Currency creation

RBI should be careful in launching a digital currency

In a recent speech, Reserve Bank of India (RBI) Deputy Governor T Rabi Sankar said the central bank was considering introducing a central bank digital currency (CBDC) in a phased manner with pilot schemes in “the near future”. The implementation of the proposal will require legislation and has the potential of changing the financial environment drastically. A CBDC would perhaps be a digital rupee, exchangeable one-to-one with physical, or electronic rupees. It would offer a more secure and stable alternative to popular cryptocurrencies. But there are many complex issues involved in launching a CBDC since it would have a bearing on money supply, exchange rates, conventional bank lending, and on anonymity, which could affect its usage.

In this context, the RBI must consider the following issues: Should CBDCs be used only in retail payments, or also in wholesale transactions? Should CBDCs be issued via a distributed ledger (synchronised between the RBI and scheduled banks) or a centralised ledger held by the RBI? As in the case of physical notes and cryptocurrencies, should each CBDC be validated and identified by a unique serial number or token, or else how would validation be done? Should distribution be only through the RBI, or via banks? The RBI would have to decide how to account for CBDCs in money supply. Opinions about this are divided among central banks. A CBDC reduces the need for paper or polymer notes, and eases transaction friction. Given instantaneous transactions, cross-border exchanges and interbank settlements become much easier, but would also increase risks. The ease of cross-border transactions with CBDCs may, in effect, trigger the dismantling of currency controls.

A CBDC also carries serious risks. It may put pressure on conventional banking by reducing the amount of deposits. A CBDC may not be interest-bearing since physical notes are not and can have implications for commercial banking. Bank credit is based on the amount of deposits. If a CBDC catches on, households may shift away from deposits, reducing the cash available for bank credit and squeezing net interest margins. This could have implications for investment and growth. There is also the possibility that, given CBDCs would allow for instant withdrawal, it could trigger a run in cases of bank failure. On the other hand, the very fact that instantaneous withdrawal is possible may prevent panic. It is impossible to make a priori judgement about how users would behave in such scenarios. The exact technical features are critical for many reasons, including money supply accounting and also anonymity, especially in low-value, high-volume transactions. Like crypto-currencies and physical notes, each CBDC may have a unique serial number, or some other means of validation.

Software may be needed to convert withdrawals instantly into unique new CBDC notes or tokens, and in reverse, to instantly extinguish CBDC notes when these are deposited in an account. This also implies real-time recalculation of the CBDC component of money supply. Anonymity may disappear in such validation systems, inducing users to prefer to stick to physical cash. Since every central bank is being forced to consider a CBDC, given the competition from private cryptocurrencies, the RBI will need to review all the implications carefully to ensure it designs a robust CBDC system offering safety, security, and some degree of anonymity, alongside ease of transactions. It’s good that the RBI is talking only about a pilot. This will help address all the issues during the proposed experimentation.