An uncharted domain

The payment system in India seems set for an overhaul as the Reserve Bank of India has explicitly expressed its intent to roll out Central Bank Digital Currency in a phased manner. The decision is contextualised with the booming cryptocurrency markets — with its value soaring between USD 2-3 trillion. The Indian government, like some other governments, is apprehensive regarding the rise of private cryptocurrencies — and not without reasons.

Economies the world over, at the current stage, are undergoing a disruptive technological transformation in the form of digitization of money, leading to a transition from one monetary system to another which is largely unknown. Steps taken at this juncture will have a definitive impact on the positioning of countries in the coming year when the effects of disruptive technology will be stabilized.

As cryptocurrencies are already transforming the way we store and transact our money, entry of the Central Bank will offer some other sort of balancing — the nature and extent of which is unknown. The impact of CBDCs is not limited to the economic domain only. Critical issues like privacy and state surveillance over people's transactions (in case of centralised ledger), and the environmental impacts on account of the energy-intensive mining process (in case of distributive ledger) have also come to the fore.

While just a few countries have established their own Central Bank Digital Currency, many are in the process at varying stages of implementation. Of course, lessons can be learnt from the limited precedents we have. Additionally, it becomes particularly important to have a look around what the researchers and academicians have to say about the pros and cons of CBDCs.

Central Bank Digital Currency

A simple break-up of the term would provide three components — Central Bank, digital, and currency. While the first component is self-explanatory as it nominates an authorised Central institution within a country, the second component qualifies the third and is not hard to understand. There is a catch in the third component though; a currency must always be seen in the light of authorisation by a competent authority, say the Central Bank. Here is the line that stands between CBDCs and cryptocurrencies (which are in fact a misnomer). Cryptocurrencies at best are investment portfolios. Another pertinent distinction that needs to be made at the very outset itself is between 'digital transaction' and 'digital currency'. While digital transactions have an underlying cash component, digital currency would be the cash equivalent itself and the part of overall money in an economy.

Historically, there has been transactions and deposits, with the Central Bank being the key guardian of monetary operations. The banks' role has been to create money with deposits through loan interests. The Central Bank also regulates the amount of money in circulation in the economy by tinkering with deposit and lending rates.

The new disruptive technologies have, however, come to affect this fundamental framework of the functioning of banks. It is speculated that once the CBDC is rolled out, people may start converting deposits into digital currency. This will affect the bank's potential to lend loans. This case however is comparatively weaker for a country like India which offers positive interest on deposits — meaning that if people keep their money with the bank, they will get incremental returns. This is contrary to the situation in most of the developed economies where there is zero rate of return on deposits. India's partial immunity will however prove out to be inefficient in crisis situations when people will anyway try to get their deposits converted to digital rupee. To see how the economy is impacted due to disruption, the disruptive technologies can be clubbed under two heads — cashless transactions and digital form of money. On one hand, cashless transactions — including card payments and other digital modes of payments — have significantly reduced the cash flow in the economy. On the other hand, the digital form of money seems to claim a part of the Central Bank's prerogative to create money. Cryptocurrencies are doing it with increasing popularity. To put it clearly, two of the core functions of the Central Banks — the magical task of creating money and the power to control the cash flow in the economy — seem to be somewhat contested. Things do stabilize gradually after each disruptive technology is introduced, in favour of the metamorphosis of a new reality. For Central Banks around the world, the quest is to maintain their relevance vis-à-vis rapidly emerging private players, and one possible answer they are seeking, though warily, is Central Bank Digital Currencies — as a balancing factor for cryptocurrencies.

Impact on Central Banks

The rollout of digital currencies is in the realm of the unknown. While its impact on Central Banks and the overall economy cannot be gauged as it is still in the preparatory phase in most of the countries, opposing and supporting views on certain structural issues can be discussed.

Broadly, the impact of CBDC can be in two respects: 1) Structural bank disintermediation and 2) The impact of CBDC in crisis situations.

Structural bank disintermediation simply means that as the Central Bank becomes the prime depositor, the role of intermediary banks and financial institutions would diminish which many see as problematic. Committee on Payments and Market Infrastructures states:

"Introducing a CBDC could result in a wider presence of central banks in financial systems. This, in turn, could mean a greater role for central banks in allocating economic resources, which could entail overall economic losses should such entities be less efficient than the private sector in allocating resources. It could move central banks into uncharted territory and could also lead to greater political interference."

On the issue of the impact of CBDCs in financial crisis, Mersch (2018) has emphasized the destabilizing effects of CBDC in a financial crisis:

During a systemic banking crisis, holding risk-free central bank issued [CBDC] could become vastly more attractive than bank deposits. There could be a sector-wide run on bank deposits, magnifying the effects of the crisis. Even in the absence of a crisis, readily convertible DBM could completely crowd out bank deposits – putting the existence of the two-tier banking system at risk. In this situation, the efficient flow of credit to the economy would likely be impaired.

At the crossroads

The path ahead for the rollout of CBDC is loaded with a handful of dilemmas — adopting a retail digital currency or wholesale digital currency; whether to go for a centralised ledger or a distributive ledger; choosing anonymity of transaction for the people or greater oversight on each transaction for the matter of traceability; reducing the cost of transaction or increasing the carbon footprint!

Wholesale vs retail digital currency: One possible approach for digital currency rollout could be to start with wholesale CBDC and then, gauging the success over time, advance towards retail CBDC — meaning to take the digital currency among the general masses. This seems a probable path as the Central Banks remain wary of venturing into the domain. Initial briefing from the Reserve Bank of India has enclosed the same view as it looks forward to a phased rollout.

Centralised vs distributive ledger / Anonymity vs traceability: This remains the key dilemma. Private cryptocurrencies operate on distributive ledger systems. The information around the transaction is distributed across the network and makes meaning only as a whole. One of the reasons for a large number of people opting for cryptocurrencies is that these run on a distributive ledger whereby privacy of transactions is ensured. The ardent proponents of CBDC seek a transformative change that could only be possible through a distributive ledger. On the other hand, in a centralised ledger system, CBDC is offered through deposit accounts with the Central Bank only. This is just an extension of the traditional banking system to the digital domain. The Central Bank will have more control over the information of transactions made by the people, which it can use to monitor money laundering, illicit funding etc. In fact, the Central Bank, by the virtue of digitized control, will have greater control over the transaction information vis-à-vis traditional banking systems.

The supporters of CBDC advocate for a decentralised ledger, consistent with the idea of sovereign money — wherein there is no oversight over people's transactions. This will work on the basis of token money, the transaction with which will be beyond the knowledge of the Central Bank — like in the case of banknotes. This brings us to the most crucial part of the debate — the question of anonymity. It is largely argued that people's transactions must be anonymous to the government.

Environment vs reduced cost: The rollout of CBDCs may, for the time being, set into motion a cyclic competition wherein private cryptocurrencies will strive to ramp up their operations exponentially — leading to huge environmental costs. This would come against the reduced transaction cost and high profits of the Central Bank. This is no doubt the most important area where the balance needs to be established.

Environmental impacts

Cryptocurrencies operate through blockchain technology. Each time a transaction is made through cryptocurrency, it adds a block with embedded codes which have to be verified and recorded for the completion of the transaction. The process of verification and recording is called mining which is more or less like decoding the embedded code. The mining of cryptocurrencies requires a computational setup that is highly energy-intensive — particularly consuming significant amounts of fossil fuels. The mining of digital currencies has huge environmental costs; it not only increases global carbon footprint but has an adverse impact on water and land footprints as well, for mining operations also alternatively (to coal) use water-based and land-based electricity-producing methods.

The potential environmental impact can be gauged from the ecological footprint of Bitcoin alone. As per Cambridge Bitcoin Electricity Consumption Index (CBECI) If this network were a country, "it would be the 27th largest electricity consumer, above countries such as the Netherlands, Norway, and Argentina"

The mining-based blockchain technology seems to be highly disruptive for the environmental sector. It goes against the global efforts to contain global warming within a particular range of temperatures. It is projected that in less than three decades, Bitcoin usage alone can produce enough greenhouse gas emissions to push global warming beyond the Paris agreement's goal of capping anthropogenic climate warming below two degrees Celsius (Mora, Camilo, et al., 2018)

Apart from China's coal-intensive Bitcoin mining, countries like Kazakhstan, Iran, Venezuela, Canada, Norway etc., have gone very much into the business of cryptocurrency mining on the basis of resources — fossil fuel, water, land etc. — available with them.

The huge profits in the cryptocurrency seem to have silenced the concerns around environmental conservation and climate change discourse. As Central Banks are trying to enter into the competition to reclaim their fading relevance, the drive towards mining may only increase over the years. This is a call to policymakers and environmental conservationists to step up their efforts to uphold the priority of the environment as we progress further down the path of technological advancement. Unlike it has largely been the case always, the environment should not be forced to the backseat this time around.

Conclusion

The rush towards digital currencies in India appears to be driven out of the urgency to drive out or moderate the cryptocurrency profits, though globally, there are supporters of CBDC who perceive it for a different set of merits. Either out of urge or choice, there is no looking back now. As India is set to roll out its CBDC, it must tread cautiously with detailed research and planning. On tackling the issue of disintermediation of the banking system and on the loss of deposits during the financial crisis, Noone and Kohomf have proposed certain principles to deal with the issue. These principles include:

(i) CBDC pays an adjustable interest rate.

(ii) CBDC and reserves are distinct, and not convertible into each other.

(iii) No guaranteed, on-demand convertibility of bank deposits into CBDC at commercial banks (and therefore by implication at the central bank).

(iv) The central bank issues CBDC only against eligible securities (principally government securities).

Further, on the issue of the environment, India must spearhead a movement at a time when the world is silent over the profit-taking over the much-touted climate control and environmental conservation. Also, before it turns out to be controversial, leading to a policy logjam, the efforts to rollout CBDCs should take into consideration the privacy issues of the people. Privacy remains a central issue today and any negligence of it will only be counter-productive. To sum up, such a long-term transformation in the economic system has to be brought with patience rather than in rush or among ambiguities. The ambiguities can only be removed through detailed research and meticulous planning.

Views expressed are personal