customers. Besides this, there are two types of CBDCs, namely CBDC-W for settling trades between financial institutions in financial markets & CBDC-R accessible to the public for retail transactions. In the chosen intermediate model, RBI will keep track of only CBDC-W for the financial intermediaries responsible for meeting the demand for CBDCs of the public and ensure that the wholesale balances are identical to the retail balances in circulation to the general public. There is also the choice of designing the CBDCs as interest bearing or not, and the RBI has decided to go with the non-interest bearing model as it would be closer to the current model of physical currency and also would be non-disruptive to the existing financial system. CBDCs can also be token-based or account based, where the former means the ownership of the currency lies with the owner of the token as opposed to account based where all transactions are exchanges between individual accounts. RBI has decided to use token-based approach for CBDC-R and account based for CBDC-W.
Role of Banks in the circulation of CBDCs
In the intermediate model, CBDCs are issued by RBI as legal tenders and responsibility for ensuring value lies with RBI itself, but distribution is done through intermediate financial institutions. This contrasts with some existing CBDCs like in Nigeria, where the CBDC is account based and issued directly by the central bank to the general public. In Indian context, the intermediate model is relevant due to the sheer volume of daily transactions, which would impose a huge computation load on RBI, if it were to follow a direct model.
Contingencies related to Banks’ role
As CBDC adoption increases and the public shifts from keeping money in the form of deposits, banks are consequently left with lower money to supply. This could have devastating effect on the economy as, in the big picture, people would have lesser access to credit.
For the banking ecosystem in general, the following is imminent:
· Increased competition among banks: CBDCs would ease the process of shifting accounts among banks, leading banks to innovate and offer better products to retain customers.
· Reduced account creation in relation to government schemes: currently government schemes applicable to the under-banked population requires the beneficiaries to create an account with the partner banks, like SBI, Bandhan bank, Grameen bank
· CBDCs will be a direct competitor to the existing digital payment modes like UPI, payment cards, NEFT, RTGS.
In spite of the above negative connotations for the banks with respect to the launch of CBDCs, RBI has to rely on the competencies of the commercial banks to reach out and cater to the demand of the public. In a country as huge as India, reaching out to the large population would require the capabilities and existing channels of the public banks.
The banks would be a party in the value chain rather than a competitor in an economy with CBDCs.
Conclusion
India, as a nation has unmet demands for financial services across a huge percentage of the population, as the unbanked population stands at 21% as of 2021. Due to infrastructural constraints, access to banks will remain an unmet need in the foreseeable future. In such a case a, CBDCs will provide a channel to propel basic financial inclusion for the unbanked population. Banks will have to tailor financial products targeted at the underserved segment, ones which could be accessed remotely, utilizing the offline capability of CBDCs. There could also be the possibility of low limit accounts with minimum KYC, which would benefit the underserved segment and would work towards increasing financial inclusion.
