digital rupee: What is the digital rupee, how does it work?

In her 2022 budget speech on Tuesday, Finance Minister Nirmala Sitharaman announced that the Reserve Bank of India (RBI) would launch its own digital rupee in the new fiscal year. The digital rupee is a central bank digital currency (CBDC) to be launched in 2022-23, the FM said.

Today, when presenting the Union budget for 2022-23 in Parliament, she explained how the introduction of central bank digital currency (CBDC) would give a significant boost to the digital economy. “Digital currency will also lead to a more efficient and cheaper currency management system,” she said.

Here is an overview of what a CBDC is and how it works according to the RBI.

What is a CBDC?

The full name of CBDC is Central Bank Digital Currency is a legal tender issued by the Reserve Bank of India (RBI). “CBDC is the same as currency issued by a central bank but takes a different form from paper (or polymer). It is sovereign money in electronic form and would appear as a liability (currency in circulation) on a central bank’s balance sheet. The underlying technology, form and use of a CBDC can be tailored to specific needs. CBDCs should be redeemable at par with cash,” according to the RBI website.

What is a currency?

According to the RBI website, “In modern economies, currency is a form of money that is issued exclusively by the sovereign (or a central bank as its representative). It is a liability of the issuing (and sovereign) central bank and an asset of the public holding company. The currency is fiat, it is legal tender. Currency is usually issued in paper (or polymer) form, but the form of currency is not its defining characteristic.

What is the need for a CBDC?

Although there is widespread interest in CBDCs, only a few countries have made it past the pilot stage of developing their own CBDCs. According to the RBI website, “A 2021 BRI survey of central banks found that 86% were actively researching the potential of CBDCs, 60% were experimenting with the technology, and 14% were rolling out pilot projects. Why this sudden interest? The adoption of CBDC was justified for the following reasons:-

1. Central banks, faced with the decreasing use of paper money, seek to popularize a more acceptable form of electronic money (like Sweden);

2. Jurisdictions with significant use of physical cash seeking to make issuance more efficient (such as Denmark, Germany, Japan, or even the United States);

3. Central banks seek to meet the public’s need for digital currencies, manifested in the growing use of private virtual currencies, and thereby avoid the most damaging consequences of these private currencies.

Advantages of CBDCs over other digital payment systems

“Payments using CBDCs are final and thus reduce settlement risk in the financial system. Imagine a UPI system where CBDC is processed instead of bank balances, as if cash was remitted – the need for interbank settlement disappears. CBDCs could also enable a more real-time and cost-effective globalization of payment systems. It is conceivable that an Indian importer would pay their US exporter in real time in digital dollars, without the need for a middleman. This transaction would be final, as if cash dollars were handed over, and would not even require the US Federal Reserve System to be open for settlement. The time zone difference would no longer matter in foreign exchange settlements – there would be no “Herstatt” risk”, according to the RBI website.

Do we need CBDC in India?

India is the world leader in terms of digital payments innovations. Its payment systems are available 24 hours a day, 7 days a week, for retail and wholesale customers, they are largely real-time, the transaction cost is perhaps the lowest in the world, users have an impressive menu of options for transacting and digital payments have grown at an impressive CAGR of 55% (over the past five years). It would be difficult to find another payment system like UPI that allows one rupee transaction. With such impressive advances in digitization, is there a case for CBDCs?, RBI said.

“Given its dynamic impact on macroeconomic policy-making, there is a need to initially adopt baseline models and test them comprehensively so that they have minimal impact on monetary policy and the banking system. India’s advancements in payment systems will provide a useful backbone to bring a state-of-the-art CBDC to its citizens and financial institutions,” according to the Trends and Progress Report. banking sector in India 2020-21.

Small value transactions

There is a unique scenario where the country’s adoption of digital payments is accompanied by continued interest in using cash, especially for low-value transactions. “To the extent that the preference for cash represents discomfort for digital payment methods, the CBDC is unlikely to replace such use of cash. But the preference for cash for its anonymity, for example, can be redirected to CBDC acceptance, as long as anonymity is assured. according to the RBI website.

printing cost

Another advantage of CBDCs is India’s high currency to GDP ratio. The cost of printing, transporting, storing and distributing currencies can be reduced as substantial sums of cash can be replaced by CBDCs.

Advent of private virtual currencies (VC)

“The advent of private virtual currencies (VCs) may well be another reason why CBDCs may become necessary. It is unclear what specific need these private VCs serve that public money cannot meet as effectively, but that in itself may not impede adoption. If these virtual currencies are recognized, national currencies with limited convertibility risk being threatened. Admittedly, freely convertible currencies like the US dollar may not be affected as most of these VCs are denominated in US dollars. In fact, these VCs could encourage the use of the US dollar, as argued by Randal Quarles3. The development of our own CBDC could provide public uses that any private VC can provide and to that extent could retain public preference for the rupee. It could also protect the public from the abnormal level of volatility that some of these venture capitalists are experiencing. Indeed, this could be the key factor preventing central banks from viewing CBDCs as a safe and stable form of digital currency. As Christine Lagarde, President of the ECB, mentioned in the BIS annual report, “…central banks have a duty to preserve citizens’ confidence in our currency. Central banks should complement their national efforts with close cooperation to guide the exploration of central bank digital currencies to identify reliable principles and encourage innovation. according to the RBI website.

The rationale for CBDCs in emerging economies is obvious – they are desired not only for the benefits they provide in payment systems, but they may also be necessary to protect the general public in a climate where private VCs are volatile.

RBI’s Approach to CBDC

According to the RBI website, “In general, countries have established special-purpose CBDCs in the wholesale and retail segments. In the future, after studying the impact of these models, the launch of general-purpose CBDCs will be evaluated. RBI is currently working on a phased implementation strategy and looking at use cases that could be implemented with little or no disruption. Some key questions under consideration are –

(i) the scope of CBDCs – whether they are to 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 example, and whether the choice of technology should vary depending on 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 pilot projects in the wholesale and retail segments could be a possibility in the near future.

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