Central Bank Digital Currencies (CBDCs) represent a potentially game-changing innovation in the field of digital payments and finance, with far-reaching implications for all players in the global financial services sector. The issuance of a central digital currency and the infrastructure that supports transactions are both covered by CBDCs.
Essentially, a CBDC represents a digital payment instrument denominated in the national unit of account, serving as a direct liability of the Central Bank. This digital currency, sanctioned by the Central Bank, functions as a legal tender in the digital realm, fulfilling the roles of a medium of exchange, store of value, and unit of account. It essentially mirrors the value of the fiat currency it represents, albeit in digital form.
CBDC in the Indian context
The government of India unveiled plans for the implementation of a Central Bank Digital Currency (CBDC), known as the “e₹” (digital rupee), few years ago. This digital form of the nation’s official currency will be under the purview and management of the Reserve Bank of India (RBI). The RBI initiated the pilot program for the e₹ in both wholesale and retail sectors, referred to as “e₹-W.” This initial phase of the CBDC’s rollout was conducted within a closed user group and involved the participation of selected banks in December 2022.
There are strong justifications for India’s pursuit of both retail and wholesale Central Bank Digital Currencies (CBDCs). In terms of retail payments, India has already experienced swift adoption of digital payment methods, largely attributed to the Unified Payments Interface (UPI). The introduction of CBDC can further enhance and refine the payment process, elevating it to a higher level. It introduces a novel payment avenue and expands the array of payment options, particularly within the realm of e-commerce. CBDC transactions resemble cash transactions, with the distinction that CBDCs are exchanged instead of physical banknotes, resulting in immediate settlement. This has the potential to significantly augment the efficiency of the payment system.
Key drivers pushing Central Banks to implement CBDCs
Internationally, the demand for Central Bank Digital Currencies (CBDCs) is being propelled by several key factors, including the drive for expedited payments, the rapid shift toward digitization, enhanced risk mitigation in clearing and settlement processes, and the growing need for more efficient domestic and cross-border value transfers. Additionally, there is a heightened focus on promoting financial inclusion. These developments have prompted numerous central banks and governments to intensify their efforts to explore the feasibility of introducing a digital version of their fiat currency.
In addition to the utilization of CBDCs as tools for shaping monetary and fiscal policies, there are four primary drivers compelling central banks to assess the feasibility of CBDCs. A study by Deloitte delves into these drivers.
- CBDCs can help make the financial services landscape more efficient: Payments conducted using Central Bank Digital Currencies (CBDCs) offer several significant advantages. These transactions are characterized by their real-time nature, involving the immediate and irrevocable transfer of funds. This attribute substantially diminishes settlement risk within the financial system, eliminating the necessity for interbank settlement and reconciliation processes. CBDCs also hold the potential to transform global payment systems by enabling real-time and cost-effective cross-border transactions. Time zone differences would cease to be a factor in currency settlements, eliminating the risks associated with asynchronous transactions.
CBDCs also stand to significantly enhance the efficiency of clearing and settlement processes, as well as post-market activities. Currently, many security clearing and settlement procedures involve multi-day delays. The introduction of CBDCs in digital form promises substantial improvements in efficiency and reductions in associated reconciliation costs.
- CBDCs can help bring Central Banks back to the centre of currency creation: Central banks are becoming increasingly aware of the emergence of novel digital currencies and the potential value of non-fiat cryptocurrencies. They recognize that they may need to take an active and central role in the evolving digital currency landscape rather than merely observe from the sidelines.
While Anti-Money Laundering (AML) and Combating the Financing of Terrorism (CFT) requirements are not inherently central to the issuance of Central Bank Digital Currencies (CBDCs), most central banks would likely incorporate measures within their CBDC platforms to align with these regulatory requirements. Additionally, central banks would prioritize data protection measures to foster trust in the digital currency ecosystem they provide to the public.
- Creation of a robust monetary and fiscal policy: The introduction of Central Bank Digital Currencies (CBDCs) holds the potential to instigate improvements in the monetary policies of central banks. The architecture and structure of CBDCs enable the transparent and seamless distribution of government benefits to individuals, affording central banks greater control over financial transactions. CBDCs have the capacity to enhance financial stability by effectively managing liquidity squeezes and offering the public viable alternatives to cryptocurrencies. This mitigates potential risks associated with unregulated digital currencies.
Furthermore, CBDCs have the potential to reduce the risk of identity theft due to the traceable and highly secure digital trail they create. Central banks can also employ CBDCs to safeguard the purchasing power of money within the economy.
- Improved financial access and financial inclusion: Many central banks are considering Central Bank Digital Currencies (CBDCs) as a means to extend financial services to the last mile, eliminating the need for intermediaries and transcending physical boundaries to democratize financial access. However, there are certain challenges that need to be addressed in achieving this CBDC vision.
One notable challenge is the strong preference for cash among low-income groups. Additionally, there are technological challenges and associated costs associated with implementing a fully digital currency, which may serve as barriers to realizing the full potential of CBDCs. A recent study by the Asian Development Bank (ADB) suggests that CBDCs could offer an effective solution to address the issue of high remittance costs and broader financial inclusion challenges. To overcome these challenges and promote innovation in delivering customer-centric solutions, a two-tier CBDC model is recommended. This model allows participating institutions to leverage open banking frameworks, enabling them to create more relevant and innovative value propositions for customers.
Global impact of CBDC
The World Economic Forum offers key insights into the impact of CBDCs from two perspectives.
- Impact on monetary policy
Without adequate safeguards, the introduction of a central bank digital currency raises worries about a possible breakdown of the monetary system. One significant concern is the possibility of withdrawing their funds from commercial banks and depositing them en masse in CBDC accounts with the central bank. This could create challenges for banks in their role as lenders, a vital function in the economy.
While CBDCs were not initially proposed as a new monetary policy tool, they could potentially provide additional leverage for central banks. For instance, CBDCs could enhance the transmission of central bank policy rates to savers by fostering competition in deposit markets. Additionally, CBDCs might allow central banks to target specific frictions in the financial system, thereby achieving more efficient stabilization of inflation and the overall economy.
The introduction of CBDCs may also entail changes to central banks’ operations and balance sheets. In particular, if CBDCs replace a significant portion of bank deposits, central banks may need to channel funds back into the banking sector through lending operations. Furthermore, the introduction of CBDC could impact the practical implementation of monetary policy. For instance, fluctuations in CBDC demand might complicate interest rate control within a traditional corridor system, potentially favoring a floor system with ample reserves. If non-bank entities are involved in distributing CBDCs to the public, this might require direct access to the central bank’s balance sheet, necessitating adjustments to the counterparty framework.
- Impact on financial stability
Just like with monetary policy, the impact of Central Bank Digital Currencies on financial stability will go through the banking system. If banks end up facing higher costs for funding, as we discussed earlier, it could reduce their profits. This might push banks to take more risks by making riskier loans or investing in speculative assets.
On the other side, CBDCs change how exposed banks are to the risk of runs, where lots of depositors rush to withdraw their money all at once. First, because CBDCs are safe and interest-bearing, people might have more reasons to run to get their money out, compared to a situation where cash is the only option besides bank deposits (we call this the ‘direct effect’). Second, to keep deposits, banks might raise interest rates in response to CBDCs being available. This makes deposits more attractive and reduces the risk of runs (we call this the ‘indirect effect’). So, the overall impact of CBDCs on how fragile banks are depends on how strong these two forces are. When CBDCs offer low (high) returns, the indirect (direct) effect is more powerful, meaning that higher returns reduce (increase) the risk of financial fragility.
Central Bank Digital Currencies (CBDCs) are rapidly advancing and are expected to have a significant impact on most major national economies within the next 12–24 months. Each nation will decide on the issuance and design of CBDCs based on its unique objectives, the maturity of its financial markets, and other regional elements.
Tokenized CBDCs, which don’t earn interest, are the closest digital equivalent to physical cash and could serve as a starting point for retail CBDCs. Wholesale CBDCs, designed for institutional use, are likely to be easier to implement and can offer immediate benefits in financial markets where payments and settlements experience delays. Multicurrency CBDCs could track international trade flows, and countries with significant trading partners might be among the early innovators in this area.
As digitalization and globalization continue to grow, CBDCs play a vital role in providing a secure, risk-free digital medium for transactions, a store of value, and a unit of account. Banks and other financial service providers should prepare for this emerging asset class. They need to consider its impact on their financial statements, customer offerings, and the advantages it brings in terms of secure and efficient transactions while reducing settlement risks.