India’s CBDC: RBI working towards a phased implementation strategy and examining use cases

RBI Deputy Governor T Rabi Shankar in a speech yesterday (22-Jul-2021) spoke on CBDC and RBI’s take on it.

Central Banks across the globe are engaged in exploring CBDCs and a few countries have also introduced proofs of concept / pilots on CBDC. The High Level Inter-Ministerial Committee (November 2017) constituted by Ministry of Finance, Government of India (GoI) to examine the policy and legal framework for regulation of virtual / crypto currencies had recommended the introduction of CBDCs as a digital form of fiat money in India. Like other central banks, RBI has also been exploring the pros and cons of introduction of CBDCs since quite some time.

Generally, countries have implemented specific purpose CBDCs in the wholesale and retail segments. Going forward, after studying the impact of these models, launch of general purpose CBDCs shall be evaluated. RBI is currently working towards a phased implementation strategy and examining use cases which could be implemented with little or no disruption. Some key issues under examination are – (i) the scope of CBDCs – whether they should be used in retail payments or also in wholesale payments; (ii) the underlying technology – whether it should be a distributed ledger or a centralized ledger, for instance, and whether the choice of technology should vary according to use cases; (iii) the validation mechanism – whether token based or account based, (iv) distribution architecture – whether direct issuance by the RBI or through banks; (v) degree of anonymity etc. However, conducting pilots in wholesale and retail segments may be a possibility in near future.

On legal matters:

Although CBDCs are conceptually no different from banknotes, introduction of CBDC would require an enabling legal framework since the current legal provisions are made keeping in mind currency in paper form. Under the Reserve Bank of India Act, 1934, the Bank is empowered to “…regulate the issue of bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage” (Preamble).

The Reserve Bank derives the necessary statutory powers from various sections of the RBI Act – with respect to denomination (Section 24), form of banknotes (Section 25), status as legal tender (Sec 26(1)) etc. There is a need to examine consequential amendments to other Acts like The Coinage Act, 2011, FEMA, 1999, Information Technology Act, 2000 etc.

Even though CBDCs will be a primarily technology driven product, it will be desirable to keep the legislation technology neutral to enable coverage of a variety of technology choices.

However, this bit on credit creation needs some updating:

CBDCs, depending on the extent of its use, can cause a reduction in the transaction demand for bank deposits. Since transactions in CBDCs reduce settlement risk as well, they reduce the liquidity needs for settlement of transactions (such as intra-day liquidity). In addition, by providing a genuinely risk-free alternative to bank deposits, they could cause a shift away from bank deposits which in turn might reduce the need for government guarantees on deposits (Dyson and Hodgson, 2016).

At the same time reduced disintermediation of banks carries its own risks. If banks begin to lose deposits over time, their ability for credit creation gets constrained. Since central banks cannot provide credit to the private sector, the impact on the role of bank credit needs to be well understood.

Plus, as banks lose significant volume of low-cost transaction deposits their interest margin might come under stress leading to an increase in cost of credit. Thus, potential costs of disintermediation mean it is important to design and implement CBDC in a way that makes the demand for CBDC, vis‑à‑vis bank deposits, manageable.

As Bank of England researchers (followed by other central banks) showed that banks first create credit which comes back as deposits. So banks are never really credit constrained and certainly not by deposits. The contraints are more on real economy side i.e. whether banks can identify are economic opportunities and so on.   Another constraint is regulations.

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