The Central Bank Digital Currency

CBDCs must be designed according to the central bank policy objectives – and they’re not the same as cryptocurrency

Joining countries such as China trying out pilot versions of their central bank digital currency (CBDC) – the digital yuan – India’s finance minister Nirmala Sitharaman announced the launch of the digital rupee as soon as this year in the recently presented Budget for the country earlier in February.

Though not yet formally defined, the Bank for International Settlements (BIS) states, a CBDC “is a new form of central bank money […] that is different from balances in traditional reserve or settlement accounts.” The idea of a CBDC today, as it stands, is rooted strongly in concepts of bitcoin and other similar blockchain-based cryptocurrencies.

“Introduction of a central bank digital currency will give a boost, a big boost to (the) digital economy. Digital currency will also lead to a more efficient and cheaper currency management system,” said Sitharaman, according to a BBC report.

Not a crypto-‘currency’

It is crucial to understand, however, that this digital rupee is not, in fact, a cryptocurrency.

While it has all the blueprints of a cryptocurrency – based on blockchain technology and aiming to reduce the dependence on physical currencies in the future – it is centralised and pegged to the value of the country’s fiat currency, meant to be used alongside it.

The key differentiator here is centralisation. A cryptocurrency, by definition, does not have a centralised authority controlling (or regulating) transactions on the blockchain. A CBDC, however, does.

Another major factor is the way cryptocurrencies are considered. In India, cryptocurrencies such as Bitcoin are seen more as assets than mediums of exchange, or currency. This is rather different from countries like the US, where even several Ivy League schools such as Wharton have started accepting payment of tuition fees of several courses via bitcoins. In India, according to The Print, “cryptocurrencies are largely seen as instruments to diversify risk and act as a hedge against swings in other asset classes.”

CBDC design principles

While designing a CBDC, stress needs to be placed on choosing the right design principles, based on the particular central bank’s policy objectives. For example, there is no requirement for CBDCs to be built on Distributed Ledger Technologies (DLTs) like blockchains. It can, quite as easily, be built on conventional centralised technology.

However, the Bank of England opines, “DLT does include some potentially useful innovations, which should be analysed when considering the design of CBDC. (While) distribution and decentralisation may enhance resilience and availability, (it) could have a negative impact on aspects such as performance, privacy, and security.

CBDC may be able to provide ‘programmable money’ through smart contracts. There would be a range of options for how this might be delivered.”

If a CBDC is intended for use as a digital equivalent of cash by businesses and households, it is called a “retail” CBDC. If it is, however, restricted to financial institutions and intended primarily for the settlement of large inter-bank payments, it is called a “wholesale” CBDC. Although we are still waiting for details on the matter, the RBI is currently considering pilot projects for both retail and wholesale CBDCs for release by the end of 2022.

The Print reports: “While a wholesale CBDC would be used for limited purposes, the implications of introducing a retail CBDC need to be carefully understood.

Rollout of a retail CBDC would require pervasive internet connectivity and an efficient telecommunication network for transacting in CBDCs. Further, as the central bank will maintain retail balances, the choice of technological architecture assumes significance. The complexity of the underlying technology may limit its adoption by households. Moreover, the underlying technology should be able to process payments efficiently and fast.”