Historically, India has been a passive adopter of technology, primarily serving as a market for consumption and not innovation. However, since the turn of the century, India has played a leading role globally in developing Information Technology (IT) and digital solutions, especially in digital payments and financial inclusion. The development of digital public goods and the India Stack has improved the adoption of digital payments and catalysed entrepreneurship and a thriving startup ecosystem. While central banks worldwide are exploring the potential benefits of Central Bank Digital Currencies (CBDC) in improving cross-border transactions, controlling monetary policy and financial sovereignty, and improving financial inclusion, in India, Finance Minister Nirmala Sitharaman announced the systematic introduction of the digital rupee by the Reserve Bank of India (RBI) at the Union Budget 2022-2023. After assessing the global developments in CBDCs, the RBI’s latest concept note explores both the new opportunities and considerable risks of a digital currency in the next phase of India’s digital transformation.
Evolution of Digital Currency
The concept of digital cash, as imagined by David Chaum first in 1983, based on the cryptographic principles of privacy and security, has evolved significantly over the years and has paved the way for research and development and innovation in digital and crypto currencies. For instance, Bitcoin eliminated the need for a trusted third party and decentralised payments using blockchain technology and cryptographically signed and secured proof-of-work protocols to validate payments. Similarly, Ethereum tested new cryptographic protocols and recently moved from proof-of-work to proof-of-stake to verify transactions. These projects helped test key features like counterfeit proofing and scarcity. They introduced new technology-enabled characteristics like decentralised consensus mechanisms and scalability, which could become essential for new CBDCs issued by central banks globally.
Central banks worldwide have closely monitored the developments in virtual and cryptocurrency for many years before developing plans to issue sovereign digital currency. A CBDC leverages the latest technological innovations to potentially safeguard liquidity and transaction risk. However, its use was still in question for many years because most of the proposed functionalities of a CBDC were already easily achieved by using a sophisticated digital payments system, especially for a country like India, which has highly developed digital payment channels. A central bank’s core directive to provide robust and adaptable means of payment must be at the core of CBDC introduction plans. Cash is being used less and less as a means of payment, and the surge of online commerce during the COVID-19 pandemic has further accelerated the adoption of digital payments.
Growth of Stablecoins and Private Cryptocurrency
The need for a CBDC essentially changed with the onset of stablecoins. Due to their volatility, private cryptocurrencies were never considered a threat to national currencies. Stablecoins, such as Tether and USD coin, changed that by providing price stability through a 1:1 backing to fiat currency. Dollar-pegged stable coins have showcased safe asset qualities with their prices rising above the peg only during periods of extreme market distress. The popularity of stablecoins has grown considerably since 2020, reaching a total market capitalisation of US $167 billion in 2022, displaying a 3000 percent growth.
Due to their largely unregulated nature, private cryptocurrencies do not meet several criteria for Anti Money Laundering/Combatting the Financing of Terrorism (AML/CFT). For instance, the limited identification and verification of participants and the lack of clarity about AML/CFT compliance and enforcement across geographies place users at risk. Additionally, holders of private cryptocurrency cannot access central banks as a lender of last resort, which greatly accentuates currency and transaction risk. There is also a risk of a run on certain stablecoins that are backed by non-cash-equivalent assets. The rise of stablecoins could easily be perceived as a threat to a sovereign currency and a central bank’s ability to control and dictate monetary policy.
Next steps for the Digital Rupee
The global CBDC landscape is nascent despite countries accounting for 90 percent of global GDP either developing, piloting, or gradually implementing digital currencies in their respective nations. China’s digital RMB was the first digital currency launched by a major economy along with CBDC projects by the Central Bank of Nigeria (e-Naira), the Bank of Bahamas (Sand Dollar), the Eastern Caribbean Central Bank (DCash), and the Bank of Jamaica (JamDex)
Assuming the G20 presidency in November 2022, India is uniquely positioned to lead the way, to experiment, and to provide recommendations to several countries as they grapple with growth of CBDCs and the incidental risks and regulations. Like most central banks around the world, the RBI is still treading cautiously while designing and launching the digital rupee as the dominant model for CBDCs is still unclear, if at all there is one. RBI’s latest concept note highlights the digital rupee’s potential design choices and implications. The exact characteristics of the digital rupee are still unclear; however, it is an excellent opportunity to prescribe solutions for fundamental concerns of CBDCs, such as anonymity and interoperability. For instance, a tiered wallet system based on transaction type and volume, similar to Nigeria’s e-Naira and Speed wallet, could be implemented to improve the range of the digital rupee in India. The RBI could also create frameworks to ensure anonymity and protect transaction data by creating a data trust that would facilitate data sharing for further policy design.
The digital rupee is unlikely to be interest-bearing and will simply be a digital version of the paper currency. The RBI will most likely launch two types of CBDCs—a general purpose or retail CBDC (CBDC-R) and a wholesale CBDC (CBDC-W). The retail CBDC is a direct liability of the Central bank, like physical cash, which will be available to the private sector, non-financial consumers, and businesses. The wholesale CBDC will mainly be used for wholesale transactions like interbank transfers. Both types of CBDCs have potential benefits. Therefore, it will be apt to launch a combination of the two.
The evolving CBDC space poses more questions than answers in terms of currency design and implementation strategies. The introduction of the digital rupee would have repercussions for the structure of payment and financial markets and, subsequently, for individuals and businesses. Due to India’s inherent market intricacies and socio-economic conditions, all stakeholders must consider the advantages and disadvantages of the new digital currency. By leveraging the latest technology, central banks can safeguard the finality of transactions, like physical cash and unlike stablecoins or any private cryptocurrency. But in the process, it must adhere to anonymity and data security principles, which, according to David Chaum, is essential for any democracy.
