On 1st February, amidst various announcements made during the budget speech, finance minister Nirmala Sitharaman's one statement, in particular, left everyone in a frenzy.
"Introduction of Central Bank Digital Currency (CBDC) will give a big boost to the digital economy. Digital currency will also lead to a more efficient and cheaper currency management system. It is, therefore, proposed to introduce Digital Rupee, using blockchain and other technologies, to be issued by the Reserve Bank of India starting 2022-23.”
CBDC? Blockchain? Digital Rupee?
The statement took the country by storm.
Was this the final nail in the coffin for cryptocurrency? What are the use cases of a digital currency? How different is it from physical currency?
This blog will take a deep dive and understand precisely how CBDC functions and what its introduction means for various entities in India.
As the name suggests, Central Bank Digital Currency (CBDC) is a form of a digital currency issued by the country's Central Bank. In our instant case, it will be issued by the Reserve Bank of India (RBI). It is pegged to national currency and functions just like physical cash or bank notes. However, unlike digital payment transactions, a digital currency would eliminate the need for banks as middlemen, as all transactions would be recorded and completed on a digital ledger monitored by the central government.
CBDC - Pilot Projects
There are 9 countries with active CBDCs - 8 of which is Caribbean nation. More than 80 Countries are researching on it and 14 countries are running pilot programs.
E-Naira - Nigeria’s CBDC launched recently. Nigeria currently s people with bank accounts and digital wallets to use it, but the idea is to give access to E-Naira even if the person does not have a smartphone.
Digital Yuan - Launched as a pilot program by China in 2014, which we can see launched on a full scale after the Beijing Olympics.
How is CBDC different from cryptocurrency?
While a CBDC and cryptocurrency are both built on a blockchain network, there are primarily 2 differences between the two.
- Cryptocurrency is decentralised, which means that no central authority governs cryptocurrency. The decentralised network is run on math and code by 'miners' who make the blockchain more secure.
CBDC, on the other hand, is centralised and issued by the government. Since it is a government recognised, it carries citizens' faith, and it can carry out value exchange transactions like a Fiat Currency.
- While CBDC is a currency used for exchanging value, cryptocurrency, at least as of now, is seen more like a digital asset rather than cash. An asset similar to stocks or mutual funds. Since governments will not be willing to let go of their sovereign authority over money, it is unlikely that cryptocurrency will ever transition into a currency in most countries.
Pros and Cons of CBDC
Now that we have understood the essence of CBDC let's break down how this digital currency could impact a country.
- It eliminates anonymity and makes money easier to track for the government. Thus, it could play a role in identifying instances of money laundering and black money hoarding.
- For the citizens, it makes transactions easier, faster and more transparent.
- A potential point of bank failure is eliminated. Citizens don't have to be at the mercy of banks and their well-being for their transactions to go through successfully. In recent past we have seen co-operative banks going bust, CBDC can be an answer to such events.
- A digital currency could mean bidding farewell to any form of privacy. Transacting through digital currency would mean leaving a digital footprint everywhere which can be traced.
- It hands heightened control and authority in the hands of the central institutions.
- It also could lead to a disruption of a country's economy. The reduced need for commercial banks would mean they would have less money and deposits and, thus, fewer loans. A country's credit cycle could be badly hurt if such a thing does happen at scale.
To solve the problem mentioned above, two types of CBDCs are being developed by various countries.
Retail CBDCs: Under this, citizens would have their digital wallets where they would be able to make direct transactions without the intervention of retail banks.
Wholesale CBDCs: In a bid to keep commercial banks relevant, the idea of wholesale CBDCs is being developed where banks would have digital wallets and would in turn help transact digital currency for citizens.
It is still to be seen which model works better, but governments are leaning towards the retail model.
Stable-coins and CBDCs
Cryptocurrencies, in general, are highly volatile. 10-20% daily price movements are regular for many of them. Such volatility makes them unsuitable to act as a currency. Hence, if you want to cash out the profits in Bitcoins and sleep peacefully, you can simply put your earnings in stable coins which are less volatile and easily transferable. Hence, stable-coins were developed whose value is pegged approximately to the national currency. - This ensured minimising the volatility of a cryptocurrency while retaining its decentralised nature. Examples - USD Coin, DAI, Tether.
It is widely believed that CBDCs would go on to replace stable-coins. While these are still early times, it will be interesting to see what eventually happens to stable-coins which currently has more than $100 billion in valuation.
The concept of CBDC is in the development phase and as discussed above many countries are still testing waters. While it offers benefits to citizens, it also has a few downsides. It is also not a direct replacement for cryptocurrency. It remains to be seen whether crypto will be banned after CBDCs are introduced or continue to be recognised as a digital asset ambiguously or someday down the line be recognised as a currency too.
But for now, it is time to embrace the new revolution in payments, CBDCs. We will wait for RBI white paper on the same.