A New Digital Coin

We need to understand how Central Bank Digital Currencies (CBDCs) fit into the modern 2-tiered banking system. While CBDCs offer potential benefits, such as banking the unbanked, do we even need a CBDC in the Indian context.

This article was first published in The Mint. You can read the original at this link.

Global interest in Central Bank Digital Currencies (CBDCs) is on the rise. According to a report by the Bank for International Settlements, 80% of all Central Banks are investigating CBDCs and half have progressed past research to running pilots. In an article last year, I applauded this trend believing, at the time, that CBDCs represented the best of both worlds - the programmability of cryptocurrency and the stability of fiat currency.

But the more I read about this new form of digital currency, the clearer it became to me that the decision to issue a CBDC was both nuanced and complex. While they might seem like just another flavour of virtual money, the very fact that they are issued by Central Banks puts a whole new spin on it.

To figure out why this is the case, we need to understand how our modern 2-tiered banking system works - and in particular, the symbiotic relationship between public and private money.

The 2-Tiered System

Simply put, private money is the money in our bank accounts - the deposits we hold with commercial banks that are their unsecured liability and which they can redeem into public money. Public money issued by the Central Banks, is the safest, most liquid form of money.

The ability to redeem private money into central bank currency and to acquire Central Bank public money in times of stress (along with deposit insurance, where it exists) is what gives the banking system its stability and interoperability. The fact that multiple commercial banks can issue private money in a variety of different ways gives the system its innovation and diversity. The relationship between the two makes our modern banking system what it is.

Central banks also issue public money to the retail public in the form of banknotes and coins. This is how we all get to put a small amount of safe, liquid Central Bank money into our wallets. When issued, CBDCs will be another form of retail public money.

Central to the decision on issuing a CBDC is figuring out how it will fit into our finely balanced monetary system. In countries where public holdings of cash are rapidly declining, CBDCs are being seen as an alternative to cash. However, until the risk of technology failure is properly mitigated, CBDCs will offer nowhere near the same psychological comfort as cash. Replacing private money with CBDCs will, on the other hand, put the stability, diversity and innovation of our dual-monetary system at risk.

Most central banks are thinking of issuing a limited number of CBDCs and placing thresholds on the amount any one person can hold. Some are keen to take advantage of the programmability of CBDC, making them interest-bearing so that they can have a more direct way to influence monetary policy. Each option involves trade-offs that require deep consideration.

Why CBDCs?

Central Banks have different motivations for introducing CBDCs. For those fear the influence that big fintechs have on their economies, CBDCs are a way to wrest back control. In China, even though the meteoric rise of Alipay and WeChat resulted in the proliferation of digital payments, it did so outside the sphere of control of the Central Bank. China’s CBDC is likely to bring digital payments back under the control of the Central Bank.

Countries that do not have a digital fast payment system see CBDCs as a way to bring digital payments to their markets - forcing Central Banks to catalyse digital innovation where fintechs and banks have failed. For other countries, the allure of CBDCs is its programmability and the fact that self-executing contracts and programmable money can be used for tax collection and insurance.

Developing countries see CBDCs as a way to bank the unbanked. Since CBDCs are issued directly by the Central Bank, they can, unlike other digital money, be used by citizens who don’t have a bank account. This is even relevant in countries like India where, despite a sharp increase in new bank accounts (between 2011 and 2017, 470 million adults opened a bank account), 20% still don’t have one.

Which begs the question - does India really need a CBDC?

An Indian CBDC?

India already has a fast payments system that performs well at scale. If required, all it will take is a little extra engineering to bolt programmability on to it - be it for smart contracts or to program end use and time restrictions onto payments. We don’t need to issue a CBDC just for that.

Unlike China, where the digital payment system was built by big tech companies outside the regulatory rails of the central bank, UPI was built by and under the supervision of the Indian banking regulator. We don’t need to issue a CBDC to regain control - we never lost it in the first place.

Which leaves banking the unbanked. Today 80% of adult Indians have bank accounts. Before we think of issuing a CBDC to the 20% who don’t, we need to ensure that those with bank accounts are actually using them. Of the 500 million bank accounts in the country, no more than 35% are active. Which means that, despite its success, UPI still has to cover 65% of its potential addressable market.

Rather than rolling out a new digital currency to cover those outside the banking system, it would be a far better use of our resources to get those who have bank accounts to use them more actively. Using a series of carefully designed initiative we should be able to incentivise them to pay online. It is only once we’ve done that, that we should think of getting those without bank accounts to also start to use digital payments.

I love the technological promise of a CBDC. But I’m not sure India needs one.