The Reserve Bank of India (RBI) is planning to launch the Central Bank Digital Currency (CBDC) or virtual currency in a phased manner in the country. This means that our knowledge of money and current methods of money transactions could entirely change in the future.

Speaking at a webinar organised by Vidhi Centre for Legal Policy on July 22, 2021, RBI's Deputy Governor T Rabi Sankar said the central bank is currently working towards a "phased implementation strategy" of bringing about the digital rupee.

"CBDC is likely to be in the arsenal of every central bank going forward. Setting this up will require careful calibration and a nuanced approach in implementation. Drawing board considerations and stakeholder consultations are important," Sankar said.

What is CBDC?

CBDC, also known as virtual currencies or digital currency, is the legal tender issued by a central bank in a digital form. "It is the same as a fiat currency (government printed currency whose value depends on the strength of the country's economy) and is exchangeable one-to-one with the fiat currency. Only its form is different," said Sankar.

In simple terms, it is equivalent to the current banknote but in electronic form and cannot be converted or drawn in paper form (cash) from a bank or an automated teller machine (ATM).

Certain economies such as the United Kingdom, the United States of America, Russia, China and South Korea have explored this domain but no country has successfully implemented it yet. China has called it the Digital Yuan and has started with trials in changing their financial systems — producing a set of global rules for CBDCs, reported Reuters on March 25, 2021.

Similarly, the United States is considering a Digital Dollar, Europe a Digital Euro and in April 2021, Russia set out to create a prototype Digital Ruble.

According to James Pomeroy, global economist, HSBC, "The Bank for International Settlements says 10% of central banks claim that they are likely to issue a CBDC within three years and 20% within six. There are pilots in Ukraine, South Korea, Iceland and Thailand, while Canada, Brazil and Cambodia are working on ideas. The Bahamas' card-based 'Sand Dollar' has already been tested on two islands."

In India's case, the RBI has been exploring the pros and cons of CBDCs for a while now, said Sankar. "Generally, countries have implemented specific purpose CBDCs in the wholesale and retail segments. Going forward, after studying the impact of these models, launch of general purpose CBDCs shall be evaluated. RBI is currently working towards a phased implementation strategy and examining use cases which could be implemented with little or no disruption," he explained.

Sankar also listed key issues that the central bank is examining:

1. Should CBDC be used only in retail or in wholesale payments too?

2. Can it be a distributed or a centralised ledger?

3. Should the validation mechanism be token based or account based?

4. Should the distribution method be a direct issuance by the RBI or through other banks?

5. What should be the extent of anonymity?

"However, conducting pilots in wholesale and retail segments may be a possibility in near future," added Sankar.

Benefits and Risks of CBDC

Payments using CBDCs are final and can limit the settlement risk in the financial system, said Sankar in the webinar.

"Imagine a UPI [Unified Payments Interface] system where CBDC is transacted instead of bank balances, as cash is handed over – the need for interbank settlement disappears," he said. Transactions can happen in real-time in a cost-effective way and time zones would no longer be a hindrance in currency settlements. Besides, the cost of printing, transporting, storing and distributing currency can be reduced, he added.

However, a pilot study conducted by the RBI on retail payment habits of individuals in six cities between December 2018 and January 2019, and published in April 2021, shows that more than half or 54.2% Indians preferred cash payments, a little over 40% preferred digital payments and only 3% preferred paying via cheques. For small value transactions, such as with amounts up to Rs 500, cash is used predominantly.

"To the extent the preference for cash represents a discomfort for digital modes of payment, CBDC is unlikely to replace such cash usage. But preference for cash for its anonymity, for instance, can be redirected to acceptance of CBDC, as long as anonymity is assured," said Sankar.

When it comes to risks, commercial banks could be affected due to the reduced intermediation of banks. This means that banks that act as a middle source during transactions would be eliminated allowing individuals to invest directly with the central bank.

"Deposits could be withdrawn, perhaps abruptly, from commercial banks, if people decide to hold CBDC in significant volume. Banks would then have to raise interest rates on deposits to retain customers, or they would have to offer better payment services. Banks could experience a compression of margins, or they could have to charge higher interest rates on loans," said Tobias Adrian, financial counsellor and director of the Monetary and Capital Markets Department, International Monetary Fund, at the International Financial Congress on June 30, 2021.

CBDC could also be a potential target for cyberattacks and illicit activity, according to the Board of Governors of the Federal Reserve System. This also opens central banks to potential reputational risks, added Adrian. The board suggests that the CBDC architecture needs to be extremely resistant to such threats because of multiple entry points to a CBDC network as compared to existing networks.

Adrian listed another risk: the macro-financial risks that can occur with the cross-border use of CBDC. "For the CBDC of reserve-currency countries, which are available across borders, there could be an increase in currency substitution (or "dollarization") in countries with high inflation and volatile exchange rates," he said.

How is CBDC different from cryptocurrency?

Digital currencies such as cryptocurrency and stablecoins are private decentralised digital assets and operate independently of the government whereas a central government's monetary authority will manage and decide the rules for CBDC.

At present, there are over 6,000 cryptocurrencies in a market worth over $1 trillion. In 2013, there were only 66 cryptocurrencies worldwide. As of July 2021, this has significantly increased to 6,044, as per Statista. Some of the most popular ones are Bitcoin, Ethereum, Dogecoin and Tether.

So, the challenge that a centralised currency or CBDC faces is ensuring authenticity, traceability and anonymity at the same time.