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Digital currency is more than just UPI, IMPS: How it can change your money transactions


As of today, the only immediate connection that an individual has with the Reserve Bank of India (RBI) is via the cash held in their hands. The finance minister in her budget 2022 speech has announced that this is about to change with the issuance of the Central Bank Digital Currency (CBDC). In our current system, commercial banks buy cash from the RBI i.e., the central bank and give the customers access to this as a means of payment. Presumably, with CBDC this would continue as otherwise the central bank would have to allow us to open accounts with it and manage customer relations which it is not geared to do, besides requiring it to compete with commercial banks.

So, what is about to change?

With cash as it changes hands in transactions, the change in possession of the notes is simultaneously a record that trade has taken place. For a CBDC, the operator of the infrastructure will have to update records. This requires a process of third-party verification to ensure that there is no counterfeiting in the transfer of a digital currency.

Verification is to be provided by a trusted party such as a clearing house or an intermediary could underwrite the settlement risk and verify the transaction immediately with the centralized verification authority that is approved by the central bank. The data centres, to be developed, would have to authenticate and issue certificates of user identities, manage the issuance, transfer, and withdrawal of CBDC and control for the risk with KYC and Anti-Money Laundering management systems. Technically the use of cryptography can make the cost of verifying the authenticity of digital currency low as has been the case with bitcoin.

Instant settlement by an RBI-backed entity

Unlike CBDC, digital payments made via payment methods like UPI and IMPS require that every rupee transferred by this mode is backed by physical currency or on the settlement of the transacting banks with the central. The advantage of the digital currency is that it will be settled instantly as it will be transacted by a clearing house that has the direct backing of the central and not by bank intermediaries as is the case with UPI where each bank has a different UPI handler.

No need of bank account

The advantage of not requiring the intermediate step of linking bank accounts with online payment systems makes CBDC more efficient but at the same time it allows the government to have more visibility into real-time transactions.

Better regulatory control for boosting user confidence

Verification of the transaction via digital currency has a positive effect. It assuages the fear of customers who would otherwise resist from holding many such digital currency. The negative factor for individuals would be that, unlike transactions in cash, the central bank will have oversight and control of financial transactions.

The RBI will have the capability to monitor and trace money transactions as well as to revert them or block them. The benefit is that it will make it easier to identify financial crimes such as tax evasion, financing terrorism and the sale of illicit goods. That benefit, however, should be traded off with the consequences of exposure to cyber risks that require central banks to invest in skill sets they do not yet have.

Gradual development of ecosystem with partners

Central banks including the RBI have realized the need to understand fintech innovations and the associated risks and have developed facilitators to test these innovations in controlled risk environments. The RBI, for instance, has a regulatory sandbox but it had indicated that for private entities, as part of the negative list, that initial coin offerings and cryptocurrency services would not be accepted for testing. The central bank itself will not have the technical competence to develop the new e-money system and it will have to acquire the technology or partner with a private company whilst developing some of the know-how internally. The liability of safeguarding information and settling transactions is the responsibility of the central bank. The central bank should conduct pilot programmes to test the convenience of the processes, the stability of the systems, and the controllability of cyber risk.

Learning from past to avoid glitches in full scale roll-out

Just last year we witnessed that the new e-filing income tax portal that was launched had issues such as the inability to generate an OTP for Aadhaar validation, failure to link old data for past income tax returns, incorrect capturing of details from Form 16 and other problems in filing income tax returns. A technical glitch for a sovereign function such as digital currency by RBI would undermine the confidence in the financial system and lead to financial instability.

Hybrid model of online and offline transactions

It would mostly be the case that individuals will access software wallets through mobile payment apps and hardware wallets through mobile phones. It is possible to have CBDC payments to be made via integrated chip cards as well. This would be desirable in a country that is susceptible to electricity outages and inadequate internet connections. Alternatively, transactions offline could be enabled by permitting two phones in close proximity to each other to make transactions as the central bank will have access to transaction data and can reverse transactions when it receives an offline transaction for validation.

Boosting financial inclusion on DBT delivery

In principle, those without bank accounts can avail advantage of financial services via a digital currency wallet. Thereby unbanked households could be financially included. Subsidies could be issued directly to citizens. The attractiveness of this should be carefully weighed as once digital payments no longer require connection to a bank account then there are risks to financial stability as capital is transferred out of banks and towards digital platforms.

Government must ensure safety before implementation

We should be aware that CBDC is traceable, unlike cash that is anonymous. The central bank must set up the infrastructure that records and settles transactions which opens it up to cyber risks. There are risks to financial stability. There is the allure of financial inclusion but that should not be the driving motivation for CBDC as there are other ways to further that objective via other payment mechanisms.

(The writer is a Professor of Economics and the Director at IIM Ahmedabad.)



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