#194 The e₹ is in Town

Programming Note: A lighter edition this weekend because life happened of late-night football, missed flights, and several other things. Also, we will be away for a short year-end break. Normal service will resume on Jan 8, 2023. Happy holiday season, everyone! India Policy Watch: Digital Rupee (e₹-R) Is In Town Insights on current policy issues in India — RSJ The RBI launched the first pilot for the retail digital Rupee this week. It is now among the select list of central banks that’s got a CBDC pilot going. The RBI press release covers the plan for the pilot: * The pilot would cover select locations in closed user group (CUG) comprising participating customers and merchants. The e₹-R would be in the form of a digital token that represents legal tender. It would be issued in the same denominations that paper currency and coins are currently issued. It would be distributed through intermediaries, i.e., banks. Users will be able to transact with e₹-R through a digital wallet offered by the participating banks and stored on mobile phones / devices. Transactions can be both Person to Person (P2P) and Person to Merchant (P2M). Payments to merchants can be made using QR codes displayed at merchant locations. The e₹-R would offer features of physical cash like trust, safety and settlement finality. As in the case of cash, it will not earn any interest and can be converted to other forms of money, like deposits with banks. * The pilot will test the robustness of the entire process of digital rupee creation, distribution and retail usage in real time. Different features and applications of the e₹-R token and architecture will be tested in future pilots, based on the learnings from this pilot. The obvious question that comes up is how’s a digital currency different from a transaction on UPI. The RBI Governor got into the explanation mode on this at the press meet. Separately, in an earlier concept note, the RBI had outlined the two different types of CBDC it would pilot as part of this process: Based on the usage and the functions performed by the CBDC and considering the different levels of accessibility, CBDC can be demarcated into two broad types viz. general purpose (retail) (CBDC-R) and wholesale (CBDC-W). CBDC-R is potentially available for use by all private sector, non-financial consumers and businesses. In contrast, wholesale CBDCs are designed for restricted access by financial institutions. CBDC-W could be used for improving the efficiency of interbank payments or securities settlement, as seen in Project Jasper (Canada) and Ubin (Singapore). Central banks interested in addressing financial inclusion are expected to consider issuing CBDC-R. Further, CBDC–W has the potential to transform the settlement systems for financial transactions undertaken by banks in the G-Sec Segment, Inter-bank market and capital market more efficient and secure in terms of operational costs, use of collateral and liquiditymanagement. Further, this would also provide coincident benefits such as avoidance of settlement guarantee infrastructure or the need for collateral to mitigate settlement risk. About 18 months back, in edition #122, I wrote a fairly detailed piece about CBDC in the context of China running a pilot for digital Yuan. It will be useful to bring that piece up to contextualise the RBI CBDC pilot. What’s Money? As we have written in an earlier post, money performs three roles for us: it is a store of value, it is a medium of exchange, and it is a unit of measure. Through it, we save for the future, pay for goods and services and measure the value of very different things using a common unit. These roles mean anything that aspires to be a currency (the usable form of money) should have a relatively stable value over time and should be widely acknowledged as a store of value and unit of account among people. If it does so, the network effect takes over after a while, and it becomes a widely used currency. Throughout history, a key feature of a sovereign state was its control over the supply and circulation of money that’s used within its boundaries. The royal mints, after all, have been around for more than two thousand years. As modern nation-states emerged through the 19th and 20th centuries and as global trade increased, central banks emerged to manage the monetary system and provide financial stability. There are three forms of money in any modern economy: * Banknotes: These are physical paper currency notes issued by the central bank that we all use in our everyday lives. This is a direct promise by the central bank to pay the note holder a specified sum of money. This promise is printed on all currency notes. * Bank Deposits: Ordinary people and businesses don’t hoard banknotes to conduct their business. They deposit their money in commercial banks. These deposits are stored in electronic form by these banks. The banks offer two services to their customers. They convert these deposits to central bank money in the form of banknotes when you demand it at an ATM and they offer to transfer your money to someone else through a payment system that exists between banks. Unlike banknotes, your deposits aren’t risk-free. They aren’t backed by any sovereign guarantee. A bank will be able to convert your money into banknotes only if it is solvent and can honour its commitments. We have seen instances of a bank failing to do so in India (Yes Bank, PMC etc.). * Central Bank Reserves (“reserves”): Commercial banks have their own accounts with the central bank where they deposit their funds. These deposits are used by banks to pay each other to settle transactions between them. The reserves are the other form of central bank money apart from banknotes. These are risk-free and therefore used for settlements among commercial banks. Where does CBDC then fit in? Simply put, a CBDC is a digital form of a banknote issued by the central bank. Now you might think we already use a lot of digital money these days. Yes, there’s money we move electronically or digitally between banks, wallets or while using credit/debit cards in today’s world. But that’s only the digital transfer of money within the financial system. There’s no real money moving. The underlying asset is still the central bank money in the form of reserves that’s available in the accounts that commercial banks have with the central bank. This is what gets settled between the commercial banks after the transaction. This is an important distinction. We don’t move central bank money electronically. But CBDC would actually allow ordinary citizens to directly deal with central bank money. It will be an alternative to banknotes. And it will be digital. CBDC: The Time Is Now So, why are central banks interested in CBDC now? There are multiple reasons. One, cryptocurrency that’s backed by some kind of a stable asset (also called ‘stablecoin’) can be a real threat as an alternative to a sovereign currency. Stablecoins are private money instruments that can be used for transactions like payments with greater efficiency and with better functionality. For instance, the current payment and settlement system for credit cards in most parts of the world has the merchant getting money in their bank accounts 2-3 days after the transaction is done at their shops. A digital currency can do it instantly. For a central bank, there could be no greater threat to its ability to manage the monetary system than a private currency that’s in circulation outside its control. Two, in most countries, there’s an overwhelming dependency on the electronic payment systems for all kinds of transactions. As more business shifts online and electronic payment becomes the default option, this is a serious vulnerability that’s open to hackers and the enemy states to exploit. A CBDC offers an alternative system that’s outside the payment and settlement network among commercial banks. It will improve the resilience of the payment system. Three, central banks need to offer a currency solut… This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit publicpolicy.substack.com