A digital currency is like any other currency, money or any money like asset that is primarily managed, stored or exchanged on a digital computer system, especially over the internet. They are unlike printed bank notes or minted coins and generally do not have any physical form.

Digital currencies however express properties similar to physical currencies. The various types of digital currencies are virtual currency (cryptocurrency) and central bank digital currency (CBDC). A digital currency can lower transaction processing costs and enable seamless transfer across borders.

Virtual currency is an electronic representation of monetary value that may be issued, managed and controlled by private issuers. They are often represented in terms of tokens and may remain unregulated without a legal tender. They rely on a system of trust and may not be issued by a central bank or any other banking regulatory authority.

They derive their value on the underlying mechanism like mining in cases of cryptocurrency. They do not have any intrinsic value. They do not represent any person’s debt or liability and there is no issuer.

The concept of CBDC is quite an old one. Nobel laureate James Tobin, an American Economist, in the 1980s suggested that Federal Reserve banks could make available to the public a widely accessible medium with the convenience of deposits and safety of currency. It is, however, in the last decade that this has been widely discussed.

Money has taken either the form of commodities (which have intrinsic value) or in terms of debt instruments. When money does not have intrinsic value it must represent title to commodities or title to other debt instruments. Paper currency is such a representative money and it is essentially a debt instrument. The owner of the currency knows who owes him or who has the underlying liability. Currency is a form of money that is exclusively by the sovereign or by a central bank. It is a liability of the issuing central bank and asset of the holding public.

CBDC is an electric form of central bank money. It is an electronic record of the official currency and is issued and regulated by the monetary authority. The introduction of cryptocurrencies paved the way for CBDCs. The advantages of CBDCs are:

Simplify implementation of monetary and fiscal policy by making it easier to propagate money directly through the economy. The current system involves commercial banks as intermediaries between central banks and the consumer.

Promotion of financial inclusion in an economy by bringing the unbanked into the financial system. Costs associated with opening of accounts, disbursements of benefits, collection of taxes and processes to other government functions. It eliminates expensive infrastructure.

The costs of transactions processing are very low for CBDC and enable seamless transfer across borders.

The invention of a secure and immutable ledger which is able to track transactions.

A CBDC eliminates third-party risk (due to rumours or external events).

A CBDC is universally accessible.

Many countries are exploring the possibility of introduction and use of CBDCs in their economy. The main disadvantage of a centralised form of currency is that it can erode the privacy of the citizens. Also, CBDC has the disadvantage of bringing in cumbersome regulations of a central bank/monetary authority.

Why a CBDC

A CBDC will keep track of all transactions and could be used to eliminate corruption/black money. The cryptocurrency ecosystem could potentially disrupt the existing monetary and financial infrastructure and therefore, the attempt by the central banks/monetary authority to pre-empt such an eventuality.

CBDC will act as a general representation of country’s currency. It will function as a unit of account, store of value and medium of exchange for daily transactions. A CBDC will be backed by suitable monetary reserves like gold and/or foreign currency. CBDCs would also potentially enable a more real time basis and cost effective globalisation of payment system.

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 payment would be final as if cash dollars are handed over and would also not require that the US Federal System is open for settlement. Time zone difference would no longer matter in currency settlements.

Crypto vs CBDC

A cryptocurrencies as we know them today are extremely volatile and do not have government backing. CBDCs overcome this deficiency by using the same underlying technology of cryptocurrency. Governments recognise CBDC as legal tender in the issuing central bank’s jurisdiction meaning anyone can use them for payments and every merchant must accept them.

It increases the safety and efficiency of wholesale and retail payments. In a digital society no notes or coins are available and the country becomes cashless. As private e-money rises the pressure on government issue, a CBDC is strong. CBDC is available round the clock and is also a great tool to avoid private counterparty credit risk.

Country experiments

While interest in CBDCs is nearly universal now, very few countries have reached even the pilot stage of launching their CBDCs. A 2021 BIS survey of central banks found that 86 per cent were actively researching the potential of CBDCs, 60 per cent were experimenting with the technology and 14 per cent were deploying pilot projects. They include: China, Digital Yuan; Sweden, e-Krona; Bahamas, Sand Dollar; Eastern Caribbean, DXCD; and Marshall Islands, Sovereign.

The advantage of issuing a CBDC might be enough to justify India issuing a CBDC. India is leading the world in terms of digital payments innovations. Its payment systems are available 24x7 to retail and wholesale. They are largely real time and the cost of transactions is virtually nil or very low.

Digital payments have grown at a impressive CAGR of 55 per cent. It is difficult to find a payment system like UPI which allows transactions to the extent of ₹1. Still cash remains the preferred mode of payment system for receiving money for regular expenses. For small transactions up to ₹500, cash is the preferred medium. India’s high currency-to-GDP ratio holds out another benefit of CBDCs.

The cost of printing, transporting, storing and distribution of the currency can be reduced. The advent of private virtual currencies (VCs) may well be another reason why CBDCs might become necessary. If these VCs gain recognition, national currencies with limited convertibility will come under threat.

Currencies like the US dollar will not be affected as most of these VCs are denominated in dollar. Developing our own CBDC could protect the public from the abnormal level of volatility some of these VCs experience. Thus CBDCs for emerging economies are desirable not just for the benefits they create in payment systems but also might be necessary to protect the general public in an environment of volatile private VCs.

Like other central banks, the RBI has also been exploring the pros and cons of introductions of CBDCs for quite a long time. The RBI is currently working towards a phased implementation strategy and examining use cases which could be implemented with little or no disruption.

Central banks are giving considerable attention to CBDCs and, therefore, they will become a reality soon. The CBDCs will help in financial inclusion of the unbanked population. CBDCs will have far-reaching implications on the future of finance, including the buying and selling of digital assets and securities. There should be a dedicated legal framework to facilitate the transparency, distribution and issuance of a digital form of money by global governments.

As the regulators and central banks take concrete steps in the direction of establishing CBDCs the world will begin to embrace digital currencies as a standard. Introduction of CBDCs has potential to provide significant benefits such as reduced dependency on cash, lower transaction costs, and reduced settlement risk. It could lead to a more robust, efficient, trusted, regulated and tender-based payment options. Any idea would have to wait for its time. It could be the time for CBDCs.

The writer is Head of Treasury, Finrex Treasury Advisors

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