CBDC and Cryptocurrency In the Indian Economy

Central Bank Digital Currency (CBDC) and Cryptocurrency are two different types of digital currencies that have gained attention in recent years. While both are digital currencies, they differ in several ways.

1. Control: CBDC is a centralized digital currency that is issued and controlled by a central bank, whereas cryptocurrencies are decentralized and operate on a peer-to-peer network, meaning they are not governed by any single entity.
2. Issuance:

• CBDC is issued by a central bank and is a legal tender. It is backed by the government and is considered a liability of the central bank.
• Any central authority does not issue cryptocurrency and is decentralized. It is created through a process called mining, where complex mathematical problems are solved to validate transactions and create new coins.

3. Purpose:

• CBDC is designed to replace physical cash and to provide a more efficient and secure payment system. It can also be used to implement monetary policy, as it allows the central bank more control over the money supply.
• Cryptocurrency is designed to be an alternative to traditional currencies and to provide a decentralized payment system. It can also be used for investment and speculation purposes.

Both of them are digital currencies, but they differ in terms of technological aspects, underlying architecture, and governance. The design of CBDC infrastructure requires careful consideration to ensure security, scalability, and interoperability. Below are some of the key infrastructural design considerations for CBDC:

1. Centralized vs. Decentralized: The biggest technological difference between CBDC and cryptocurrency is their underlying architecture. CBDC is a centralized digital currency, which means it is issued and controlled by a central authority, such as a central bank or government. Cryptocurrencies, on the other hand, are decentralized and operate on a peer-to-peer network, with no central authority or governing body.
2. Distributed Ledger Technology: CBDC and cryptocurrencies use different Distributed Ledger Technologies (DLT) to record transactions. CBDCs are likely to use a permissioned DLT, where only authorized participants can access the network, and transactions are validated by trusted nodes. Cryptocurrencies, on the other hand, use a permissionless DLT, where anyone can participate in the network, and transactions are validated by a decentralized network of nodes.
3. Privacy and Anonymity: Another significant technological difference between CBDC and cryptocurrencies is their approach to privacy and anonymity. CBDCs are likely to have strong identity verification measures, which would make it difficult for users to remain anonymous. In contrast, cryptocurrencies provide varying degrees of anonymity, depending on the type of cryptocurrency and the level of privacy features.
4. Smart Contracts: Cryptocurrencies have the ability to execute smart contracts, which are self-executing contracts with the terms of the agreement directly written into code. Smart contracts can automate processes, eliminate the need for intermediaries, and reduce transaction costs. CBDCs, however, are unlikely to use smart contracts initially, as they are primarily intended to replace physical cash.
5. Interoperability: Cryptocurrencies are designed to be interoperable, meaning that they can be used across different platforms and networks. CBDCs, on the other hand, are likely to be designed for use within a specific country or region and may not be compatible with other CBDCs or cryptocurrencies.
6. Security: Security is of utmost importance when it comes to CBDC infrastructure. The design should ensure the highest level of security to protect against cyber threats and attacks. This can include measures such as using strong encryption, implementing multi-factor authentication, and maintaining strict access controls.
7. Scalability: CBDC infrastructure needs to be scalable to accommodate the potentially large number of users who may be transacting with the digital currency. The design should be able to handle high transaction volumes while ensuring fast and efficient processing.
8. Privacy: CBDC infrastructure needs to ensure privacy for its users while maintaining transparency and compliance with anti-money laundering (AML) and know-your-customer (KYC) regulations. This can be achieved through the use of advanced privacy-enhancing technologies.
9. Resilience: CBDC infrastructure should be designed to be resilient against potential disruptions or downtime. This can include redundancy measures, such as distributed ledgers, to ensure that the system remains operational even in the event of a localized failure.
10. Accessibility: CBDC infrastructure should be accessible to all users, regardless of their level of technological sophistication. This can be achieved through the use of user-friendly interfaces and educational resources to help users understand digital currency and how to use it.

CBDCs can be categorized into several types based on their underlying technology, the degree of anonymity, and the scope of usage. Here are some of the main categories:

1. Retail CBDCs: These are CBDCs that are available to the public for use in everyday transactions. Retail CBDCs can be accessed through mobile apps or other digital wallets and can be used to pay for goods and services or to transfer money to other users.

Here are some ways in which a retail CBDC could affect the system:

• Increased competition: A retail CBDC would provide an alternative to bank deposits and physical cash, which could create competition for banks and increase consumer choice.
• Increased efficiency: CBDCs could potentially make payments faster, cheaper, and more secure, which could improve overall economic efficiency.
• Changes to interest rates: CBDCs could potentially make it easier for central banks to implement negative interest rates, as they could be used to store money outside the banking system.
• Changes to the money supply: The introduction of CBDCs could potentially increase the money supply, as individuals could hold both physical cash and CBDCs.
• Increased financial inclusion: CBDCs could potentially increase financial inclusion by providing a digital payment option to individuals who do not have access to traditional banking services.

2. Wholesale CBDCs: These are CBDCs that are only available to financial institutions and are used for large-value interbank transactions. Wholesale CBDCs are not accessible to the public. One of the main benefits of wholesale CBDC is that it could improve the efficiency and speed of financial transactions, which would reduce settlement times and lower costs. This, in turn, could lead to increased liquidity in financial markets and potentially reduce the risk of financial crises.

Additionally, wholesale CBDC could also help central banks to better monitor and manage financial transactions, since all transactions would be recorded in a centralized ledger. This could potentially improve the effectiveness of monetary policy and reduce the risk of money laundering and other financial crimes. However, the introduction of wholesale CBDC could also pose some challenges to the monetary system. For example, it could lead to a reduction in demand for traditional bank deposits, which could affect the stability of the banking system. Additionally, the introduction of wholesale CBDC could potentially disrupt the existing payment systems, which could have a negative impact on financial stability.

3. Token-based CBDCs: These are CBDCs that are issued in the form of digital tokens that can be transferred between users without the need for an intermediary. Token-based CBDCs can be used for both retail and wholesale transactions.

4. Account-based CBDCs: These are CBDCs that are issued and stored in user accounts maintained by the central bank or a licensed financial institution. Account-based CBDCs can be used for retail transactions and can offer features like interest payments and overdraft facilities.

5. Anonymous CBDCs: These are CBDCs that provide a high degree of anonymity to users. Anonymous CBDCs can be used for retail transactions and are designed to protect the privacy of users.

6. Traceable CBDCs: These are CBDCs that are designed to be easily traceable, enabling authorities to monitor and prevent illegal activities like money laundering and terrorist financing.

Some of the risks associated with CBDCs and cryptocurrencies:

1. Operational risk: Both CBDCs and cryptocurrencies are digital assets that rely on complex technological infrastructure to function. Any technological glitches, software bugs, or cyberattacks can lead to operational risk and affect the functionality and security of these assets.
2. Market risk: The value of cryptocurrencies is highly volatile and can fluctuate significantly in a short period of time. This volatility can be attributed to several factors, such as investor sentiment, global events, and regulatory changes. CBDCs may also be subject to market risk if they are traded on digital exchanges.
3. Regulatory risk: Cryptocurrencies are largely unregulated, and their legality varies from country to country. Regulatory changes or crackdowns on cryptocurrencies can lead to significant price drops or even make them illegal. CBDCs are likely to be more regulated, but changes in regulations can also affect their value and use.
4. Privacy risk: CBDCs are digital currencies issued by central banks, which means that they may have access to a lot of personal financial data of users. This can raise privacy concerns and may lead to surveillance and monitoring of financial transactions. Cryptocurrencies, on the other hand, offer greater privacy as they are decentralized and operate on blockchain technology that does not require the personal information to be shared.
5. Counterparty risk: In the case of cryptocurrencies, there is no central authority or institution to guarantee the value or security of the asset. This means that investors bear the counterparty risk associated with the exchanges and wallets they use to trade and hold their cryptocurrencies. CBDCs, being issued by central banks, are likely to have lower counterparty risk.

6. Adoption risk: The success of CBDCs and cryptocurrencies depends on their adoption and usage. Low adoption rates or lack of mainstream acceptance can lead to a decline in value and limit their usefulness. At the time, the Reserve Bank of India (RBI) has already introduced the first pilot in the Digital Rupee - wholesale segment (e?-W) on November 1, 2022, the RBI has also launched the first pilot for retail digital Rupee (e?-R) on December 01, 2022, thereby making India one of the front-runners in digital payment domain, as most of the major economies have not introduced the CBDC yet.

CBDC is a digital or virtual currency, yet it is not comparable to the private virtual currencies which have mushroomed over the last decade. Private virtual currencies sit at substantial odds with the historical concept of money, they are not commodities or claims on commodities as they have no intrinsic value.

The scope of CBDC in India is such that it will have a significant impact on the Indian Economy in general and the banking sector in particular. The Digital Rupee issued by RBI shall form a part of the overall money supply in the economy which will impact the demand and prices, the velocity of circulation of currency would undergo a change, and the overall cost of transaction is expected to decrease, thereby bringing in efficiency.

Furthermore, it could significantly improve the monetary policy development in India, its real-time situational monitoring and enhanced surveillance enabled by the central bank digital currencies can go a long way in stimulating these processes.