Do CBDCs uphold the values of a Digital Currency?

Published on March 30, 2022

Understanding Central Bank Digital Currency

An article published by Subarna Singh on Feb 7th, 2022

The Indian finance minister, Nirmala Sitharaman, in her budget speech on 4 February 2022 announced the introduction of the Digital Rupee into the Indian economy. The proposed digital currency will be issued by the Indian Central Bank, Reserve Bank of India (RBI) early next year. The primary objectives of the digital Rupee are to boost the digital economy of India and help curb the issue of black money.

The infrastructure supporting a digital currency allows a transaction trail of every rupee. This will render tax evasion difficult for persons and organizations.

The infrastructure will also make the current currency management system more efficient and cheaper. The benefits of which will be

  • reduced dependency on cash
  • higher seigniorage due to lower transaction costs
  • reduced settlement risk.

A CBDC is a 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. Only its form is different.

The objective of CBDC is two folds:

  1. to provide users with convenience and security of a digital currency
  2. to provide the regulated, reserve-backed circulation of the traditional banking system. CBDC will be backed by the full faith of the issuing government — just like fiat currency

As of early 2022, it is estimated around 87 countries are exploring a CBDC. This is a significant increase since May 2020, when only 35 countries were considering a CBDC.

There are 9 countries that have fully launched a digital currency. The Bahamas, countries in Easter Caribbean, and Nigeria. Nigeria is the latest country to launch a CBDC, the e-Naira, on 25 October 2021.

Around 14 countries, including China, Sweden, Singapore, South Africa, and South Korea, are now in the pilot stage with their CBDCs. They are likely to launch soon.

India though in the development stage of digital Rupee is still in the process of examining issues pertaining to the implementation of the Digital Rupee.

The Deputy Governor, Reserve Bank of India in his speech on Central Bank Digital Currency — Is This the Future of Money highlighted design issues that were yet to be finalized:

  • the scope of CBDCs — whether they should be used in retail payments or also in wholesale payments;
  • the underlying technology — whether it should be a distributed ledger or a centralized ledger, for instance, and whether the choice of technology should vary according to use cases;
  • the validation mechanism — whether token-based or account-based,
  • distribution architecture — whether direct issuance by the RBI or through banks;
  • degree of anonymity

The pending design issues indicate that while India may have taken the decision to have its own CBDC, the nature of the CBDC and the consequent changes in the functioning of the financial system due to the introduction of CBDC are largely undetermined.

here is a tracker for CBDC development around the globe: Central Bank Digital Currency Tracker

The adoption of Central Bank Digital Currency (CBDC) will accrue benefits to both the government and its people. The benefits will be seen in the form of:

  1. Improved efficiency via technological advancement: payments have been made through intermediaries such as banks and clearinghouses. Money transfers and payments will become real-time, allowing direct transfer of money between the payer to the payee. Thus eliminating the need for an intermediary.
  • This guarantees a reduction in transaction fees, making the system cheaper for users.
  • By making the system real-time it reduces settlement risk which has been inherent to the financial system.

2. Financial inclusion: the lack of inclusivity in the current financial system is evident in the number of people who still remain unbanked. The free or low-cost bank account provided by the central bank, an attribute of the type of CBDC infrastructure implemented, will promote financial inclusion for the unbanked citizen.

3. Tax collection: the traceability of every unit of CBDC means tax avoidance and tax evasion will become very difficult. It will be a challenge for anyone to hide their financial activity from the government or the central bank.

4. Combating crime: traceability of financial activity makes it much easier to spot criminal activity.

5. Banking competition: Commercial banks have enjoyed the monopoly of bank deposit services. With the introduction of CBDC, if central banks are to offer bank accounts, they will not only be free or low cost but also offer complete safety of money deposits. This creates fair competition in the market and forces banks to offer better services and returns to their customers in return for their deposits.

7. Monetary policy transmission: the creation of a new and direct channel for monetary policy transmission. Central banks would not have to rely on indirect tools such as quantitative easing and interest rates. This could also pave way for an alternate financial system with a full reserve banking system.

8. Financial safety and stability: CBDC would limit the practice of fractional reserve banking and potentially render deposit guarantee schemes obsolete.

Satoshi Nakamoto proposed Bitcoin as a digital currency with the aim of providing:

A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.

The main benefits of digital currency are lost if a trusted third party is still required to prevent double-spending

Based on his paper Bitcoin: A Peer-to-Peer Electronic Cash System for the purpose of this article we will consider the following underlying principle mandatory for a currency to be considered a digital currency:

  1. Self-custody: Bitcoin allows users to hold their money (bitcoin) in wallets giving them complete control and ownership of their assets. This means that the user and the user alone are responsible for their digital asset.

2. Security: The security of a user’s asset solely depends on them protecting their private key. The network is designed to ensure no one except the owner of an asset can access it. The possibility of the system being hacked is almost improbable.

3. Inclusion: The network does not hold the power to exclude anyone from joining or transacting. There are no gatekeepers in the system.

  • No censorship: Nobody should be able to prevent valid transactions from being confirmed.
  • Permissionless: No arbitrary gatekeepers should ever prevent anybody from being part of the network.

4. Transparency: Due to the public nature of the ledger, the transactions are visible to anyone looking at the ledger. The network allows traceability of assets.

5. Privacy: The ledger of Bitcoin may be transparent but the privacy of a user is maintained by not disclosing the personal information of the account holder. This makes it challenging to collect data and identify patterns of financial activity of a particular user.

6. Decentralization: Bitcoin has no central point of control. No one person or entity is in charge. Connecting to any node on the network gives you the same rights and responsibilities, ensuring no single point of failure.

7. Irreversible Transactions: Confirmed blocks should be set in stone. Blockchain History should be immutable.

The answer to this question largely depends on the design of CBDC by the Central banks. Taking India as an example, a lot remains unclear as to how RBI plans to execute CBDC into its framework.

  1. Accounts:
  • A token-based or account-based mechanism: an account-based system requires verifying the identity of the payer, while a token-based system requires verifying the validity of the object used to pay. The mechanism will determine the level of privacy the account holder will be allowed to have.
  • Custodianship of CBDC: It remains unanswered whether the account holder is the custodian of CBDC owned by them or will Central Bank hold the coins on their behalf, similar to the existing model?
  • A barrier to entry: KYC requirements to open an account can hinder account opening for persons who lack a valid identification document. In a developing nation like India which is still trying to introduce a Unique Identity for all its residents, a portion of the population exists that is still not documented. Opening an account will remain a challenge for them very similar to the current system.

2. Transactions:

  • Irreversible transaction: will the central bank guarantee irreversible transactions or does the institution hold power to alter the ledger to make amendments?
  • Block transactions: to stop financial crimes and other criminal activity a controlled ban on transactions of certain accounts is mandated. However, this leaves a grey area of what the institution considers a crime. This can easily be misused to stop financial support for causes the authorities deem unfit.
  • Privacy: will the central bank guarantee the privacy of user data? Access to information about transactions of an individual can be misused against the person. What checks will be put in place to ensure that this data is not made available beyond screening for criminal activity and tax evasion?

3. Central Control:

  • Centralized or decentralized: In contrast to cryptocurrencies, a central bank’s digital currency would be centrally controlled, even if it is implemented as a blockchain. So a blockchain or other distributed ledger would likely not be required or useful — even as they were the original inspiration for the concept.
  • Security: The centralized nature of CBDC raises security concerns. It automatically becomes a central point of failure and is prone to cyber-attacks. Focus on cyber security may be a possible solution but it does not compare to the advantages of a distributed blockchain.

The cryptocurrency is a solution to the problem of centralization of power in the hands of intermediaries in the financial system. The intermediaries have been prioritizing their profits at the cost of their customers for a very long time. The cryptocurrency infrastructure aimed at removing these financial institutions in the payment system by allowing direct payment between payer and payee.

Central Bank Digital Currencies are designed to solve a different set of issues. Its integration into the financial system has the potential to redefine the system’s current model. It has the potential to allow transparency, financial inclusion, reduce cost borne by the customers, efficient taxation, and create a competitive and well-regulated financial system for its citizens.

The success of achieving these goals largely depends on the implementation plan of the central bank for CBDC infrastructure. It is a given that CBDC cannot be as private and decentralized as cryptocurrencies, but a completely centralized infrastructure controlled by a single authority opens the system to the inherent risks of security, privacy violation, exclusion from the system, and manipulating the system for the benefit of few. Thus, central banks need to take special care that their design for CBDC is carefully selected to try to achieve the aforementioned principles of digital currencies to avoid loopholes in the system. There is no perfect solution but CBDC should not be a new facade for the existing financial system.


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