Central Bank Digital Currency(CBDC) Explained | AMA with Head of Quant, CoinDCX

What is a Central Bank Digital Currency(CBDC)?

Central bank digital currency or CBDC is the ‘digital’ form of a national currency, issued by central banks, and a blockchain based solution to solve the problems of traditional financial systems. The value of a CBDC is equivalent to the value of a country’s fiat currency. For example, Digital rupee, Digital Yuan, Ekrona, E-Naira and many others.

The introduction of Central Bank Digital Currency (CBDC) will result in a more efficient and cost-effective currency management system, providing the digital economy a significant boost. 

CBDCs are being developed in various countries, and some have already integrated them into their financial systems. As countries develop plans to transition to a digital monetary system, it’s critical to grasp what they are and what they mean for the general public. 

How does the current financial system work? 

The Reserve Bank of India (RBI) prints currency notes, while the Indian government mints coins. According to research, banknotes account for 15% of the money supply in India. Whereas in Sweden and other developed countries, bank notes make up 1-2% of the total. This means, even today, the majority of transactions are conducted using actual cash.

What are the problems in the current financial system?

Operational Issues: The Reserve Bank of India is in charge of managing the bank notes in circulation. To prevent fraud, they should ensure that security checks are performed at the appropriate checkpoints during the printing of bank notes. After printing, the money should be transferred to a vault, from which it will be distributed to end users via banks. The supply chain as a whole is time-consuming and complicated.

Financial Costs: Different components, such as nickel, must be poured in precise proportions while producing coins. Any metal added in excess of the required amount could raise the expenses of producing that single coin. The printing of banknotes and coins, as a whole, is expensive. 

Security Challenges: A large number of counterfeit 500 and 1000 currency notes had been produced by 2016. Anti-national activities were funded through this channel, putting national security at risk. Which is why the Indian government was forced to take harsh measures and implement a demonization process, which was challenging for both the public and the government.

Money Laundering: If profits from a business or any other medium are handled in cash, it is possible to avoid paying GST tax. Because it’s impossible for the enforcement directorate and income tax intelligence to coordinate and follow such actions without a paper trail, it’s a nightmare. Large cases are opened in 2-3 years, following paper trails and forming links takes time.

What is the status of current CBDC Pilots around the world?

The Bahamas was the first country to start a CBDC pilot programme, SAND. SAND dollars were introduced in 2020 for testing, to a small group. Sweden and India are anticipating the release of their respective CBDCs, eKrona and Digital Rupee, which will also be tested with a small group.

The United States, on the other hand, has chosen a conservative stance and is seeking public input before making any decisions. In Europe, a 24-month investigation period is underway, during which the digital euro will be examined. If all goes well, the eEuro might be operational by 2025.

​​260 million Chinese had signed up for its CBDC, eCNY, by December 2021. During the Winter Olympics, it was revealed that the CBDC pilot programme would be pursued aggressively. While the Hong Kong Dollar is used in Hong Kong, Yuan is used in Mainland China. People traveling between the two cities find it difficult to carry wallets for each currency. Due to the direct convertibility solution that blockchain can provide, it is believed that digital yuan will solve this problem.

Additional Read: What are Virtual Digital Assets? | Taxed at 30% in Budget 2022

What are the benefits & use-cases of CBDC?

Verifiable Trail of Funds Flow: With cybercrime on the rise, government authorities and intelligence agencies are finding it difficult to arrest fraudsters by tracing the paper route of money movement. Since all transactions are by default recorded on a ledger with a blockchain-based solution like CBDC, a trail of flow of each digital rupee is already documented, and the authorities can instantly identify the imposters. Additionally, a smart contract can be developed on the blockchain, to flag and review transactions involving large amounts of money before they are completed.

Slippage Reduction in Banks: The central government distributes funding to the state government in order to execute government schemes or welfare programs. The state government then allocates funds for each scheme. Consider the following scenario: If the central government pays Rajasthan 1000 crores, the state then creates ten government schemes, each with its own account and 100 crores allocated to it. Let’s say 70 crores is spent for its execution. The remaining 30 crores could be wasted or unreported if the government’s organizational hierarchy is not followed and audits are not reviewed. With blockchain technology, however, a smart contract may be created in which money that is not utilized expires after a certain period and is returned to the RBI. Transparency and accountability of government officials will also be maintained.

Cross Border Payments: According to a report published by the Ministry of External Affairs in 2018, there are 32 million non-resident Indians (NRIs) and OCIs (Overseas Citizens of India) living outside of India. And as per the World Bank, India received $87 billion in remittances in 2021, making it the world’s largest remittance recipient. When faced with withdrawal or transaction limits in such an environment, it becomes difficult for those living outside India to send funds for their families. Furthermore, cross-border transactions are more expensive, and the possibilities of failure are higher. However, as the banking system evolves through CBDCs, such transactions will be processed relatively faster and at a lesser cost. Eventually, withdrawal bottlenecks will decrease to some extent.

What are the demerits of CBDC?

According to a research published in 2018 by the Digital Empowerment Foundation, about 90% of India’s population is digitally illiterate. The elderly and residents of tier 5 and tier 6 cities, where internet connectivity is also poor, have a poor understanding of UPI transactions. Firstly, it will be challenging for this sector to grasp such innovations, and whether or not financial inclusion through CBDC will occur here is debatable.

Secondly, banks gain an income by investing 80 percent of their customers’ deposit and earning interest on it. With the adoption of CBDCs, bank deposits will fall, reducing the bank’s operational capital and loan availability for companies and individuals.

Third, fintech firms assess and rate a person’s financial data in order to sanction loans. But how would such enterprises receive the data they need, if only a central body has access to blockchain data? It will be fascinating to see how the government comes up with a solution for this issue.

What will RBI’s next steps be? What does the future look like?

Bitcoin, the world’s largest crypto asset by market capital, is experiencing scalability challenges as the number of nodes and transactions grows. The Indian government will draw on the expertise of industry leaders, researchers, and personnel from prestigious institutions such as IIT and IISc to identify solutions to such existing blockchain-related issues, while simultaneously ensuring that individuals’ privacy is protected.

There will be measures taken to mitigate the impact of CBDC adoption on banks, such as imposing a daily limit for CBDC transactions and offering a flexible adoption window. According to research, just 38% of Indian households are digitally literate. As a result, extensive user research should be conducted in order to create a user experience that is easy-to-use for not just aged citizens, but to even those with minimal education.

CBDCs are set to gain an official recognition in India. After the inception of digital rupee, financial and documentation services such as insurance, lending and borrowing, government bonds, and certificates (birth, education, and contracts) will be deployed using blockchain technology, paving the way for the country’s involvement in the digital revolution.

Which blockchain network will RBI use to create the digital rupee?

A whitepaper for the development of the digital rupee hasn’t been published yet. It’s unclear if the blockchain will be entirely centralized or include some decentralized elements. It is speculated that a smart contract-based solution may be developed or deployed.

When will the digital rupee be launched? What will its buying price be?

According to the Union Budget 2022, Reserve Bank of India (RBI) would issue a digital rupee using blockchain and other technologies, starting in 2022-23. There is no official record or notice on the exact launch date. It will, however, be released in a testing period with a limited audience.

CBDC is a ‘digital’ form of fiat money. Therefore, the digital rupee will be equivalent (1:1) to the Indian rupee (INR). For example: 1000 digital rupees is equal to 1000 Indian rupee (INR). There is no buying price as such.

Are digital rupee and stablecoins like USDT the same?

No, they are not the same. USDT is a private token. Whereas CBDCs like the digital rupee will be a legal tender, and have the same legitimacy as the fiat rupee. 

While stablecoins like USDT are “pegged” 1:1 with USD dollars, and are issued by private companies, CBDCs are issued by a central authority like a central bank, and are a “digitized” form of a national currency.

Do we have to pay 30% tax on the transfer of digital rupee?

The Union Budget for 2022-23 was presented in the Parliament by Union Finance Minister Nirmala Sitharaman, who announced a 30% tax on income from the transfer of virtual or digital assets.

Despite the fact that both central bank digital currency (CBDC) and crypto assets are based on blockchain technology, they are vastly different. Bitcoin, Ethereum and NFTs are digital assets, whereas CBDCs are the ‘digital’ form of a fiat currency. As a result, you may not have to pay 30% tax on CBDC transfers. A different set of tax rules may be developed for CBDCs.

Additional Read: Crypto Taxation Guide Budget 2022: 30% Tax on Digital Assets

Where can I buy digital rupee?

Neither the Indian government nor the Reserve Bank of India have provided clarity on where the digital rupee could be purchased. However, according to speculation, a mobile app or a card could be launched. A card, on the other hand, may have more advantages because it is simple to use, whereas a mobile app could require OTP, which may cause public fear of falling prey to frauds. 

E-Krona, Sweden’s CBDC, is bought through commercial banks. Other CBDC-testing countries, such as India, might use the same approach.

Will the digital rupee have market capital?

Fiat money, such as the Indian rupee (INR), is not backed by any commodity such as gold or silver, is issued by a central bank, and has no intrinsic value. CBDCs, like the digital rupee, will have no intrinsic value, such as market capital, because they are a ‘digital’ version of fiat money.

CBDC adoption will be limited during the test phase. For example, if 1 crore Indian rupees are in circulation, 0.1 percent of that amount will be issued as CBDC, resulting in 10,000 Indian rupees being circulated in their ‘digital’ form, the ‘digital rupee.’

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