In her Budget Speech, the Finance Minister announced a proposal to issue a Digital Rupee by the Reserve Bank of India (RBI) starting financial year 2022-23. What functions might a Digital Rupee (synonymously, a central bank digital currency or CBDC) issued by the RBI, serve? Identifying the use-cases of a CBDC is critical to the design of the Digital Rupee, and the design of the infrastructure for its issuance, distribution and transfer. Understanding its use cases is also key to conceptualizing the amendments required to the RBI Act to enable the RBI to issue the CBDC. As a first step, we should ask: how would the average household or depositor benefit from a CBDC? What is its utility to businesses, small and large alike?
World over, the unique selling point of CBDCs is ‘cheap and instant settlement’ of payment transactions. Many have, however, argued that the retail payment systems in India – namely, the Immediate Payment Service (IMPS), the Unified Payments Interface (UPI) and the applications built on them (BHIM, GooglePay, WhatsApp payments, etc.) – have made digital payment transactions in India cheap, accessible and efficient for the average Indian consumer. A small-sized RBI survey conducted in 2021 shows that for transactions in excess of Rs. 500, nearly 60% of the survey respondents preferred digital payment instruments. This suggests that the current array of digital payment instruments in India are meeting Indian consumers’ payments related needs.
Indeed, a CBDC’s potential in every jurisdiction might vary depending on the efficiency of its payment systems. If the domestic payment system of a country is efficient, it is hard to see an immediate use case for CBDCs to the average consumer. In this post, leaving aside the issue of efficiency of payments, I emphasize two use-cases of a CBDC to households and businesses in India.
A risk-free settlement asset
The first use case of a CBDC in India is to the average bank depositor. Today, world over, money is issued in (at least) two forms.[1] The first kind of money is the liability of a central bank. For example, in India, the RBI issues currency notes which are RBI’s liability. Similarly, the reserves maintained by commercial banks with the central bank are liabilities of the central bank. The second kind of money are the deposits that depositors (either individuals or businesses) keep with commercial banks. The liability underlying these deposits is not that of the central bank. In other words, if a commercial bank becomes insolvent or has liquidity problems, one cannot directly claim the value of the deposit from the RBI. And this is where a CBDC’s biggest value proposition is to the average Indian household or business.
Since the CBDC is a liability of the central bank, it minimizes depositors’ exposure to their bank. The idea that a central bank will default on its obligation to honour a payment or settle a transaction is currently unthinkable. A CBDC is, therefore, a risk-free settlement asset.
Depositors’ exposure to bank distress, and even bank insolvency, in India is real. In the last few years, depositors of about 21 banks were restricted from withdrawing their funds from their bank accounts due to bank distress (excluding the demonetization exercise which triggered caps on withdrawals). The Deposit Insurance and Credit Guarantee Corporation (DICGC) is obligated to insure depositors the value of their deposits with commercial banks up to Rs. 5 lakh. However, the DICGC’s track record shows that pay-outs can be slow and staggered over time. A CBDC, which is a liability of the RBI, will mitigate the risk of losses that Indian depositors face when dealing with commercial banks in India.
The risk-free nature of a CBDC reduces the risk of settlement default for institutions as well. Currently, banks and financial institutions settle their obligations through reserves maintained with the RBI. Allowing inter-bank settlement through a CBDC would reduce the solvency and liquidity risks faced by the counterparty banks, financial institutions and the RBI, when settling such inter-bank transactions.
Cross-border settlement costs
The second use case for a RBI-issued CBDC lies in cross-border payments. Globally, cross-border payments are expensive as they involve multiple banks across jurisdictions and, sometimes, within the same jurisdiction as well. Since in most jurisdictions foreign banks operate through ‘correspondent banks’ which have their settlement account with the central bank, the time and costs involved in the settlement of cross-border remittances are considerably higher compared to domestic payment transactions. The settlement time for cross-border remittances may also vary depending on whether the remitter and the payee is a retail consumer, a small or a large business, a regular importer or exporter, the type of bank involved in the remittance chain, and so on.
CBDCs have the potential bring down the costs of making cross-border payments as they potentially dispense with correspondent banks. A CBDC, being issued by the central bank, can be directly settled in the central bank’s digital ledger without having to go through the entire chain of banks otherwise involved in a cross-border transaction. To give the reader a tangible picture of how this might work, imagine that you are making payment for a book in USD currency notes over the counter at a bookshop at the airport. The settlement of such a transaction is instantaneous. A cross-border payment using CBDC will work in a similar fashion. This is, however, linked to the cross-border interoperability of a CBDC. That is, to realise this use case, it will not be enough to simply issue a CBDC in India. The RBI and the Ministry of Finance will require to work with central banks and sovereign governments of other jurisdictions to ensure that their payment system has the necessary infrastructure to accept CBDCs issued by the RBI, or that a payment instruction in CBDCs will effect an equivalent currency transfer in the relevant jurisdiction.
To conclude, several central banks around the world are considering the introduction of CBDCs, with the People’s Bank of China and Riksbank of Sweden having piloted CBDCs at a small scale. Some major central banks, such as the Federal Reserve and the Bank of England, have issued discussion papers articulating the potential benefits and costs of issuing CBDCs. These papers have highlighted concerns relating to monetary policy, financial stability and privacy in connection with CBDCs, and have invited feedback from the public on these aspects. The hope is that the RBI will do the same before issuing its own Digital Rupee.
Given the evidence that retail payment systems work reasonably well at scale in India, the argument for a CBDC must be backed by clear use-cases to the average household and business, small and large alike. It is important that as with every regular financial product, the use-case drives the design of the CBDC, and not the other way round.
[1] There are various forms of non-bank money, such as pre-paid cards, wallets, etc. However, in India, all of them are necessarily linked to the commercial bank deposits. In some countries, hyper-liquid assets such as money market mutual funds are also considered money as they allow investors to withdraw money from the fund on demand. However, there are limitations on the extent to which such money can be used to make payments, including practical limitations such as settlement time.
I think this is not a situation where the digital currency would make sense only if it made “commercial sense”. Or if there was a problem that needed a solution.
Its more like, there are digital currencies that are out there, and for whatever reason, people are using them. Bringing with them, their own hosts of problems.
Over time, Digital currencies may or may not become mainstream. But that when they are about to, the government can categorically state, that this, the RBI mandated one, is the one which is legal and accepted to the disadvantage of all others.
Its not just India, but any economic sovereign would need its own digital currency to both tax and have proper control over its economic/ fiscal/ monetary policy over a period of time.
comprehensive as always. but it goes beyond payments. i think monetary policy will be difficult to handle and banking will have to be rethought
Excellent piece Bhargavi. Keep up the good work. Simple yet insightful.
Thank you, Dr. Krishnan!
Good analysis but quite wrong in some parts. When the CBDC is transferred into a savings/current account it will also come under the 5 lac insurance. While this has not been clarified yet by the RBI it is possible that any CBDC which is held in a private wallet (with no bank interest and also not recorded as a liability by banks and more like cash in your back pocket) will be safe from bank collapse, which means the CBDC in a e-wallet is comparable to cash in a physical wallet. If a bank collapses, the physical cash in your physical wallet is safe and has nothing to do with the 5 lac bank deposit insurance, same with CBDC held in a e-wallet.