The Emergence of Central Bank Digital Currencies.

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While the popularity of cryptocurrency is on the rise as a medium of exchange and investment, there are worries about the volatility of private digital currencies available on the internet and how they might affect the currencies of countries in the long run. As a result, the concept of central bank digital currency (CBDC) is garnering interest among institutions and governments alike. Several initiatives are being undertaken in countries such as the US (Digital Dollar), China (Digital Yuan), Sweden, New Zealand, etc. With the RBI also set towards launching a CBDC, let us take a look at what a CBDC is and what its implications will be in the economy.

What are CBDCs?

Also known as digital base money or digital fiat currency, a central bank digital currency (CBDC) is the digital form of legal tender issued by the central bank of a country. It is similar to a fiat currency and is exchangeable one-to-one with the fiat currency. Only its form is different. It is backed by the credit of issuing government and appears as a liability on the central bank’s balance sheet. A CBDC is meant to coexist with the present monetary system while simplifying transactions. 

Generally, CBDCs are being implemented for specific purposes in the wholesale and retail segment: 

  • Wholesale CBDCs make use of the banks for settling transactions. They are similar to banking reserves. The underlying technology used is helpful in seamless international transactions transfers as well. 

  • Retail CBDCs are used by consumers. The official digital currency is transferred directly, thus eliminating the risk of banks becoming illiquid. 

    • Account-based CBDC is a validation mechanism used which works like a regular deposit account, wherein a user can open an account and can then make transactions. 

    • Another mechanism is a token-based CBDC which involves the transfer of CBDCs through a digital wallet. 

What is the need for CBDCs?

Several countries have different reasons for justifying the implementation of CBDCs. For instance, the US is interested in digital currencies to make its payments system more efficient. For emerging economies such as India, CBDCs could provide a secure and stable form of digital money and meet the public’s demand for digital currencies. A central bank digital currency has definite advantages such as: 

  • A digital currency helps in the easier implementation of the monetary and fiscal policies of governments. It simplifies the processes for other government functions, such as distribution of benefits or calculation and collection of taxes, which would lead to a reduction in costs. 

  • It would help governments to transfer public funds or emergency grants quickly in crises. 

  • A central bank will be able to track money easily throughout its jurisdiction, thereby preventing illicit transactions using CBDCs. Similarly, unaccounted money in the economy could be tracked. This would help the governments in controlling money laundering, terror financing and tax evasion. 

  • As a digital currency establishes a direct connection between consumers and the central bank, it is easier to set up and doesn’t require expensive infrastructure. This helps in promoting financial inclusion, especially in developing nations. 

  • A CBDC is also a very efficient and secure form of retail payment. 

    • It reduces the settlement risk on the financial system. For instance, if CBDCs are transacted like cash instead of bank balances, there is no need for inter-bank settlements; thus, transactions can take place in real-time. 

    • The use of CBDC for international transactions would eliminate Herstatt risk, i.e., cross-currency settlement risk as time zone differences would not matter. An Indian exporter and an American importer can potentially transact on a real-time basis without the need for an intermediary. 

What are the risks associated with CBDCs?

  • There are fears that without a proper framework CBDCs might affect the banking system negatively in the long run. If the transaction demand for deposits is reduced, the banks will be left with a lesser amount of currency. If banks lose a significant amount of deposits, the interest margin would get narrower leading to a higher cost of credit. Thus, the credit creation capacity of banks would get constrained considerably. 

  • A CBDC issued by a foreign country with a strong currency could potentially replace the currency of a weaker economy. For instance, Ecuador had to replace its currency with the US Dollar in 2000 as a result of high rates of inflation. 

  • Adequate technology preparedness is necessary for the successful use of CBDCs. Lack of high-speed internet and telecommunication services would limit the reach of CBDCs and increase inequalities concerning access to financial services. 

  • There is also a threat from a cyber-security perspective. 

    • CBDCs are at risk of cyber-attacks similar to what the current digital payment systems are facing. Credential theft and loss is a major concern as account funds and data could be compromised. 

    • In nations with low financial literacy, an increase in digital modes of payment may lead to a higher number of frauds and financial crimes. Thus, efforts for improving financial literacy are the need of the hour. 

What is the future for CBDCs?

Although no central bank has officially established a CBDC yet, many countries have eagerly undertaken pilot programs and research projects to evaluate the pros and cons of implementing digital currencies in their economies. Some key issues under consideration are - the scope of these currencies, the legal framework required, the underlying technology and validation mechanism to be used, etc. Experiments are going on and this could lead to a long-term plan for CBDCs. Careful planning and effective integration with the existing banking and payment systems will be critical success factors for the implementation of digital currencies. CBDCs are likely to be used by most central banks in the coming years as the future is digital.


References :


- By Sagar Gala



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