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Lessons for the RBI on central bank digital currencies from abroad

While the Reserve Bank of India (RBI) only recently acknowledged that it is studying the proposal for issuing a Digital Rupee, central banks around the world have made considerable progress in recent months on the interoperability of digital currencies and how they should be designed globally. The RBI certainly has its task cut out for it and should constantly monitor the global conversation on Central Bank-backed Digital Currencies and engage actively with multi-country projects.

Earlier this week, the Bank for International Settlements (BIS) published a paper which said that central banks need to collaborate with each other to create CBDCs that are compatible with others, which could create a diverse and competitive market for services. The BIS is a global body of central banks, of which the RBI is a member.

“At least conceptually, single mCBDC systems and inter-linkages can significantly reduce existing frictions in cross-border payments (although they also come with governance, technical and cooperation challenges). Yet a condition for their success is the underlying compatibility,” it said.

While digital currencies have several benefits for the domestic economy in terms of monetary transmission, reducing banking intermediation and improving access to financial services, CBDCs can actually improve payments between institutions, particularly international institutions. Most central banks globally are developing their own digital currencies and could launch them in the next two to three years.

According to a January 2020 survey covering 66 central banks by the Bank of International Settlements, 80% of central banks across the world were engaged in research and experimentation of a CBDC. The Bank of Canada, the Federal Reserve, the Bank of England and the Bank of Japan, have respectively announced that they are are evaluating the contours of issuing a CBDC, while the European Central Bank is working on launching Digital Euro project sometime in 2021. Last year, the Bahamas became the first country in the world to start issuing CBDCs.

Recommendations for digital currency inter-operability

The BIS has recommended three models for digital currency inter-operability:

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  1. Compatible CBDC systems: Existing banking relationships are leveraged to settle transactions between multiple digital currencies, with compatible message stands to reduce loss of data, compatible compliance regimes and common requirements for wallet players
  2. Interlinked CBDC systems: Multiple digital currencies will be settled on a common clearing platform, which will have a common messaging standard which would harmonise standards across jurisdictions. This avoids the need to create common compliance requirements would not be affected.
  3. Multi currency systems: Single message standard across the system and single set of access requirements to ensure common compliance standards.

The BIS has recommended that cental banks coordinate on the following aspects:

  1. Central banks should share information on their CBDC implementation
  2. Agree on joint standards for domestic CBDC and coordinate on technology infrastructure and rules
  3. Design, establish and govern links between the CBDC and domestic systems
  4. Design, establish and govern links between the CBDCs on a multiple CBDC platform

Crypto-token and payments firm Ripple recently released a whitepaper stating that its token XRP could act as an intermediary to connect different digital currencies or CBDCs. XRP could act as neutral bridge between different currencies, which can be used by commercial companies to facilitate easier ways of doing international business.

Recently, Mu Changchun, Director of the Digital Currency Research Institute at the People’s Bank of China said that as most monetary authorities around the world want to protect their fiat currencies and monetary sovereignty, the CBDCs or digital currencies of one central bank should not impede anothers’ ability to carry out its mandate for monetary and financial stability. He said that central banks should “avoid dollarisation” of digital currencies.

Speaking at an event organised by the BIS, Changchun said that cross-border payment arrangements using digital fiat currencies should comply with with the regulations and the laws of the jurisdictions concerned. He also said that information from fund flows should be synchronised so that regulators can monitor transactions for compliance. In February, China joined a global CBDC project for cross-border payments along wit the Hong Kong Monetary Authority, Bank of Thailand and the Central Bank of the United Arab Emirates.

Thinking about the Digital Rupee

While we await more clarity from the RBI, which will soon publish a policy paper detailing the operations of the Digital Rupee, there have been a few hints on how the central bank is thinking of design the digital currency.

In a recent speech, RBI Governor Shaktikanta Das said that assessing the financial stability implications of introducing a CBDC and that it exploring ways to develop a clear, safe and legally certain settlement for the proposed digital currency or Digital Rupee. “It also needs to be appreciated that there are not many practical instances of operationalisation of CBDC across the world; this calls for utmost precaution so that we can produce a safe and robust model,” Das added.

Recently, its Report on Currency and Finance for 2020-21, the RBI hinted at how they were thinking about the possible design of the Digital Rupee. The central bank said that a CBDC or the Digital Rupee could be used to provide direct benefit transfers and act as a tool for capital account and liquidity woes. The report added that the proposed digital currency could have a 2-tier remuneration system, “whereby transaction balances held by an individual remain interest free and is subject to a ceiling; while CBDC balances of the individual over and above the ceiling are subject to a penal negative interest rate.”

To create a CBDC or Digital Rupee, the RBI can:

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  1. Amend the rules for its regulatory sandbox and allow blockchain firms, payment companies, banks and crypto-firms to experiment wi9th designing a Digital Rupee
  2. It can participate in any of the BIS’ innovation hubs around the world working on CBDCs, including in Hong Kong, Singapore or Switzerland.
  3. Build a second digital payments rail for the Digital Rupee on similar lines of the Unified Payments Interface (UPI) as Nandan Nilekani recently suggested.
  4. Work with Ripple and local blockchain companies like Polygon to scale payment transactions on a blockchain
  5. Work with Mastercard and VISA, both of whom want to support CBDCs

How to design a digital currency

China is also pursuing a two-tier system for a CBDC. At the first level, the central bank issues the retail CBDC and at the second level, commercial banks, payment service providers and other private sector and financial institutions will provide or exchange the digital yuan with the public.

In March last year, the BIS released a paper on technology standards for retail CBDCs. While highlighting the various benefits and models for a digital currency, the paper said that central banks had to decide whether to base this infrastructure on a conventional centrally controlled database or instead on Distributed Ledger Technology. It said that central banks need to keep in mind various aspects when designing their digital currencies such as consumer choice, privacy and security, resilience, cash-like convenience, impact on central bank balance sheets’ and wholesale or retail use-cases, among other issues.

In a blogpost in May 2020, former Finance Secretary Subash Chandra Garg, who headed the government’s inter-ministerial committee on virtual currencies, said that the blockchain form of issuing CBDCs can be expensive, Garg suggests that the regulators create a special wallet through which people can receive Digital Rupees. “Digital rupee can be created in a single unit of one rupee. It is easy in digital mode to make payment of any amount in units of one rupee. Demat rupee in digital wallet is our digital rupee- the next generation of rupee. The system of digital rupee does not make any difference in the authority and management of money by the Central Bank” he said.

This view was echoed by Burkhard Balz, a German politician and executive board member of Deutsche Bundesbank. In a speech last October, Balz said the Bundesbank was “thinking of alternative solutions which could help to overcome existing pain points, reap the benefits of digitalisation and support new payment use cases without introducing CBDC – and without the possible undesirable implications related to it.”

The Bundesbank recently issued a 10-year bond a blockchain platform in conjunction with Deutsche Börse and the German Finance Energy and banks like arclays, Citibank, Commerzbank, DZ Bank and Goldman Sachs. The system, which allowed subsequent primary and secondary market trading and settlement of the bond on the blockchain, is Germany’s way of saying ‘we do not need a digital currency to settle blockchain-based payment transactions’

CBDCs versus crypto-currencies

Unlike crypto-currencies which are issued without a central bank backing and are issued and traded on exchanges, a CBDC is a digital currency which holds the same value as fiat currencies issued by a country’s central bank. The value of the CBDC is pegged to the value of the fiat currency. The ‘private’ crypto-currencies include Bitcoin, Ethereum and Ripple, among many others.

While crypto-currencies can be used as a currency or as a means of exchange/payment, regulators across the world have adopted different approaches. Most regulators around the world treat the majority of crypto-currencies as investment vehicles, like in the case of the Securities and Exchange Commission of the United States. But since Bitcoins can be used as payment instruments in Singapore and Japan, the central bank in each country is in charge of issuing regulations for the use of cyrpto-currencies like Bitcoin as a means of exchange.

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It is important to note that each crypto-currency can have several use-cases. While Bitcoin can be used as a means of payment, it behaves like a stock and is traded every day for the potential returns on their investment. Other cryptos like Ethereum and Ripple, which are also traded for investment returns, are building blockchain-based infrastructure and tools.

Types of CBDCs

A CBDC can take many forms. It can be issued on blockchain ledger like regular crypto-currencies, or through a demat account or a specific payments instrument. There can be retail CBDCs, which would be accessible to all types of consumers, or wholesale CBDCs that are meant only for institutions. There are three models of issuing CBDCs:

  • Direct: issued by a central bank to banks and then to consumers; the claim on CBDC payments is on the central bank
  • Indirect, wherein digital currencies are issued by banks to customer; the claim on CBDC payments is on the bank or market players
  • Hybrid: market players on-board customers and issue CBDCs; the claim on payments is on the central bank

CBDCs can also be interest-bearing or non-interest bearing:

  • Interest-bearing: For every Rs 100 in digital currencies, the wallet holder will receive some interest rate directly from the central bank. This helps the central bank directly affect people’s consumption expenditure in the fight against inflation. If inflation rises to 6%, the RBI can provide specific sets of customers with a 8% interest rate directly into their accounts without any bank intermediation. As inflation reduces, the RBI can reduce the interest rate.
  • Non-interest-bearing: The value of the CBDC is pegged to the fiat currency. Just like money sitting in a bank deposit depreciates due to inflation, the value of a non-interest bearing CBDC depreciates due to inflation.

MediaNama has prepared a guide on crypto-currency regulations in India, listing the government’s position over the last few years and various policy recommendations; read it here: A complete low-down on crypto-currency regulation in India.

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Reports on banking, payments, fintech and crypto-curencies. Additional reporting on media regulations, data protection and other areas.

MediaNama’s mission is to help build a digital ecosystem which is open, fair, global and competitive.



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