Even as private virtual currencies such as bitcoin began attracting followers by droves over the last two years, work on CBDCs, considered an antithesis to the private crypto currencies, has also been progressing at a rapid pace. The RBI has been ‘extremely concerned’ about the misuse of private virtual currencies by nefarious elements and had been aiming to control such activities with the help of CBDCs.

But in the recent monetary policy press conference, the RBI Governor sounded hesitant when asked about the timing of the launch of Indian official digital currency, saying that the RBI was proceeding with ‘utmost care’ in this issue. The Governor’s reply shows that launching an official digital currency is not going to be a cake-walk.

A CBDC is official fiat currency in a digital form. It will be issued by the RBI and holders of this currency will have a direct claim on RBI. But the central bank has to weigh multiple factors before deciding on the design of the CBDC including protecting the privacy of the data that will be at its disposal, maintaining anonymity in the digital currency transactions, manner in which the retail transactions (which are likely to be really humungous in volume) are to be captured and maintained, whether any private sector entity can be relied upon to help the central bank in this, and so on.

RBI is not alone in facing such quandary. According to a BIS survey conducted in 2021, 86 per cent of central banks are still in the research phase regarding CBDCs. 60 per cent were experimenting with the technology and only 14 per cent had begun pilot projects. No central bank has taken the plunge yet and the exact impact of CBDCs on the banking system, cash in circulation or digital payments in the economy are unknown, as of now. If the right architecture is not selected, the CBDC may not be successful.

Are CBDCs needed?

The question that needs to be answered is, are CBDCs really needed?

Initial thought process in beginning work of CBDC was that they could act as a substitute for private virtual currencies. But it is now obvious that CBDC cannot replace bitcoin et al which are just speculative assets given to wild gyrations in value. Investors trade in them due to these wild swings in prices. CBDCs, on the other hand, are fiat currencies issued by central banks in digital forms and are exchangeable one-to-one with fiat currency.

This means that their price movement will be far too sedate and boring to entice speculators. Also those who use private virtual currency for cross-border payments prefer them for the manner it shields their identity from regulators. These users are unlikely to shift to CBDC.

Some countries such as Sweden where usage of cash in retail transactions is down to 15 per cent are trying to increase use of official currency through a CBDC. But India does not have that problem since cash remains the predominant mode of payment in the country.

The issuances and use of CBDCs could check excessive cash usage and creation of black money but depends on the kind of CBDC architecture adopted by the country.

Also digital payments is just beginning to gain traction in India. A CBDC will be yet another form of digital payment mechanism (in retail CBDCs — discussed below), although costs could be lower here and data could be held by the central bank instead of a payment service provider, if the RBI decides to maintain records of all retail CBDC transactions. This could however get onerous and be a drain on RBI’s resources.

Choices before the RBI

The main decision that the RBI needs to make is whether to launch CBDCs for only wholesale payments or for retail payments as well. Wholesale CBDCs are restricted to financial institutions and payment service providers and used for settling transactions between these institutions. The domestic payments will be captured in the central bank balance sheet. There does not seem to be too much risk in wholesale CBDCs with the data being securely held by the central bank. Countries such as Canada and Singapore are moving towards launch of such CBDCs

The complications arise in retail CBDC. Here the central bank issued digital currency is held directly by retail users in digital wallets, just as they would hold cash. The difference between bank deposits or other monetary deposits and CBDC is that there is no intermediary here and the claim is directly on the central bank so there is no risk of default or settlement risk. But an investor does not earn any interest on CBDCs Also there is no cost involved in payments using CBDCs unlike other forms of digital payments where there is some form of cost burden on users.

The problem with retail CBDC is that the central bank can not handle the customer onboarding, KYC compliance, maintaining records of transactions, addressing complaints etc. Intermediaries such as banks or payment service providers would have to be used for these activities. With the personal data protection Bill not yet passed by Parliament, giving personal details as well as details of transactions to an intermediary is fraught with risk. But it may be next to impossible for the RBI to oversee these transactions itself

Also, retail users would prefer to remain anonymous while making transactions through CBDCs. If that is absent, there may be no incentive to shift to CBDC. There are two options in design of retail CBDCs. One is to issue token based currency which will give access to users based on a password-like digital signature using private-public cryptography, without requiring personal identification.

The other design option is to use account based method where the identity of the user is captured through his account and hence all the transactions in CBDC are captured by the central banks. This design is ideal for checking tax evasions and containing black money, but this will not be preferred by retail users who would prefer anonymity. But development of a token based CBDC will need more time.

Account based CBDCs will once again face a hurdle at the lack of governance regarding data privacy in our country. Would retail users want the government to know about every monetary transactions they make, especially when there is no assurance that the data will not be misused?

The final choice would be with regard to the kind of ledger that would maintain records of these digital transactions — whether it would be distributed ledger accessible to all or if it would be a centralized ledger.

This can wait

Given that CBDC will not end bitcoin and other private virtual currencies’ reign, there does not really seem to be any urgency in launching CBDC. It would be better if the central bank takes its time over designing the right structure for the official digital currency, keeping in mind the resources available with the central bank and the extent to which private sector intermediaries can be relied upon to handle such sensitive data.

Finally, in the absence of a solid private data protection law, a CBDC should not be launched as it would render all users of CBDC vulnerable.