Insights into Editorial: Sovereign digicoin: a road map for RBI
Given the social cost of cash payment, and privately issued bitcoins’ challenge for “trust,” the argument for central bank’s digital currency seems natural. In fact, several central banks have already changed their operations, or started developing digital currencies in coordination with the private sector.
- In this context, the report of committee on digital payments, which was recently submitted to RBI, has asked the Reserve Bank of India (RBI) to evaluate the possibility of RBI-issued digital currency and testing proof of concept. The report notes several benefits of introducing a central bank digital currency (CBDC).
Design of CBDC:
The report of committee on digital payments notes that a CBDC would be like “e-cash”, essentially a non-interest-bearing liability of the central bank issued in digital form. That is correct but it need not be issued merely as e-cash. The central bank may choose to issue the CBDC as an interest-bearing instrument as well.
- Experts say, it would be more consequential to financial stability and more relevant to monetary policy if the RBI were to issue it as an interest-bearing instrument. Issued simply as “e-cash”, it would function exactly as physical cash functions presently, as a medium of exchange between peer-to-peer and peer-to-business transactions and as a counter-cyclical store for value.
- Issued as an interest-bearing instrument, it would compete with the deposits issued by commercial banks. Given that it would be issued by the central bank, it is possible that subject to its widespread accessibility, it would raise the cost of capital for commercial banks as households may flock to it.
- If it is as easily accessible as bank deposits or “mobile money”, it may catalyze capital structure changes in the way commercial banks fund themselves by eating into their current and savings account ration. If so, they may have to fund themselves on the wholesale markets, thus introducing much-needed market discipline through bond-holder monitoring and run-risk.
- Over time, if the flight to CBDC is substantial, the need for deposit insurance may also require a rethink, thus saving taxpayer money.
Mechanics of issue?
Three elements appear critical here:
- Unlike private currencies that do not have a specific issuer and essentially rely on the trust of the participants to circulate, a CBDC will create a liability on the balance sheet of the RBI. Operationalizing the CBDC would also sequentially require validation and settlement.
- Validation is necessary to avoid the so-called “double-counting” problem that arises in the context of digital currencies. Simplified, it means ensuring that the payer has not already used the “same” CBDC to pay another payee prior to the current transaction. Borrowing from the Bitcoin architecture, the RBI may choose to outsource the validation function to several licensed nodes on the blockchain. Again, on the lines of Bitcoin, these payment system participants may perform the validation function against the incentive of receiving CBDCs, the value whereof is contingent upon the complexity of the mathematical code-crunching that goes into validation.
- Finally, settlement finality is critical; the RBI may develop a standard consensus procedure that determines the precise moment at which the “transfer” from the payer to the payee is completed; this may involve determining the number of “nodes” necessary to validate the transfer for it to be deemed complete by the payment-system participants. A key challenge would be to balance the competing interests of latency and robustness.
However, there are few concerns associated with digital currency backed by RBI:
- First, banks could lose their dominant position in the payments business if individuals have direct access to the central bank clearing house for a digital currency.
- Second, people directly holding base money with the central bank will undermine bank business models that are based on credit creation through the fractional reserve system.
- Third, the existing monetary policy consensus could be overturned as central banks shift back to directly targeting money supply rather than interest rates.
Need for a central bank digital currency (CBDC):
The emergence of cryptocurrencies like Bitcoin have led central banks around the world to develop a research agenda around digital currencies, both private and sovereign.
Development of digital currencies around the world:
- Nederland: In March 2016, National Bank of Nederland (DNB) published it would develop a prototype of digital currency, called “DNBcoin,” by applying blockchain.
- Russia: In October 2016, Central Bank of Russia published it had successfully developed a prototype block chain for transactions confirmation, called “Masterchain,” with leading financial market players.
- Canada: In June 2016, Bank of Canada published it was partnering Canadian banks, fintech entrepreneurs and other companies to test this.
- United Kingdom: In June 2016, the Governor of Bank of England(BOE) stated it would explore the use of digital currency in bank’s core activities, including the operation of real-time settlement system.
- China: In January 2016, People’s Bank of China published it had a “mid-term” strategy of issuing its own digital currency, and would try to launch it as early as possible.
These are still early days. Digital currencies still have a lot of issue, and the wild swings in bitcoin prices are not exactly a good advertisement as far as those who are bothered about monetary stability. These are teething problems in what could be a dramatic shift in the way the world transacts, if the technology needed for digital currencies keeps pace with demand from the new payments ecosystem. These are interesting times for monetary thinkers.
The various prerequisites for an eventual move towards a cashless economy are gradually falling into place. India already has a new digital platform for mobile payments that is perhaps one of the best in the world. It has now decided to join the revolution. A bit of futurism would not be a bad idea at all. A few US economists have talked about a Fedcoin—or a Fed version of the bitcoin. Maybe it is time for a similar discussion in India.
Should RBI consider issuing digital currency? What are the benefits of introducing a central bank digital currency (CBDC)? Examine. (200 Words)