Central Bank Digital Currency (CBDC)- e₹-R & e₹-W- A new financial landscape in India

Discover the landscape of Central Bank Digital Currency (CBDC) in India with e₹-R and e₹-W, exploring its functions, motivations, types, models, and technological considerations, along with its global scenario and pilot runs.

Management of currency is one of the core central banking functions of the Reserve Bank of India for which it derives the necessary statutory powers from Section 22 of the RBI Act, 1934. Along with the Government of India, the Reserve Bank is responsible for the design, production and overall management of the nation’s currency, with the goal of ensuring an adequate supply of clean and genuine notes in the economy.

The history of money is fascinating and goes back thousands of years. From the early days of bartering to the first metal coins and eventually the first paper money, it has always had an important impact on the way we function as a society. The Concept of Money has practiced progress from Commodity to Metallic Currency to Paper Currency to Digital Currency now.

In modern economies, currency is a form of money that is issued exclusively by the sovereign (or a central bank as its representative). It is a liability of the issuing central bank (and sovereign) and an asset of the holding public. Currency is fiat, it is legal tender. Currency is usually issued in paper (or polymer) form, but the form of currency is not its defining characteristic.

What is a central bank digital currency CBDC?

A CBDC is the legal tender issued by a central bank in a digital form. It is the same as a ϐiat¹ currency and is exchangeable one-to-one with the ϐiat currency. Only its form is different.

It is also important to understand what a CBDC is not. CBDC is a digital or virtual currency but it is not comparable to the private virtual currencies that have mushroomed over the last decade. Private virtual currencies sit at substantial odds to the historical concept of money. They are not commodities or claims on commodities as they have no intrinsic value; some claims that they are akin to gold clearly seem opportunistic. Usually, certainly for the most popular ones now, they do not represent any person’s debt or liabilities. There is no ISSUER. They are not money (certainly not CURRENCY) as the word has come to be understood historically.

Key Motivations for CBDC:

The adoption of CBDC has been justified for the following reasons: –

• CBDC, being a sovereign currency, holds unique advantages of central bank money viz. trust, safety, liquidity, settlement finality and integrity.
• The key motivations for exploring the issuance of CBDC in India among others include reduction in operational costs involved i
• There are no sources in the current document.  physical cash management, fostering financial inclusion, bringing resilience, efficiency, and innovation in payments system, adding efficiency to the settlement system, boosting innovation in cross-border payments space and providing public with uses that any private virtual currencies can provide, without the associated risks. The use of offline feature in CBDC would also be beneficial in remote locations and offer availability and resilience benefits when electrical power or mobile network is not available.
• Jurisdictions with significant physical cash usage seeking to make issuance more efficient
• Central banks seek to meet the public’s need for digital currencies, manifested in the increasing use of private virtual currencies, and thereby avoid the more damaging consequences of such private currencies. It is not clear what specific need is met by these private VCs that official money cannot meet as efficiently, but that may in itself not come in the way of their adoption. If these VCs gain recognition, national currencies with limited convertibility are likely to come under threat. To be sure, freely convertible currencies like the US Dollar may not be affected as most of these VCs are denominated in US Dollar. In fact, these VCs might encourage the use of US Dollar, as has been argued by Randal Quarles². Developing our own CBDC could provide the public with uses that any private VC can provide and to that extent might retain public preference for the Rupee. It could also protect the public from the abnormal level of volatility some of these VCs experience.
• In addition, CBDCs have some clear advantages over other digital payments systems – payments using CBDCs are final and thus reduce settlement risk in the financial system. Imagine a UPI system where CBDC is transacted instead of bank balances, as if cash is handed over – the need for interbank settlement disappears. CBDCs would also potentially enable a more real-time and cost-effective globalization of payment systems. It is conceivable for an Indian importer to pay its American exporter on a real time basis in digital Dollars, without the need of an intermediary. This transaction would be final, as if cash dollars are handed over, and would not even require that the US Federal Reserve system is open for settlement. Time zone difference would no longer matter in currency settlements – there would be no ‘Herstatt’ ³
• India’s high currency to GDP ratio holds out another benefit of CBDCs. To the extent large cash usage can be replaced by CBDCs, the cost of printing, transporting, storing and distributing currency can be reduced.

Types of Central Bank Digital Currencies (CBDC):

CBDC is Classified Broadly into Two Types, viz. General Purpose or Retail (CBDC-R) Digital Currency and Wholesale (CBDC-W) Digital Currency. The Retail CBDC (e₹-R) would be purportedly available for use by all entities, viz., Private Sector entities, Nonfinancial Consumers and also Business Entities. While Wholesale CBDC (e₹-W) is intended for limited use or access to the selected Financial Institutions in the Financial System like Banks / Insurance Companies in India.

While Wholesale CBDC is proposed for the settlement of Interbank Transactions like (Payments / Transfers) from One Bank to another Bank and related Wholesale Transactions, Retail CBDC is an Electronic Variety of Cash mostly for Retail Transactions i.e., by the Public.

e₹-W-Wholesale	e₹-R-Retail
1.Wholesale CBDC is planned for restricted access to select financial institutions.	1.Retail CBDC would be actually available for use by all viz., Private Sector, Non-financial Consumers and Business Entities.
2.Wholesale CBDC is planned for the clearing of interbank transfers and related wholesale transactions.	2.Retail CBDC is an electronic form of Cash Primarily meant for Retail Transactions of General Public.
3.Wholesale CBDC is capable to transform the settlement systems for financial transactions and make them more well-organized and protected.	3. Retail CBDC can provide access to safe money for payment and clearing as it is a direct liability of the Central Bank.

Model for issuance and management of CBDC:

There are two models for issuance and management of CBDCs viz. Direct model (Single Tier model) and Indirect model (Two-Tier model). A Direct model would be the one where the central bank is responsible for managing all aspects of the CBDC system viz. issuance, account-keeping and transaction verification.

In an Indirect model, central bank and other intermediaries (banks and any other service providers), each play their respective role. In this model central bank issues CBDC to consumers indirectly through intermediaries and any claim by consumers is managed by the intermediary as the central bank only handles wholesale payments to intermediaries.

The Indirect model is akin to the current physical currency management system wherein banks manage activities like distribution of notes to public, account-keeping, adherence of requirement related to know-your-customer (KYC) and anti-money laundering and countering the terrorism of financing (AML/CFT) checks, transaction verification etc.

Various Forms of Central Bank Digital Currency:

CBDC can be Classified into as:

• Token-based’ or
• ‘Account-based’.

A Token-based CBDC is a bearer-instrument and it is similar to Bank Notes, meaning whosoever holds the tokens at a given point in time would be supposed to own them.

The difference, an Account-based system would require upkeep of record of Balances and Transactions of all Holders of the Central Bank Digital Currency and designate the ownership of the Monetary Balances / Value. In view of the above features offered by these both Forms of CBDCs, a Token-based CBDC is regarded as a favoured means for CBDC-R as it would be Nearer to the Physical Cash, while an Account-based CBDC may be measured for CBDC-W.

CBDC ‘e₹’ and its Technology Considerations:

Convenience: For the users tap-to-pay with relatively modern Smartphones, Storage of Value Cards and Custom Devices fitted with NFC (Near Field Communications) is been well understood and straightforward. There should be various user-friendly payment alternatives which may be in order to support the various use cases. For example: e-commerce or person-to-person payments.

Secure and Resilient: To protect the end user data, there are a variety of mature Cryptographic Techniques flexible enough to be used across the Centralised or Distributed Ledgers. Typically, in a Centralised Platform, it is the System Administrator who enforces the privacy policy, while distributed or device-based environments with less straight forward governance arrangements that can face complications from the software-based privacy enforcement. As Critical Infrastructure, the resilience of Central Bank Digital Currency will likely need to be similar to the Current Payment Systems and Operate for 24/7/365 service.

Fast and Scalable: The Central Bank Digital Currency system will need to be able to meet the volume and also throughput (transactions per second) requirements at a justifiable cost. Preferably, the volumes can drive with marginal costs to tremendously at low levels. The Present large centralised systems like Card Networks demonstrate which are having very high transaction capacity for the large populations may also possible with the conventional technologies.

Interoperable: Technologies in order to support the platform of various business models, permitting third parties in order to build the services on top of a Central Bank Digital Currency System, are well recognized. Challenges in interoperating with the existing payment arrangements will be based on their designs but most of it have mechanisms which are standardised to make inter-account transactions.

The Common Data Standards: Most notably ISO 20022, will likely play a part in enabling the interoperability with other payment systems. With intermediaries, in a Central Bank Digital Currency System, its design will support payments (Be it Online or Offline) between the Customers of one Intermediary and another and support portability, in order to avoid users which are being locked in to a single intermediary.

Flexible and Adaptable:

Several Factors to determine how it is adaptable a Central Bank Digital Currency system and is-how accurately the fundamental concepts of the Money and Payments are enacted; a careful, layered design with a clear separation of the concerns; designing with foresight into how the environment may evolve (e.g., Micro Transactions, Changes in Cryptography) and so on.

Technology choice:

CBDCs being digital in nature, technological consideration will always remain at its core. The infrastructure of CBDCs can be on a conventional centrally controlled database or on Distributed Ledger Technology. The two technologies differ in terms of efficiency and degree of protection from single point of failure. The technology considerations underlying the deployment of CBDC needs to be forward looking and must have strong cybersecurity, technical stability, resilience and sound technical governance standards. While crystallising the design choices in the initial stages, the technological considerations may be kept flexible and open-ended in order to incorporate the changing needs based on the evolution of the technological aspects of CBDCs.

Instrument Design:

The payment of (positive) interest would likely enhance the attractiveness of CBDCs that also serves as a store of value. But, designing a CBDC that moves away from cash-like attributes to a “deposit-like” CBDC may have a potential for disintermediation in the financial system resulting from loss of deposits by banks, impeding their credit creation capacity in the economy. Also considering that physical cash does not carry any interest, it would be more logical to offer non-interest bearing CBDCs.

Degree of Anonymity:

For CBDC to play the role as a medium of exchange, it needs to incorporate all the features that physical currency represents including anonymity, universality, and finality. Ensuring anonymity for a digital currency particularly represents a challenge, as all digital transactions would leave some trail. Clearly, the degree of anonymity would be a key design decision for any CBDC. In this regard, reasonable anonymity for small value transactions akin to anonymity associated with physical cash may be a desirable option for CBDC-R.

Features of Central Bank Digital Currency:

• The Sovereign Currency Issued by Central Bank of the Country i.e., RBI.
• It shown as Liability Side in the Central Bank’s Balance Sheet.
• It is Recognized as a Medium of Payment or the Legal Tender of the Country.
• It is Freely Convertible into Cash whenever required.
• The Holders need not have a “Bank Account” to use the Central Bank Digital Currency.
• It Lowers the Cost of Issuance and Managing of the Money and Transactions in the Country.

CBDC-The Global Scenario:

All over the World, more than 60 Central Banks have stated interest in introducing the CBDC in their Country, with a few enactments already been made under Pilot across both the Retail (R) and Wholesale (W) Categories and several others are doing Research, Testing, and/or launch their own CBDC as their Agenda. As of July 2022, there are 105 Countries in the process of Discovering the CBDC, and the number that Covers 95% of the Global Gross Domestic Product (GDP) and 10 Countries have already implemented a CBDC, and the first of which were:

• The Bahamian Sand Dollar in 2020, and
• The latest was Jamaica’s JAM-DEX.

Currently, 17 other Countries in the World, together with the Major Economies like China and South Korea, are in the Pilot Stage and formulating for probable launches. China was the ϐirst Large Economy to Pilot Lunch of Central Bank Digital Currency way back in April 2020 and their intentions for extensive domestic use of the e-CNY by 2023 by the People of the Country. Gradually, the CBDCs are being seen as a gifted invention and as the Next Step in the Evolutionary Development of Sovereign Currency in the World.

Pilot / Trial Run-Central Bank Digital Currency:

The first experimental in the Digital Rupee-Wholesale segment (e₹-W) commenced on November 1, 2022 in India which was the Historic Event of the Country. The used case for this pilot is the clearing of the Secondary Market transactions in government securities etc.

The use of e₹-W is expected to make the interbank payments market and it is a more competent. Settlement in central bank money would reduce the transaction costs by anticipating the need for settlement guarantee set-up or for collateral to alleviate settlement risk. Going forward, other wholesale transactions and cross border payments (Country to Country) will be the focus of upcoming pilots, based on the learnings from this pilot run.

RBI has recognized Nine Banks for Trail Run for partaking in the Digital Rupee’s Wholesale Pilot Project, and the following Banks were identified by the Reserve Bank of India:

• State Bank of India.
• Bank of Baroda.
• Union Bank of India.
• HDFC Bank.
• ICICI Bank.
• Kotak Mahindra Bank.
• Yes Bank.
• IDFC First Bank.
• HSB.

The Reserve Bank has launched the first pilot for Retail Digital Rupee (e₹-R) on December 01, 2022. The Experimental would cover select locations in the Country in a Closed User Group (CUG) covering active customers and merchants of the various Banks. The e₹-R would be in the form of a digital token that denotes the legal tender. It would be issued in the same values that paper currency and coins are currently issued in India. It would be distributed through intermediaries, i.e., through Commercial Banks. Users will be able to perform with e₹-R through a digital wallet offered by the active banks and stored on mobile phones/devices. The Transactions can be both in: Person to Person (P2P) and Person to Merchant (P2M). The Payments to Merchants can be made using QR Codes shown at various merchant establishments. The e₹-R would offer structures of physical cash similar available in the Country i.e.,

• The Trust.
• The Safety and
• The Settlement Finality.

As in the case of Cash, it will not earn any interest at present and can be changed to other forms of money, like Deposits with Commercial Banks, loan repayments etc. The Eight Commercial Banks that have been identified for phase-wise participation in this pilot stage of CBDC are:

The First Stage will begin with Four Banks, viz., State Bank of India. ICICI Bank. Yes Bank and IDFC First Bank in four major Cities across the Country.

Adding Four more Commercial Banks in due course, viz., Bank of Baroda. Union Bank of India. HDFC Bank and Kotak Mahindra Bank join this pilot afterwards. The Pilot would ϐirstly cover Four Major Cities in India, viz., Mumbai, New Delhi Bengaluru and Bhubaneswar.

Later on, extending to the other Centres like: Ahmedabad, Gangtok, Guwahati, Hyderabad, Indore, Kochi, Lucknow, Patna and Shimla.

Conclusion:

The Central Bank Digital Currency (CBDC) is proposed to match, rather than to replace, the current forms of money and it is predicted to provide an additional payment system to users of the Country, and not to substitute the existing payment systems of the Country. As it is proposed to be supported by up-to date payment systems that are inexpensive, reachable, suitable, well-organized, safe and secure. The Digital Rupee (e₹) system will further strengthen India’s Digital Economy, and make the Monetary and Payment Systems more Efficient and Subsidize for broadening Financial Inclusion in India, with an added advantage of discouraging the trade or investments in private virtual digital currencies.

References:

1. www.rbi.org.in

2. Concept Note on CBDC by the RBI.

3. Keynote address delivered by Shri T Rabi Sankar, Deputy Governor, Reserve Bank of India, on July 22nd, 2021 at the webinar organised by the Vidhi Centre for Legal Policy, New Delhi.

4. https://www.federalreserve.gov/newsevents/speech/quarles20210628a.htm

Notes:

1 Fiat currency in a broad sense refers to a type of currency that is not backed by a commodity but are made legal tender by a government degree or fiat. 

2 https://www.federalreserve.gov/newsevents/speech/quarles20210628a.htm

3 Herstatt Risk also known as settlement risk or cross-currency settlement risk, is the risk associated with settlement of foreign exchange transactions.