Testing the Viability of Central Bank Digital Currencies

This week's Visual Legal Analytica presents a legal view on Central Bank Digital Currencies, or CBDCs by Sanad Arora from VLiGTA.

Advancing technology and a growing trend towards peer-to-peer transactions facilitated by online platforms has ushered a revolution in the field of digital payments. Even the Central Banks want to exploit these new technological developments and are investigating the technology of ‘Central Bank Digital Currency (CBDC)’ to use it as a medium to not only proliferate the space of digital payments but also make it accessible to the public at large and expedite the payments and settlements mechanism for retail and wholesale payments. More than 60 Central Banks are researching on the use of CBDC’s in their economy, with countries like China, Sweden, Canada and the U.K launching pilot projects.[1] But astonishingly, it is the smaller countries such as the Caribbean, Bahamas and Cambodia which are leading the charge on CBDC’s with live projects such as Bahamas Sand Dollar, Bakong Cambodia, and Eastern Caribbean DCash[2]. Taking into consideration, the rising consensus towards the use of CBDC’s for advancing the economy, even the RBI is exploring the use of CBDC’s, and has already started working on a pilot project, with plans to launch its own CBDC by the end of 2022[3]. Amidst all these developments, it is imperative that we don’t stay blindsided to the potential pathbreaking impact CBDC’s can have on the functioning of the payments and settlements system and the economy. Through this article, the author makes an attempt to apprise the readers of the fundamentals of the technology and partake in an analysis discussing its pros and cons.

Before delving into further analysis, it is crucial to note that CBDC’s should certainly not be mistaken for cryptocurrency, at the risk of sounding reductionist, CBDC in very simple terms is just fiat currency but in a digital form. The RBI defines CBDC as “legal tender issued by a central bank in a digital form. It is the same as a fiat currency and is exchangeable one-to-one with the fiat currency” (Reserve Bank of India, 2021). Despite being considered as ‘legal tender’ and equivalent of fiat currency the digital nature of CBDC allows it to hone characteristics specific to the function it has to perform, hence the purpose for which CBDC is being issued will have a great influence on its design.

Possible iterations of CBDC’s

Since CBDC’s are essentially a form of programmable currency, there are a lot of customisations which the issuer can make to alter its characteristics, such as:

• They can be token based or account based. A token based CBDC can be formulated on a centralised blockchain with the Central Bank as its regulator, which would operate via a public private key mechanism. On the other hand, an account based CBDC is similar to the current account-based model with respect to physical currency and would essentially require a banking relationship with the CBDC holder and the bank, where each transaction is debited or credited through the account(Fernández de lis & Gouveia, 2019 ).
• They can be made universal via the system of token-based currencies or private via the system of private currencies (Fernández de lis & Gouveia, 2019 ).
• They can be anonymous (like cash) or identified (like current accounts). The first corresponds to the idea of token-based CBDCs, and the second to account-based CBDCs (Fernández de lis & Gouveia, 2019).
• They can be programmed to pay interest at the option of the issuer, which essentially translates to interest being enabled as a feature on such currencies (Fernández de lis & Gouveia, 2019).

From the various possible customisations of CBDC’s, there are three basic objectives which can be culled out, acting as the basis for issuing of it: (i) to improve the working of wholesale payment systems; (ii) to enhance the instruments available for monetary policy (iii) to innovate new methods of monetary policy and quantitative easing during financial crisis. However, the conundrum with respect to achieving each of these goals is that every individual goal requires us to create a CBDC with different characteristics, which would be interacting with different categories of individuals/institutions and thus have different levels of market and technological penetration. To cut it short, there are a lot of variables which have to be considered for designing a CBDC which results in added complexity. For better understanding of the readers, the author has made an attempt to conceptualise the CBDC which can be issued to achieve the aforesaid said goals, herein below:

(i) If the objective is to improve the functioning of wholesale payment systems, it can be argued that Digital Ledger Technology (DLT) can provide an excellent basis for such CBDC’s. First of all, since we are just referring to wholesale payments, we can have a DLT platform which is just restricted to banks, financial institutions, and large corporations [4]. The best suited CBDC for such transactions would have to be tokenised, identifiable and restricted. It can or cannot be interest bearing depending on the contractual obligations between the parties involved in wholesale payments. It will be tokenised because it is based on a DLT and coupled with a public/ private key system along with a consensus mechanism programmed into that ledger to authenticate transactions. This way the Central Bank would have not have to waste any of its human resources completing compliances to affect those transactions because such work would have then been automated owing to the transaction happening on a DLT and a rigid consensus mechanism. The only role of the Central Bank would be to act as an intermediary with secure IT systems put in place ensuring smooth transactions. The role of the Central Bank would be similar to that in traditional RTGS or NEFT transactions, where it is placed at the fulcrum of the system hence it will retain control over the entire transaction including features of the system, like admission, membership and due diligence.

(ii) If the aim is to replace cash with a more efficient means of payment, the Central Bank should introduce a CBDC that is universally available – a public Distributed Ledger can be set to manage the payments and settlement of CBDC or the existing account-based infrastructure of commercial banks could be utilised where the CBDC can be directly transferred to the account of the individual. Tracking of transactions through CBDC’s poses major data privacy concerns to remedy these concerns the low cost transactions can be kept anonymous, this would reduce the compliance burden of data collection on the Central bank and a threshold can be decided upon by the Central Bank beyond such transactions would be monitored (Mancini-Gri§oli et al., 2018). Such a CBDC would aid in cutting major costs which the government has to incur to sustain the system of physical currency such as - the logistics of digital currency would come at a fraction of a cost, compared to that of physical currency, investment in setting up the requisite infrastructure for manufacturing and transportation of physical cash would be saved, the digital currency deteriorate over time, and won’t be vulnerable to falsifications if the requisite technological safeguards are implemented.

iii) If a CBDC has to be made to innovate new methods of monetary policy and quantitative easing during financial crisis, the three must have characteristics for it would be universality of transaction, identifiability, ability to bear interest. It has to be traceable because this way the Central Bank would be able to track the amount of money which is being transacted. It would have to be non-interest bearing or bear a negative interest rate because we don’t want people to hoard cash. Hence, during times of financial crisis to flush money into the economy instead of issuing cash to the people which they might hoard or invest in some savings oriented, we can give them essentially provide them with CBDC’s which won’t bear any interest the public would have no other option but to spend it and increase the flow of money into the economy. This enhances the level of flexibility the Central Bank has when deciding upon quantitative easing policies because issuing of CBDC’s delinks credit and the payments mechanism.

Read the rest of the article at https://visual.indicpacific.com/p/testing-the-viability-of-central

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