Arrival of digital currencies: From Cryptocurrency to CBDC
During the budget speech, the introduction of CBDC (Central Bank Digital Currencies) by the Hon’ble Finance Minister Nirmala Seetharaman, kindled a spark of technology in the Indian finance sector. It was announced that the RBI would launch “digital Banknotes” in the upcoming fiscal year. This introduction of Digital currency is akin to a warm welcome of Fintech in India, which shows the forthcoming developments in the digital landscape. The boom of cryptocurrency from 2017 to 2019, has opened doors for medium of exchange and investment of assets in the virtual platform. With high demand and limited supply, cryptocurrency soon became a profitable asset and the prices of cryptocurrency and crypto-based assets were sky rocketing. In lieu of profits, many people from different countries traded in cryptocurrencies, despite the losses incurred by them due to the high volatility and unpredictability in crypto market.
About 100 nations are investigating CBDC, and some have actually implemented it, according to the IMF. The Bahamas was the first country to introduce its central bank digital currency, Sand Dollar. Nigerian central bank has also launched its Central Bank Digital Currency named eNaira in Nigeria in 2020. However, the Government of India is analysing the situation very meticulously , so as to implement the same in our country without any hassle and deleterious impact on the users.
The same year also saw, China became the first major economy to test the e-CNY digital money, popularly known as ‘digital yuan’. Several nations have started testing the digital money, including Korea, Sweden, Jamaica, and Ukraine, and many more may do so soon. The Federal Reserve Board and the European Central Bank are taking the CBDC issue seriously. Likewise in Many countries like Egypt, Bolivia, Turkey and Indonesia; central banks have put an outright ban on cryptocurrency.
Any currency, whether it be physical (paper) or digital, should have a sovereign control over its form and quantities, as this will ultimately affect the macroeconomic fundamentals and how monetary policy is conducted. Private money can be as good as credit, and it shouldn’t be confused with the legal cash that central banks acting on behalf of the government issue.
In order to provide more dependable digital currencies that may function as legal currency, many nations have decided to establish their own CBDC, which has led to the displacement of private digital currencies.
Despite the fact that CBDC is built on a cryptocurrency architecture, its regulatory character will provide it a fresh perspective. Cryptocurrency is a highly volatile type of investment that is encrypted and unpredictable thanks to a decentralised public ledger. In contrast, a digital currency will be fiat money that is controlled by a nation’s central bank, accepted everywhere, and has a steady value. The sender, receiver, and bank will still have access to the transaction information, which is secured by a password.
Could CBDC qualify as “electronic money” if it is digital? The solution will rely on conditions unique to the relevant jurisdiction. Having stated that, the definition of electronic money as a claim on the issuer that is issued upon receipt of funds for the purpose of performing payment transactions and is recognised by natural or legal persons other than the issuer is that it is monetary value that has been stored electronically. The majority of countries do not recognise electronic money as legal currency. For instance, in UK and Singapore, central banks have warned citizens to use cryptocurrency at their own risk. In these countries, it is issued by electronic finance institutions that are authorised to offer particular payment services at par upon receipt of funds (and the monetary value may be redeemed at par). Its regulatory framework primarily consists of regulations governing the licencing of institutions that deal with electronic money, the initial capital and own funds they are required to have, general prudential regulations, oversight, and regulations protecting funds received in exchange for electronic money.
Indian Perspective on Digital Currencies: Legal analysis of CBDC
In India, Reserve Bank of India (RBI) has made a clear view that with respect to digital assets including cryptocurrency, the transactions should be prohibited. RBI in its annual report, has even stated that cryptocurrencies pose a “a real danger”.
In the Monsoon session of the Parliament, Finance Minister said, “RBI mentioned that cryptocurrencies are not a currency because every modern currency needs to be issued by the Central Bank / Government. Further, the value of fiat currencies is anchored by monetary policy and their status as legal tender, however the value of cryptocurrencies rests solely on the speculations and expectations of high returns that are not well anchored, so it will have a de-stabilizing effect on the monetary and fiscal stability of a country,” report not only points out the problems based on digital assets but also questions its usage and fundamentals. As per the foreword of the 25th Financial Stability Report (FSR), increase in digitization, is accompanied by the growth of cybersecurity risks.
The idea of digital currency could be a crucial step in abolishing the use of paper money and quickly transitioning to a paperless society. In India, the informal or shadow economy is thought to be 53% of the total economy. It makes it challenging to manage illicit and underreported activities as well as account for economic activity. So, one method to formalise the Indian economy and make it transparent and effective is to switch from paper currency to CBDC. It may also result in a decrease of crime rate in India.
CBDC can offer a simple way to expedite the development of a secure domestic settlement and payment system that partially replaces paper money. Subject to specific country-level design compatibility, interoperability, and legal permissibility, it could also be used for cross-border payments.
In India, switching to digital payments by using UPI during COVID-19 was encouraged not only for hygienic concerns but also for the speed with which digital payment systems enable a transaction to take place. Although, there are several services offered by financial institutions and other service providers that allow for speedy account transfers, payments must still be made by moving money from one account to another, which might cause delays. This process is complicated by the need to reconcile the ledgers between banks and the central bank, which is another problem. However, these problems will be solved by CBDC’s usage of ledger technology.
The cost and expenses associated with paper money consume a significant portion of the RBI’s books of accounts. Damaged money raises the expense of managing and processing currencies for the RBI. It could be decreased with the usage of controlled digital currency.
Since currency in India has only ever been legal tender in physical form, the RBI Act, 1934, would need to be significantly changed if this were to actually occur in the near future (whether through bank notes, coins, postal orders, cheques, draughts and the like). Currently, the Act is ill-equipped to deal with entirely digital or virtual currency. For instance, Sections 22, 24, 25 and 26 of the RBI Act deal with the RBI’s power and ability to issue bank notes and set forth their criteria in this regard. These provisions are inadequate to manage CBDC specifications, issuance, or regulation in their current state. It’s noteworthy to observe that the Coinage Act, 2011 and the Act barely overlap (through which the Central government covers coins as legal tender). It only applies to the degree that it must provide various means of payment, which is limited by Section 39 to the issuance of coins in place of bank notes and vice versa. This clause does not use wording that is neutral to CBDC.
Bank notes are issued by the Issue Department of the RBI (Section 23), and Section 33 of the Act has specific guidelines on the types of assets that department is permitted to retain. It is unclear if the Issue Agency will be updated and given the authority to issue CBDC as well as hold it as an asset, or if a new department will be established. In this regard, the Act would also need to be modified.
It makes the sense that the RBI is still debating and deciding (in limbo) whether to deploy CBDC in the wholesale, retail, or combined divisions. But it would need to take into account how the CBDC would affect scheduled banks’ commitments to keep cash reserves with the RBI (Section 42).
In both of the aforementioned situations, CBDC value stability would be crucial since without it, the aforementioned provisions might be seriously hindered. It could be worthwhile to investigate whether the Act also needs to include measures regarding the effects of excessive fluctuations.
The Act needs to be thoroughly examined to ensure CBDC compatibility. Given how inefficient virtual currencies have been thus far in terms of energy use, the RBI would also need to take into account more practical factors like the infrastructure needed to control, store, and maintain CBDC. In this context, there are dangers associated with using private party infrastructure through tenders or subcontracts. One hopes that the RBI creates a thorough road map for the revolutionary change that CBDC signifies.
Additionally, the CBDC might reduce costs and reallocate real-time payment to bridging global disparities. By removing middlemen and lowering transaction costs, it would be easier for Indian imports to make payments to other nations exported in their digital currency. Time zone differences would not affect the exchange of currencies.
Full report can be read on the website.
In order to move the informal economy into the formal economy and assure better tax and regulatory compliance, it may be possible to examine the increased usage of CBDC for a variety of different financial operations. Additionally, it may open the door for greater financial inclusion.
Since many of the market’s traded securities have been converted to digital form during the past ten years, CBDC, with its inherent advantages, is the next in line. As a result, the CBDC can expand the advantages of liquidity scalability, convenience of transaction, acceptance, and quicker settlement in contrast to existing money.
Advantages in CBDC
By lowering the cost of cash management, CBDC can gradually bring about a cultural shift toward virtual currency. As the system integrates, it can also eventually enable cross-border payments, initially with trading partners who engage in two-way (Bi-lateral trade) communication.
The Union Budget 2022–23 made the wise decision to establish a CBDC to begin this fiscal year in order to reduce risks and costs associated with handling physical currency as well as those associated with phasing out soiled notes, transportation, insurance, and logistics.
Additionally, it will make consumers less likely to use cryptocurrency for money transfers. Cryptocurrencies, whose value fluctuates according to supply and demand, can still be employed by those who enjoy speculation.
Although the RBI has been wary about cryptocurrencies because of the risks involved, outlawing them in a growing economy would suggest a reluctance to adopt new technologies. It might also be an indication that its risk management systems aren’t robust enough to handle cryptocurrencies. Therefore, the choice to introduce CBDC in India confirms its capability to manage the operational risks that come with it.
Disadvantages in CBDC
The following are some concerns with respect to CBDC in emerging economies:
• Disintermediating banks: The move to CBDC may limit a bank’s ability to invest money in credit intermediation if it is sufficiently large and widespread. Another scenario is that deposit flight to CBDCs could result in the expansion of central bank balance sheets, raising the issue of how the deposits that leave the banking system should return to the real economy.
• Low user adoption: This may happen if its value to customers and businesses is not properly understood. Low CBDC uptake could interfere with the central banks’ policy goals.
• Increased expenditures for firewall protection, vulnerability testing, and cyber security threats.
• The central bank’s operational workload and expenses related to operating CBDC.
• Less privacy compared to actual currency due to the ability to manage and account for CBDC holdings.
• Threats to data privacy and credential compromise
• The CBDC ecosystem may be threatened by faster technological obsolescence, increasing the expense of updating.
• Intermediaries’ operational risks since staff members need to be retrained and prepared for employment in the CBDC environment.
The usage should be payment-focused to enhance the payment and settlement system in order to mitigate some of the shortcomings of CBDCs. Then it can avoid the hazards of disintermediation and its significant implications for monetary policy by refraining from acting as a store of value.
In order for the RBI to continue serving merely as a mechanism of payment and settlement, it should refrain from collecting interest on the balances. These dangers of CBDC have been noted by BIS.
To reduce them, the central banks should create an ecosystem that involves all parties. Despite, the initial difficulties and hazards, CBDC could hasten digital transformation and support the transition to a digital economy.
Central banks around the world are looking more closely and keenly at establishing central bank digital currencies as a way to combat the bitcoin frenzy. The Reserve Bank of India (RBI) is also thinking about conducting its own CBDC test in December.
If the pilot is a success, the adoption of CBDCs will have significant ramifications that will go beyond the banking sector and include issues with data protection.
The introduction of CBDCs presents three significant challenges that must be addressed: first, the growing threats to people’s privacy; second, selecting the technology that must be used to enhance privacy and security; and third, the regulatory framework that must be set up to address problems like a data breach.
The increased risk to user privacy must be addressed as an undeniable priority, considering that the central bank may eventually have to manage a vast amount of data pertaining to user transactions. Given that users of digital currency won’t have the same level of privacy and anonymity as those who interact with cash, this will have major ramifications. Furthermore, there would be significant security risks associated with the data held with the central bank in a centralised system, necessitating the establishment of strong data security mechanisms to guard against data breaches. Therefore, it’s crucial to use the best technology to support the CBDCs issue.
The second issue is that the technology used for CBDCs must be scalable, safe, and, needless to say, privacy-preserving and strong firewalls, with practically low latency. The RBI would be aware of all settlements if the central bank implemented a system resembling a core banking solution, which would raise privacy concerns. A conventional multi-tier web architecture ought to be the best option for CBDCs, although it too may have drawbacks. If payment transactions are handled by the same system, it will remain difficult to size the infrastructure needed for the CBDC. The RBI will need to carefully map out the technology ecosystem before deciding on the best technology to introduce CBDCs.
Finally, India lacks the regulatory framework necessary to begin creating digital currency. India has not yet approved a Personal Data Protection Bill or established a data protection authority to monitor a variety of institutional privacy compliance, including the resolution of complaints in cases of infringement of personal data.
Conclusion:
The government would have to carefully consider the regulatory framework because the financial data gathered from transactions using digital currencies will be of a sensitive kind. This would call for close coordination between the data protection and financial regulators, where power struggles between agencies could also be a problem. The institutional structures would need to make sure that there is no overlap between various regulators and lay out a clear course of action in the event that a digital currency data breach occurs.
India has experienced numerous conflicts between regulators over the years, including those involving merger control between the RBI and the Competition Commission of India (CCI) and the Ulips (unit-linked insurance plans) issue between the Securities and Exchange Board of India (SEBI) and the Insurance Regulatory and Development Authority of India (IRDAI). This trap must be avoided because previous conflicts have led to a great deal of confusion, delays, and costs for both the regulator and the regulated parties.
RBI is moving quickly to operationalize CBDC in FY 2023 with the goal of transforming India into a cashless and $5 trillion economy. The RBI must carefully examine the benefits and drawbacks of CBDC and how it would affect the conventional financial industry. The Central Bank of India must connect its graded approach with current monetary policies and the current currency structure in order to issue digital money in the upcoming fiscal year. The strategy must guarantee no disruption and a minimum amount of economic impact.
Despite all of these difficulties, it would be wise to continue exploring the possibility of CBDCs because they would lower the transaction costs, facilitate immediate cross-border transaction settlements, and make the transmission of monetary policy simpler. The centralised network of data collecting and storage, as well as the information gathered on these digital transactions by central banks, may inspire creative solutions and make it simpler to track consumer spending, issue loans, and trace credit histories of individuals. Therefore, it’s critical that we manage the numerous risks in order to introduce CBDCs in a way that benefits the system as a whole.