Context

• The Reserve Bank of India (RBI) is in the process of implementing the Central Bank Digital Currency (CBDC) in a phased manner for wholesale and retail segments.
• The introduction of CBDC was announced in the Union Budget 2022-23, by Finance Minister Nirmala Sitharaman and necessary amendments to the relevant section of the RBI Act, 1934 have been made with the passage of the Finance Bill 2022.

Issues with Cryptocurrencies

• A cryptocurrency like bitcoin is a cryptography-based peer-to-peer electronic cash system, founded on blockchain and distributed ledger systems, that allow the transfer of values without any financial intermediary such as banks.
• Cryptocurrencies aspire to be a new, digital, encrypted, and decentralised form of currency. However, to be considered a currency, there has to be a unit and a defined process of issuance. 
• Many countries have refrained from officially recognising cryptocurrencies. There are reasons that legitimise the uncertainty regarding cryptocurrencies.
• One, the technology is decentralised where there is no central agent to regulate or stabilise the value of the currency. Two, the transactions are slow, costly, non-scalable, and the process is far from simple. 
• Three, cryptocurrencies are extremely volatile. And lastly, there is a threat to the security of the parties involved in the transaction and there is a potential risk of fraud.  
• So, clearly, if digital money has to exist, central banks have to play an important role as a regulatory, supervisory, and issuing authority.

What is CBDC?  

• • A Central Bank Digital Currency is a digital token, similar to but not the same as cryptocurrency, issued by a central bank of a country. They are pegged to the value of that country’s fiat currency and enjoy government mandate as opposed to cryptocurrencies.

• Fiat money is a currency that lacks intrinsic value and is established as a legal tender by government regulation.

• Usually, token-based CBDC doesn’t require the two parties to have a bank account; a person can pay with CBDC much like a payment made in cash.  
• The RBI is currently working towards a phased implementation strategy.
• Some key issues under examination are– (i) the scope of CBDCs– whether they should be used in retail payments or also in wholesale payments; (ii) the underlying technology– whether it should be a distributed ledger or a centralised ledger; (iii) distribution architecture– whether direct issuance by the RBI or through banks.

Innovative Approach

• It is important to understand that digital currencies are not the same as the transactions made on digital payments portals. The transactions on these portals are merely an exchange of fiat money facilitated by technology where no physical exchange is taking place between parties involved in the transaction.
• A digital currency on the other hand is another category of fiat money that lacks any physical attributes and exists only in electronic form.  

CBDC vs Cryptocurrencies

• There are certain key factors that make the introduction of CBDC inevitable in India given the scope of digitisation in day-to-day banking activities.
• First, there is a diverse range of virtual currencies being circulated and the market currently is extremely fragmented. Second, due to their limited scale and efficiency, the number of transactions occurring through private virtual currencies is very low.
• Third, the degree of pseudo-anonymity provided by private digital currencies discourages participation as the transactions have to be recorded on a public ledger that every participant has access to. Fourth, there are many technical and security concerns associated with its use.
• Moreover, cryptocurrency is largely decentralised with no issuance authority behind it which makes it a less trusted source of investment. 
• Despite a diverse range of virtual currencies being available, penetration of private digital currencies remains low which offers a strong case for India’s own digital fiat rupee that will promote financial inclusion. It will ensure privacy, transferability, convenience, accessibility, and financial security.  
• In a macroeconomic sense, the introduction of CBDC will also help in reducing the cost of transactions for corporate consumers, particularly large ones, across borders.
• CBDCs can reduce the costs that the central bank bears for printing, transporting, and managing cash.
• While they have all the positives of cryptocurrencies, CBDCs are regulated and standardised as opposed to being dictated by investor sentiments, usage, and user interest.
• Discontinuation of paper currency is also desirable as a large sum of cash is precisely used to hide transactions in countries, especially India. Additionally, digital currencies offer a way to track frauds, ensuring that resources of the economy are not misused.

Way Forward

• Once the use of digital currency becomes widespread, backed by the government’s mandate, it can be used in Direct Benefit Transfers (DBTs) to the vulnerable population ensuring increased exposure to digitisation and quick financial assistance at the same time.
• CBDC will also be a further push to e-commerce with the greater trust of the masses in digital transactions that are backed by the  government.
• A country like India with a large and diverse population works as a sample market for the entire world to understand the mechanism of a new product, in this case, a digital currency.

Reference:

1. https://www.thehindu.com/business/phased-implementation-of-digital-currency-for-wholesale-retail-segments-in-the-works-rbi-official/article65663242.ece