Central Bank Digital Currency – The Future of Money?

CBDCs are a form of digital legal tender issued by the central bank. While their introduction would be nothing short of revolutionary for global monetary police, they carry with it their own set of risks and rewards.

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The concept of “money” as we know it is fast evolving and the move towards a Central Bank Digital Currency (CBDC) is fast gaining momentum.

The inception of CBDCs would be nothing short of a revolution in global monetary policy which would, of course, carry its own set of benefits and risks. To explain, CBDCs are typically digital tokens (but in the form of a legal tender issued by the central bank) whose monetary value would be identical to that of a country’s physical fiat money and would be exchangeable one-to-one with such fiat money.

CBDCs can be stored in digital wallets (even on a person’s cell phone) through a curated form of technology used by that concerned country. Interestingly, such digital form of currency could certainly act as near-perfect substitute for commercial and physical bank notes.

It is believed that around 100 countries are exploring and experimenting with the use of CBDCs. For example, in the Bahamas, the ‘sand dollar’ (their own domestic CBDC) has been in use for over a year now; in the case of China, e-CNY (the digital renminbi/yuan) is being used in more than 20 cities throughout China and continues to progress with more than a hundred million individual users and billions of yuan in transactions.

Recently, in January 2022, the US Federal Reserve said, “A CBDC could fundamentally change the structure of the US financial system, altering the roles and responsibilities of the private sector and the central bank.”

Also read: RBI May Launch Digital Currency Pilot Next Year, Says Report

At the outset, to appreciate the use and nature of CBDCs, it is pertinent to delve into the background of cryptocurrencies. Cryptos or virtual currencies came into being with an anti-establishment philosophy, which can neither be regulated or monitored by any central bank of the world. Such decentralised currencies digitally represent any form of value encrypted in a certain format and recorded in a digital ledger.

As currently recognised by the Indian government, ‘Crypto’ is a class of asset and not a legal tender backed by the central bank or the Union government. 

It is common knowledge that the concept of a ‘cryptocurrency’, or any such decentralised virtual currency, has not found any support from the Reserve Bank of India (RBI). Due to the highly volatile nature of cryptocurrencies, the RBI has taken the stance that the mammoth Indian middle-class population must be protected from the vagaries of such unregulated marketable asset classes.

However, this week, the finance minister clarified that while the RBI wants to put an end to the use of cryptos, the government would need global support before it can implement any legislation to regulate or ban cryptocurrencies.

While cryptocurrencies may, indeed, act as a digitally-tradable form of value or a store of such value (for example, the Union government is currently taxing any income generated from the trade of cryptocurrencies at a 30% slab rate), it cannot be granted the status of a ‘legal tender’ (that is, supported by a guarantee from the RBI or the Union government) for a variety of economic, logistical and technical factors.

In November 2017, a high-level inter-ministerial committee was constituted by the Union government with a mandate to examine the viability of virtual currencies and propose a regulatory framework which could be used to govern the use of such currencies. The committee recommended that all decentralised virtual currencies should be banned by the RBI and instead, the government may consider introducing a CBDC as a digital form of fiat money in India.

Also read: India Shouldn’t Throw Out the NFT Baby With the Crypto Bathwater

Recently, during the Union Budget 2022-23 speech, as a part of the monetary policy, the finance minister announced the launch of a CBDC to provide a necessary boost to the digital economy. She proposed that a ‘digital rupee’ will be introduced using blockchain and other similar technologies, managed by the RBI, which would positively impact the ‘cost, distributional and settlement efficiency’ of the rupee.

The legal framework

The authority to issue bank notes (electronically or otherwise) within the jurisdiction of India is sourced from the Reserve Bank of India Act, 1934 (the ‘1934 Act’). In that light, there is a need to highlight two sections of the Act. 

Section 25: “The design, form and material of bank notes shall be such as may be approved by the [Central Government] after consideration of the recommendations made by Central Board”.  

Section 26(1): “Subject to the provisions of sub-section (2), every bank note shall be legal tender at any place in [India] in payment or on account for the amount expressed therein, and shall be guaranteed by the [Central Government].”

Therefore, there is not even a shadow of a doubt that if the Union government, in consultation with the RBI, chooses to introduce CBDCs, it would be valid tender as per Section 25 of the 1934 Act and would be ‘legally tenderable for discharge of debt or obligation’ throughout the territory of India and supported by a guarantee by the Union government (in terms of Section 26).

To clarify, such a CBDC would be a sovereign currency (in an electronic version) and would appear as ‘liability’ on the RBI’s annual balance sheet.

Pros and cons

As the saying goes, every coin has two sides; it does not only come bearing gifts. Likewise, a CBDC, too, will have its own technological, economic, security and logistical issues. But let us weigh and analyse the benefits and risks of adopting CBDCs as the future of fiat currency.

First, the COVID-19 pandemic has been an eye-opener for the world. It has made us realise the need for continuous access to liquid funds to ensure the basic survival of the people.

From an Indian perspective, many FinTech companies (such as Paytm, BharatPe, PhonePe) using the unified payments interface (UPI), came as a blessing as they assisted millions of Indians in making their daily transactions in a completely cashless form. In the unfortunate event of a similar pandemic in the future, CBDC would be able to make available fiat currency in a digital form to the common people without much difficulty.

Unlike paper currency, where a bank is directly involved at every step, the storage, management and use of CBDCs could be done by way of a digital wallet on our personal cell phones, making it much more accessible, even for people in remote and rural areas. 

Second, in connection with the point above, another aspect where governments failed miserably was their so-called ‘subsidy programs’ during the pandemic. The primary reason for such failure was the human intervention factor in such subsidy programs which did not allow the benefits to trickle down to the targeted population.

After a point, it became a herculean task (in terms of logistics, costs, time and so on) for governments to ensure a safe route for the subsidy money to reach the target population. This issue could entirely be negated with the introduction of CBDCs as digital currency can be transferred from the government accounts directly to the target accounts in negligible time, and with minimal human intervention or possibility of manual error. 

Third, as compared to other forms of fiat currency, CBDCs would enhance the storage, cost and operational efficiency of money. Governments can save millions by simply introducing CBDC-enabled digital wallets, which they otherwise would have spent on printing, storing and managing paper currency, including ensuring their safe pathway to an ATM or a bank.

Just by way of statistics, the Union government’s yearly spending on the printing of paper currency is around Rs 50 billion (5,000 crore). To provide a comparable figure, the Union Budget (2022-23) for India estimated the total expenditure on petroleum subsidies to be 5,813 crore – which is becoming a major concern in the country at the moment. The sheer amount of money spent on printing such paper currency can be easily reduced with introduction of CBDCs, and such resources can be put to better use in other necessary sectors. 

Fourth, one of the major drawbacks of the paper currency system is the difficulty in tracking its full life-cycle, including supply, movement/nature of transactions, holding patterns and the like, as it is digitally untraceable. However, in case of CBDCs, it would be rather easy to report, monitor and track transactions. It has also been argued that CBDCs would make the computation and collection of tax, as well as compliance with Anti-Money Laundering laws, far easier

Fifth, even from a national security and anti-money laundering perspective, CBDCs are the safest bet as the movement of every digital unit of currency can be tracked and proper surveillance of the operators can be ensured. 

Finally, it should go without saying that CBDCs would make cross-border transactions far easier in terms of logistics and cost efficiency.

Watch: What You Should Know Before Investing in Crypto

Now, there are several risks involved in using CBDCs as well. The major risk that underlies the introduction of CBDCs is dismantling the stability of the system of bank deposits.

By way of background, bank deposits (as compared to CBDCs) are not backed by a Union government guarantee and therefore, are not as safe a store for value as the CBDC alternative. This risk is even further elevated if the RBI suddenly decides to provide a certain amount of interest upon the CBDCs stored in digital wallets, creating a direct competitor for the traditional banking system. This would lead to a panic in the banking and financial sector as CBDC wallets would become the obvious choice for the middle-class to store all their savings in (which would be interest-bearing) as compared to bank deposits.

Such a situation may hugely impact the monetary stability of countries. Some authors have argued that “this risk can be offset by the [central bank] re-lending CBDCs to banks and also by carefully adjusting the interest rates (which can be positive, zero or even negative).”

The counter argument to that is: “This analysis makes many assumptions, including the incentivisation for individuals shifting to CBDCs with remuneration comparable to a regular deposit account.” According to Forbes, in 2020, three central banks (namely, the Bank of Japan, Reserve Bank of Australia and Bank of Korea) seem to have delayed their plans of rolling out CBDCs based on such a risk. 

Second, the operational framework for CBDCs would demand huge technological and technical support on a 24*7 basis, specifically for larger economies. The primary challenge is to make technical support available to customers round-the-clock.

The system must be capable of running a billion transactions each minute (both domestic and cross-border) in an extremely private, responsive and secure manner. For less developed countries in the Asia Pacific region, the setting up of such a massive framework would need multiple pilot projects, training sessions (where people would be trained in the use of digital wallets) and awareness campaigns to not only identify the flaws and gaps in the system, but also to make people understand and recognise its benefits.

Thirdly, some people have also raised concerns about potential privacy breaches and state surveillance in our daily monetary transactions (which would not otherwise have been there in case of paper currency) if so done with CBDCs. 

Finally, another major risk is the vulnerability of the digital wallet system to cyber hacking and cyber terrorism. 

Is the private sector the answer?

Although slightly off-topic, but to highlight quite a baffling fact, the richest family in Asia belongs to a country (India) where there is no fundamental right to property. Typically, scholars talk about  governments, central banks, federalist states and so on, however, in my view, our focus should, rather, be on the de facto authority wielded by the ‘private sector’.

The next development for law could possibly be ‘corporate constitutionalism’. In my home country, its journey actually began in the 1990s, when the Indian version of socialism collapsed. Opening the doors to foreign investment, the Union government started privatising sectors, such as banking, telecom, ports, petroleum and the like. 

Also read: Privatisation of PSBs Will Deal a Blow to Reservation, Government’s Coffers

It is, today, undeniable that the private sector has enormous potential to pioneer new technologies, including expanding the reach of CBDCs to the most rural and underdeveloped sectors of the world. According to the Indian finance minister, during one of her speeches at the International Monetary Fund (IMF), she noted that with the help of the private sector, over 350 million Indians in rural India are using their telephones to make digital payment transactions. This, indeed, is an incredible achievement for our country and its corporate sector.

The private sector can actually be a saviour in addressing the risks associated with the CBDCs (to whatever extent possible). In such cases, tenders could also be released and interested private players could bid for such initiatives to collaborate with the government.

In my view, the private sector can support the government in: first, making several subsidy programs a reality and expanding the reach of the financial aid schemes to rural areas without any need for complex know-your-customer programs; second, providing the back-end technical and IT support required for the functioning of the operational framework for CBDCs; third, arranging pilot projects, awareness programs and training sessions; and fourth, the setting up of ethical hacking personnel groups to identify potential risks and vulnerabilities of the IT framework used to run the CBDCs and provide for the constant monitoring of such systems.

Regulating international transactions

Dealing in CBDCs, especially in cases of cross-border transactions, would also involve a regulatory angle from a foreign exchange control perspective. India follows a very strict regulatory regime with respect to foreign exchange transactions or any dealings in foreign currency.

For example, any lending or borrowing transactions, investments or liabilities undertaken (such as, loans, guarantees, security and the like) by an Indian entity on behalf of any offshore entities, are regulated by the RBI through the foreign exchange control regulations of India (the Foreign Exchange Management Act, 1999; or FEMA and any regulation, notifications, circulars passed thereunder). In the event the any of the conditions or parameters (as set out under the FEMA or other relevant regulations) are not met, prior approval from the RBI is required before such a transaction can be undertaken. 

Generally, each such foreign exchange transaction is undertaken via a designated authorised dealer (AD) bank in India of the transacting entity. Such AD Banks have certain delegated powers under RBI regulations and are specifically authorised by the RBI under Section 10(1) of the FEMA to deal in foreign exchange or foreign securities. They are also responsible for reporting each such transaction to the RBI with all relevant particulars. 

In this context, it becomes pertinent to bring the CBDC framework within the larger purview of FEMA and foreign exchange control regulations, with a carefully crafted technological framework for reporting such transactions. This shall ensure all transactions made with CBDCs are directly reported in the RBI system; increase the volume of inflow and outflow of foreign exchange in India; and keep a check on all suspicious transactions, such as for trafficking, terrorism sponsorships and so on.  

Anubhav Khamroi is an LL.M. Candidate at the New York University School of Law