The Reserve Bank of India (RBI) has recently launched the Central Bank Digital Currency (CBDC) or Digital Rupee and subsequently aims to create awareness about CBDCs in general and the planned features of the Digital Rupee (e₹), in particular. The Reserve Bank plans to commence pilot launches of e₹ for specific use cases.
CBDC or digital rupee is basically a form of a digital currency that will be issued by a central bank. The digital rupee will provide an additional option to the currently available forms of money. “It is substantially not different from banknotes, but being digital it is likely to be easier, faster and cheaper. It also has all the transactional benefits of other forms of digital money,” said RBI.
Usage of Technology and Data Analytics
The Reserve Bank says that the concept note will help generate a large amount of data in real-time, which in turn will help in policy making. “The CBDC platform is expected to generate huge sets of data in real time. After factoring in the concerns related to anonymity, appropriate analytics of Big Data generated from CBDC can assist in evidence-based policy making. It may also become a rich data source for service providers for financial product insights,” says the official spokesperson of RBI. Apart from that, the Central Bank also hopes that the generated data would also be useful for enforcing money laundering regulations.
RBI has identified nine banks for participation in the Digital Rupee’s wholesale pilot project. These include:
- State Bank of India
- Bank of Baroda
- Union Bank of India
- HDFC Bank
- ICICI Bank
- Kotak Mahindra Bank
- Yes Bank
- IDFC First Bank
Modus Operandi and Differentiation
RBI said the first pilot of the Digital Rupee in the retail segment is planned for launch within a month in select locations. The Digital Rupee in retail segment will be commenced in closed user groups comprising customers and merchants. Wholesale segment (e₹-W) commenced on November 1, 2022. Retail segment (e₹-R) is planned for roll out within a month in select locations in closed user groups comprising customers and merchants. The details regarding operationalisation of e₹-R pilot will be communicated in due course. “The use case for this pilot is settlement of secondary market transactions in government securities. Use of e₹-W is expected to make the inter-bank market more efficient. Settlement in central bank money would reduce transaction costs by pre- empting the need for settlement guarantee infrastructure or for collateral to mitigate settlement risk,” rationalized an RBI official.
Nevertheless a common question comes up that how is this digital rupee different from cryptocurrency. A cryptocurrency is a decentralised digital asset and a medium of exchange based on blockchain technology. However, it has primarily been controversial due to its decentralised nature, meaning its operation without any intermediary like banks, financial institutions, or central authorities. On the contrary, the Central Bank Digital Currency (CBDC) issued by the RBI will be a legal tender in a digital form.
“The digital rupee will be different from Bitcoin, Ethereum and other cryptocurrencies in the sense it will be backed by the government. Secondly, having an intrinsic value on account of government backing, the digital rupee will be equivalent to holding a physical rupee equivalent,” explained Manoj Dalmia, Founder and Director, Proassetz Exchange.
Taken together, these three differentiating characteristics – identifiability, programmability, and distributed ledgers – can unleash a new set of economic possibilities. These can be realized in three ways: central bank wholesale money (wholesale CBDC), central bank digital retail money (retail CBDC), and commercial bank money (tokenized deposits or the liabilities of commercial banks) created under fractional reserve banking. While technically speaking, only RBI issued digital money can be termed as digital rupee, for the sake of simplicity, we are also including tokenized rupee-denominated commercial bank liabilities under the term ‘Digital Rupee’.
CBDC has the potential to provide significant benefits, such as reduced dependency on cash, higher seigniorage due to lower transaction costs and reduced settlement risk. It may also possibly lead to a more robust, efficient, trusted, regulated and legal tender-based payments option.
Rationalizing Associated Risks
Another school of thought believes the advent of private virtual currencies may well be another reason why CBDCs may be necessary. It is not clear what specific need is met by these private virtual currencies that official money cannot meet as efficiently, but that may in itself not come in the way of their adoption. If these virtual currencies gain recognition, national currencies with limited convertibility are likely to come under threat.
There are certain risks associated with CBDCs, with the availability of these currencies might be making it easier for depositors to withdraw balances if there is stress on any bank. Flight of deposits can be much faster compared to cash withdrawal. On the other hand, just the availability of CBDCs might reduce panic “runs” since depositors have knowledge that they can withdraw quickly. One consequence could be that banks would be motivated to hold a larger level of liquidity, which could result in lower returns for commercial banks.
Likely Benefits Accrued
Lowering Cash Dependence – India’s 17% cash propensity – the ratio of cash withdrawn to GDP – is higher than those of the Nordic countries, the UK and Australia. Sweden’s central bank, Riksbank, has an e-krona project which provides a template for the use of digital currency as a digital alternative to cash and electronic money that is directly issued by the state. This approach is featured as an example in the BIS Annual Economic Report, which describes CBDC as a “public good that offers, in digital form, the unique advantages of central bank money: settlement finality, liquidity and integrity.
Improving Resilience and Overcoming Infrastructural Constraints – India is among the global leaders in terms of the number of digital payment transactions. A distributed ledger would dramatically improve systemic resilience, and a new umbrella entity (NUE) for payments leveraging the Digital Rupee could provide us with an alternative instant settlement mechanism, since DLT-enabled payment systems are inherently more secure than highly centralized systems. The adoption of a Digital Rupee would support greater diversification of India’s payment system by offering alternative payment rails. It would also increase the resilience and security of the entire payments infrastructure.
Preventing Fraud – RBI data shows that in just three years (2018 to 2020), Indian banks lost approximately USD 50 billion to fraud. While the current system relies on post-facto checks, such as CA audit reports and stock statements etc, looked at in parts by different lenders, a digital currency could address these proactively with embedded programmability and regulated traceability.
Facilitating Faster and Cheaper Cross-Border Payments – The rupee is a local medium. While rupee currency notes can circulate widely and be held offshore, the reserves can only serve domestic payments. A Digital Rupee that can be held by non-residents and be available to conduct cross-border and offshore financial transactions seems a natural extension to enable new retail payment possibilities and business models.
A Digital Rupee, therefore, needs to enjoy international acceptance while retaining sufficient controls for the RBI to ensure that its international circulation will not impair domestic policy objectives. The CBDC project Jura, which explores the direct transfer of euro and Swiss franc wholesale CBDC between French and Swiss commercial banks on a single DLT platform, offers one possible approach for controlling a digital euro in an international setting.
Improving Welfare Distribution – India has significantly improved its welfare distribution with initiatives such as Direct Benefit Transfer and the e-RUPI. A Digital Rupee could further strengthen welfare distribution and make it more robust by plugging leakages – such as preventing welfare money from being diverted to unrelated bank accounts. If one examines the current landscape, the e-RUPI doesn’t completely address leakage as it is delinked from the banking system and, hence, does not benefit from its KYC processes.
On the other hand, a digital currency with embedded programmability and a distributed ledger across banks could be tightly integrated with the envisaged welfare chain, health chain and education chain to address these leakages.
Deciding on and Executing Targeted Monetary Policy – A digital currency would have the unprecedented ability to provide the RBI and other policy makers with real-time visibility and insights into the state of the economy. Policy makers would have access to data that could help them understand the flows and stock in every sector at a granular level.
Further, a programmable currency would allow the RBI to conduct its monetary policy interventions with hyper-precision, enabling faster transmission through the economy and more complete achievement of policy objectives. The Khokha2 digital currency project by the South African Reserve Bank is an example of a wholesale CBDC use case which includes enabling interbank and bond settlements.
Crystal Ball Gazing on Digital Rupee
The opportunity canvas for the Digital Rupee is compelling. It could help India spur financial innovation, address persistent fraud, improve resilience and increase the ease of doing business. It could help the RBI with more precise monetary policy execution and make regulation pre-facto. In addition, it may enable the rupee to leverage the Indian diaspora and its trading influence to expand its role as a reserve currency.
Token-based mediums provide new functionalities that leverage identifiability, programmability and decentralized consensus that can spur financial innovation. Banks provide many critical functions for the economy, including providing maturity transformation – they take short-term liabilities and support long-term lending.
The Government of India and the RBI should consider establishing a Digital Rupee Corporation of India (DRCI) to develop the technology, protocols, and infrastructure for a nationwide distributed ledger of financial services powered by the Digital Rupee. The DRCI should establish connectivity with other chains as part of the National Blockchain Mission. It could also leverage an initial coin offering to fund its own growth and/or generate capital for the government.