• The Reserve Bank of India (RBI) has launched India’s first digital rupee (e₹) pilot project. 

• Central Bank Digital Currency (CBDC) is a digital form of currency notes issued by a central bank.

• The first pilot in the digital rupee-wholesale segment commenced on November 1.

• RBI announced that the first pilot in digital rupee-retail segment is planned for launch within a month in select locations in closed user groups comprising customers and merchants.

• Nine banks — State Bank of India (SBI), Bank of Baroda, Union Bank of India, HDFC Bank, ICICI Bank, Kotak Mahindra Bank, Yes Bank, IDFC First Bank and HSBC — have been identified for participation in the pilot project.

• The use case for the pilot is settlement of secondary market transactions in government securities.

• 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.

• Going forward, other wholesale transactions and cross-border payments will be the focus of future pilots, based on the learnings from this pilot.

What is CBDC?

• With the developments in the economy and the evolution of the payments system, the form and functions of money has changed over time, and it will continue to influence the future course of currency.

• The concept of money has experienced evolution from commodity to metallic currency to paper currency to digital currency. The changing features of money are defining new financial landscape of the economy. 

• Further, with the advent of cutting-edge technologies, digitalisation of money is the next milestone in the monetary history. Advancement in technology has made it possible for the development of new form of money — Central Bank Digital Currencies (CBDCs).

• A CBDC is the legal tender issued by a central bank in a digital form. It is the same as a fiat currency and is exchangeable one-to-one with the fiat currency. Only its form is different.

• The government had announced the launch of digital rupee from fiscal year 2022-23 onwards in the Union Budget tabled in Parliament on February 1, 2022.

• Across the globe, more than 60 central banks have expressed interest in CBDCs with a few implementations already under pilot across both retail and wholesale categories and many others are researching, testing, and/or launching their own CBDC framework. 

• As of July 2022, there are 105 countries in the process of exploring CBDC, a number that covers 95 per cent of global Gross Domestic Product (GDP). 

• As many as 10 countries have launched a CBDC, the first of which was the Bahamian Sand Dollar in 2020 and the latest was Jamaica’s JAM-DEX. 

• Currently, 17 other countries, including major economies like China and South Korea, are in the pilot stage and preparing for possible launches. China was the first large economy to pilot a CBDC in April 2020 and it aims for widespread domestic use of the e-CNY by 2023. 

How is CBDC different from private cryptocurrencies?

• CBDC is a digital or virtual currency, but it is not comparable to the private virtual currencies.

• Private virtual currencies sit at substantial odds to the historical concept of money. They are not commodities or claims on commodities as they have no intrinsic value. The rapid mushrooming of private cryptocurrencies in the last few years has attempted to challenge the fundamental notion of money as we know it. 

• Claiming the benefits of decentralisation, cryptocurrencies are being hailed as innovation that would usher in de-centralised finance and disrupt the traditional financial system.

• According to the RBI, the inherent design of cryptocurrencies is more geared to bypass the established and regulated intermediation and control arrangements that play a crucial role of ensuring integrity and stability of the monetary and financial ecosystem.

• As the custodian of monetary policy framework and with the mandate to ensure financial stability in the country, the RBI has been consistent in highlighting various risks related to the cryptocurrencies. 

• These digital assets undermine India’s financial and macroeconomic stability because of their negative consequences for the financial sector. 

• Further, a wider proliferation of cryptocurrencies has the potential to diminish monetary authorities’ potential to determine and regulate monetary policy and the monetary system of the country which could pose a serious challenge to the stability of the financial system of the country.

• Therefore, CBDCs will provide the public with benefits of virtual currencies while ensuring consumer protection by avoiding the damaging social and economic consequences of private virtual currencies.

Advantages of CBDC 

• CBDC, being a sovereign currency, holds unique advantages of central bank money — trust, safety, liquidity, settlement finality and integrity. 

• Payments using CBDCs are final and thus reduce settlement risk in the financial system. Imagine a UPI system where CBDC is transacted instead of bank balances, as if cash is handed over – the need for interbank settlement disappears. 

• CBDCs would also potentially enable a more real-time and cost-effective globalisation of payment systems. It is conceivable for an Indian importer to pay its American exporter on a real time basis in digital Dollars, without the need of an intermediary. This transaction would be final, as if cash dollars are handed over, and would not even require that the US Federal Reserve system is open for settlement. Time zone difference would no longer matter in currency settlements – there would be no ‘Herstatt’ risk.

The key motivations for exploring the issuance of CBDC in India among others include:

i) Reduction in operational costs involved in physical cash management.

ii) Fostering financial inclusion.

iii) Bringing resilience, efficiency, and innovation in payments system.

iv) Adding efficiency to the settlement system.

v) Providing the public with uses that any private virtual currencies can provide, without the associated risks.

• Cost of cash management in India has continued to be significant. The total expenditure incurred on security printing during April 1, 2021 to March 31, 2022 was Rs 4,984.8 crore as against Rs 4,012.10 crore in the previous year (July 1, 2020 to March 31, 2021)10. This cost does not include the environmental, social and governance (ESG) cost of printing money. It is predominantly borne by four stakeholders — general public, businesses, banks, and the central bank.

• CBDC reduces operational costs including costs related to printing, storage, transportation and replacement of banknotes, and costs associated with delay in reconciliation and settlement.

• The introduction of CBDC, would possibly lead to a more robust, efficient, trusted, regulated and legal tender-based payments option (including cross-border payments).

• The use of offline feature in CBDC would also be beneficial in remote locations and offer availability and resilience benefits when electrical power or mobile network is not available.

• CBDC is aimed to complement, rather than replace, current forms of money and is envisaged to provide an additional payment avenue to users, not to replace the existing payment systems.

Types of CBDC to be issued

• CBDC can be classified into two broad types — general purpose or retail (CBDC-R) and wholesale (CBDC-W). 

• Retail CBDC would be potentially available for use by all — private sector, non-financial  consumers and businesses. Wholesale CBDC is designed for restricted access to select financial institutions. 

• While Wholesale CBDC is intended for the settlement of interbank transfers and related wholesale transactions, Retail CBDC is an electronic version of cash primarily meant for retail transactions.

• It is believed that Retail CBDC can provide access to safe money for payment and settlement as it is a direct liability of the central bank. Wholesale CBDC has the potential to transform the settlement systems for financial transactions and make them more efficient and secure. Going by the potential offered by each of them, there may be merit in introducing both CBDC-W and CBDC-R.

Model for issuance and management of CBDC

• There are two models for issuance and management of CBDCs — Direct model (Single Tier model) and Indirect model (Two-Tier model). 

• A Direct model would be the one where the central bank is responsible for managing all aspects of the CBDC system like issuance, account-keeping and transaction verification.

• In an Indirect model, central bank and other intermediaries (banks and any other service providers), each play their respective role. 

• In this model, the central bank issues CBDC to consumers indirectly through intermediaries and any claim by consumers is managed by the intermediary as the central bank only handles wholesale payments to intermediaries.

• The Indirect model is akin to the current physical currency management system wherein banks manage activities like distribution of notes to public, account-keeping, adherence of requirement related to knowyour-customer (KYC) and anti-money laundering and countering the terrorism of financing (AML/CFT) checks, transaction verification, etc.

Forms of CBDC

• CBDC can be structured as ‘token-based’ or ‘account-based’. 

• A token-based CBDC is a bearer instrument like banknotes, meaning whosoever holds the tokens at a given point in time would be presumed to own them. 

• In contrast, an account-based system would require maintenance of record of balances and transactions of all holders of the CBDC and indicate the ownership of the monetary balances. 

• Also, in a token-based CBDC, the person receiving a token will verify that his ownership of the token is genuine, whereas in an account-based CBDC, an intermediary verifies the identity of an account holder. 

• Considering the features offered by both the forms of CBDCs, a token-based CBDC is viewed as a preferred mode for CBDC-R as it would be closer to physical cash, while account-based CBDC may be considered for CBDC-W.

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