On 1st November, the Reserve Bank of India launched a pilot project that was aimed at testing the concept of Central Bank Digital Currency (CBDC). The pilot involved the trade of Government securities (bonds issued by the government) between the RBI and nine commercial banks in the country. The announcement of this project was much awaited, given the Finance Minister’s declaration that the ‘digital rupee’ will be introduced by the end of 2022 to boost the digital economy. But before we discuss how effective this pilot run was, we need to understand how a CBDC works and what impact it can have on the economy.
What Is A Digital Currency?
A Digital Rupee, or a Central Bank Digital Currency (CBDC), in general, is a fiat currency in digital form. It is simply electronic money that can be freely exchanged against the physical currency. Issued by the central bank of an economy, digital currencies are known to be safe digital assets that carry no risk and are made available to the public at large. However, a CBDC cannot be compared to private virtual currencies/cryptocurrencies. What makes a digital currency valuable is its sovereign backing; it is issued directly by the central bank to the public with no intermediaries aiding this process.
Why Do We Need CBDCs?
If CBDCs are identical to physical currency notes, why bother introducing them at all? There are many benefits that a digital currency offers – both to the central bank and the citizens. Primarily, the usage of CBDC significantly reduces the cost of transactions. There is no chance of losing currency, no requirement to physically carry it as well as no possibility of counterfeit transactions. While the advent of UPI has already highlighted these benefits, the introduction of CBDC will only accentuate the same. Further, CBDC leverages blockchain technology, albeit with a centralized and altered structure, unlike its more prevalent usage in the virtual currencies market, to “enable near-instant payments” with no fee. This technology also acts as a ledger that allows the central bank to track transactions across a national network.
However, the most significant benefit to the central banker is the absence of printing costs. Contrary to popular opinion, the magnitude of currency in circulation has not decreased since the period of demonetisation in 2016. In 6 years, the currency with the public has risen by more than 70% to 30.88 lakh crore (as of 21st Oct. 2022), with cash still remaining the preferred mode of payment in the underbanked pockets of the nation. With increasing per-unit printing costs, issuing CBDC can result in significant cost savings for the RBI.
On the other hand, the citizens will benefit from disintermediation. A CBDC eliminates the need for a financial intermediary to facilitate payments, be it for businesses or individuals. CBDC transactions can be processed by citizens, similar to how banks do, without any further approval. As mentioned above, this would also help unbanked individuals transact without needing an account with a financial entity. What this essentially means is that you and I can transfer money digitally without owning an account. If you look closely, this result is a double-edged sword – because bank accounts (or, deposits in general) are quintessential in money creation. If citizens can carry currency safely, demand for deposits decreases, thus impeding banks’ ability to create credit through public deposits. To create demand, banks might have to compromise on their net interest margins (the difference between interest on deposits and interest on loans), resulting in increased cost of credit. However, this impact on deposits might not be too significant since carrying CBDCs offers no interest to citizens.
The Global Scenario
Currently, 105 countries worldwide are on the path to developing their digital currency and as of 2022,10 countries have already launched CBDCs. The Bahamas was the first one to launch its
digital currency, the Sand Dollar, in late 2020 with a few other Caribbean nations following suite in the last two years. While developed nations are looking to provide their citizens with safe and innovative digital assets, the purpose of CBDC in developing ones is to enhance government transfers and accelerate financial inclusion. One such example is that of Nigeria which became the first African nation to launch a CBDC in October 2021. However, low adoption rates have led to devaluation of the currency, e-Naira, in a country where cash is still largely the king. This is unlike the case of The Bahamas, whose central bank is being labelled the leader in digital currencies allowing for excellent recording of income and spending.The ‘Sand Dollar’ launched in 2019 has thus allowed the island nation to integrate data to support micro-loan applications. Jamaica too has gone ahead with the launch of its CBDC “Jam-Dex”, recognised as legal tender since June 2022. With smaller nations seeing such successful pilots, it is only time that the major powers of the world look to implement currency digitalisation. Surprisingly however, US and UK have been laggards in this regard, setting similar targets for later in the decade. The trend is soon catching up with South-Asian countries, led by South Korea, Japan and India who are either in the development or the pilot stage.
RBI’s Pilot Project
The CBDC pilot in the wholesale segment can offer significant insights into the digital currency’s operations, ahead of a similar retail rollout expected to happen next month. Currently, the pilot project involves the settlement of secondary-market trades of government bonds. On day one, a total of 48 trades, which amounted to INR 275 Crore with yields hovering around 7.2-7.4%, were executed by the nine participating banks. These banks could convert their cash reserves into digital rupees and vice versa at any time. This allowed them to settle trades instantly, unlike the T+1 settlement system that the Clearing Corporation of India Ltd. (CCIL) follows. These transactions do not require banks to pay charges to the CCIL as they are settled directly with the RBI. Further, the central bank also introduced a ‘Negotiated Dealing System-Order Matching CBDC’ that allows for the exchange of quotations and payment terms between the buyer and the seller. Officials mentioned that appropriate technology solutions would be chosen for the launch after successful pilot runs. While the existing project has seen smooth transactions among banks, the RBI needs to tackle more critical issues of cybersecurity threats and trust within the system going forward – two concerns that have possibly deterred powers like the UK and the USA.