RBI’s Unsure Walk With E-Rupee

Two years ago, central banks across the world, including the Reserve Bank of India (RBI), were being called old and obsolete for the modern financial system. Cryptocurrencies were the centre of attraction for investors as well as traders and many experts wrote the obituary of the centralised financial system.

While many countries are trying to ride the wave of cryptocurrencies by either recognising them as an asset class or letting them be used as legal tenders in the hope that they will be able to reap the benefits of a new age financial order, the RBI has other plans. On December 1, 2022, it joined the ranks of the countries that have launched a pilot project on central bank digital currency (CBDC) as they strive to maintain their hegemony in the country’s financial system.

The RBI has launched pilot projects to test the use of e-rupee in the retail as well as wholesale markets. If these pilots are successful, a citizen will be able to use e-rupee to pay for goods and services instead of paper currency notes or digital money from their wallets or bank accounts.

Not a UPI Clone

Does this sound like a Unified Payment Interface (UPI) or wallet transaction that people are already familiar with? RBI deputy governor T. Rabi Sankar, at a recent monetary policy review conference, explained, “Any UPI transaction involves the intermediation of the bank. So, when I use a UPI app, my bank account gets debited and money gets transferred to the recipient’s bank.”

E-rupee is closer to the paper currency instead, where one withdraws money from the bank, keeps it in the wallet and spends it at a shop. “Similarly, in CBDC, you will draw the digital currency and keep it in your mobile phone wallet. When you make a payment at a shop or to another individual, it will move from your wallet to that person’s wallet. There is no routing or intermediation of the bank,” he added.

This means that e-rupee could conceptually restrict the role of commercial banks in distribution and management of currency. This is tricky. Since the establishment of the RBI Act, 1934, commercial banks have played an integral role in the retail circulation of the Indian currency. The RBI never dealt with the general public; its primary role was to manage the conduct of commercial banks and provide stability to the monetary system of the Indian economy.

Motivation behind CBDC

For over a decade, India has looked for ways to move from physical to digital money transactions. The need to go digital was part of India’s efforts to formalise its economy, which could help reduce the size of black economy, along with bringing down the cost of transactions and easy distribution of cash subsidies. The government has taken several steps in this direction, including enactment of a separate law for payment and settlement systems resulting in the creation of round-the-clock electronic payment systems such as Real-Time Gross Settlement and National Electronic Funds Transfer.

Apart from that, other services like Immediate Payment Service and the UPI, Bharat Bill Payment System and National Electronic Toll Collection were launched over the years. Among all these, the launch of the UPI has turned out to be the most effective, resulting in adoption of digital payments by the masses. It is believed that India would not have survived Covid-19 without a robust digital payments system that allowed the economy to function even during the strictest lockdown, which brought a country of 1.4 billion people to a standstill.

But Covid-19 gave a push to private cryptocurrencies as well. KuCoin, a Seychelles-based cryptocurrency exchange, estimates the number of Indians with investment in cryptocurrencies at over 115 million. For the RBI, which is responsible for providing stability to the Indian financial system, this was an alarm bell.

Looking at the alarming rise in crypto investments from India, RBI governor Shaktikanta Das, in the central bank’s “Financial Stability Report”, said, “We must be mindful of the emerging risks on the horizon. Cryptocurrencies are a clear danger ... While technology has supported the reach of the financial sector and its benefits must be fully harnessed, its potential to disrupt financial stability has to be guarded against.” Das has been relentless in his endeavour to dissuade Indian investors from making investment in cryptocurrencies. His vision was duly espoused by the ministry of finance, which has levied 30% capital gains tax on crypto investments in the country, without any option of provisioning for the losses incurred by investors.

In hindsight, the RBI has proved to be right on the ability of cryptocurrencies to destroy wealth. The global crypto industry was valued at $3 trillion at its peak in 2021 but was down to around $900 billion in November 2022. Since then, no agency has put out credible numbers, but it can be safely assumed that the Das’s comparison of craze for cryptocurrencies with the Tulip Mania of the 17th century was not unfounded. While some of the crypto projects have completely gone bust, including the FTX, Bitcoin, the bellwether of the crypto world, has lost over 50% of its value since its peak. And there is no end to its downcycle yet.

The RBI has this volatility in mind while explaining the rationale of CBDC. “[D]eveloping CBDC could provide the public a risk free virtual currency that will provide them legitimate benefits without the risks of dealing in private virtual currencies. It may, therefore, fulfil demand for secured digital currency besides protecting the public from the abnormal level of volatility which some of these virtual digital assets experience,” it says in the note on CBDC.

But, the lure for an asset class cannot be done away with in vacuum. The RBI wants to offer an alternative to cryptocurrencies in the form of CBDC and hopes to satiate the desire for a digital currency of investors.

Can CBDC Kill Cryptomania?

Sunil Aggarwal, author of Bitcoin Magnet, believes that the RBI plan to kill crypto is a step in the wrong direction. “Crypto coins are an instrument for investment, whereas CBDC in its current form is just a replacement for the RBI-issued physical currency. It will not bear any interest, forget value appreciation, as has been the case with crypto coins. So, it is unlikely that CBDC can actually dethrone crypto coins from the category of investment class,” he says.

Bitcoin rose from $30,000 a piece in January 2021 to $68,000 by November 2021—a whopping 127% rise in 11 months. It may have lost all those gains since the beginning of the Federal Reserve’s interest rate hikes, but investors continue to believe in the future of Bitcoin and many other cryptocurrencies as an asset class.

Rajgopal Menon, vice president of crypto exchange WazirX, says, “With CBDC, we will see more institutional transactions and wholesale payments going through. Cross-border payments, settlements between financial institutions, etc. will also be carried out through CBDCs.”

He adds, “Private cryptos, on the other hand, will be used for retail payments, transfer between individual wallets, in-game purchases for blockchain games, NFT minting and buying, store of value asset, etc.”

But, is there space for another digital mode of payment in an economy already saturated with UPI transactions that are quite smooth and have gained widespread acceptance by the public at large?

A. Damodaran, professor at Indian Institute of Management, Bangalore, argues that for the CBDC to do well in the country, it will have to be better than the UPI system. “Only then will people feel inclined to shift to a different mode of transaction,” he says.

Between March 2020 and August 2022, the volume of UPI transactions grew by 427%, according to Das. In November 2022, the National Payments Corporation of India (NPCI), the umbrella body that governs digital payments in India, reported transactions worth Rs 11.9 lakh crore through the UPI.

Currently, the UPI has 376 partner banks as part of its ecosystem. It has spread its wings in countries like Singapore, the United Arab Emirates, France and Bhutan, making it India’s first global tech product in the payments business and challenging the hegemony of Visa and Mastercard.

Once a system becomes so robust, it becomes challenging for another system to take over.

But Mihir Gandhi, partner and leader, payments transformation, PwC India, has a different take on the issue. He says, “UPI settlements are real-time for customers, but it takes a few hours for the banks to settle accounts with each other. CBDC, on the other hand, can be real-time for everyone, and that’s where it will be a differentiator as the transaction can be final. Banks will be motivated to promote it if the government provides the right incentive.”

The Promise of CBDC

Apart from the robust concept and technology, the success of the UPI system rides largely on the government’s 2019 decision to remove the merchant discount rate (MDR), bringing the transaction fee to zero. Union finance minister Nirmala Sitharaman announced that banks—the infrastructure providers—and service provider apps would not charge any fee from users, including commercial players, for transactions via the UPI. However, this has negatively impacted the payment ecosystem, a committee headed by D.B. Pathak, professor emeritus at the Indian Institute of Technology, Bombay, observed, recommending “a lower controlled interchange instead of zero MDR”.

In December 2021, the government approved a Rs 1,300 crore incentive scheme for the banks to provide infrastructure for the smooth operation of UPI services. However, the amount appears inadequate against the Rs 5,500 crore loss incurred by the service providers, as estimated by the Payments Council of India.

“The government managed to force banks once to make the UPI successful without charging money. But, it will not be possible to force them again to promote CBDC without any incentive. Is the government willing to make that kind of investment in the CBDC ecosystem?” asks a senior executive from a bank, requesting anonymity.

Subhash Garg, a former Union finance secretary, believes that the RBI should not have a problem in financing the CBDC infrastructure. “The government spends around Rs 8,000 crore every year in printing and circulating physical cash in the economy. The RBI must bear the cost of the infrastructure to promote digital currency, which is unlikely to cost more than the cost of maintaining the physical currency system; it is a good value proposition,” he remarks.

Another challenge that emerges from the implementation of CBDC is the disruption it can cause in the monetary system of the country. “The high adoption of CBDC within a country’s financial system could have an impact on the monetary policy, creating unnecessary instability in the economy without proper measures. Higher adoption rates curb the flow and use of fiat currency and in extreme circumstances the economy is forced into substituting the Indian rupee for any foreign currency like the dollar,” says a PwC report published in September 2021.

The CBDC in its current form will work on a single-tier model, which means that the central bank will be responsible for managing all aspects of the CBDC system. This will include “issuance, account-keeping, transaction verification, etc. In this model, the central bank operates the retail ledger and therefore, the central bank server is involved in all payments”, according to a white paper published by the RBI.

The central bank, in nearly 88 years since its establishment, has successfully managed India’s currency market with the help of commercial banks. But when it comes to CBDC, the central bank may have to brace itself for new challenges which may alter its historical equation with commercial banks. “We do not know what digital currency system will emerge once the pilot projects are over. In addition to banks, it is quite possible that the RBI takes the services of private fintech players to manage the digital currency management system on a real-time basis,” adds Garg.

In its current framework, the Indian CBDC may not have the wherewithal to kill the lure of cryptocurrencies among Indian investors. But, there are other reasons for the central bank to go for it. The UK, France, Canada and China among several other nations have already carried out pilot tests for CBDCs. At the same time, global institutions are exploring ways to improve international settlements, and the RBI could not have ignored the call.

Aggarwal believes that China is exploring the possibility of using its CBDC to challenge the hegemony of the US dollar, and the RBI too needs to think in that direction instead of worrying about the crypto challenge. “India must use this historic opportunity to showcase monetary imagination. It should move from a single legal tender to dual legal tender system by launching on-chain sovereign currencies that can be backed by commodity, service, land or care hours,” says Aggarwal. His framework for the Indian CBDC envisages anchoring it against any new age commodity—for example data usage in India—and positioning it as a global currency which has a face value of Rs 10 to India’s current fiat currency.

The Privacy Factor

The government and the RBI seem inclined towards promoting the CBDC as a replacement for cash. However, cash has anonymity attached to it. The RBI has acknowledged the challenge that a digital currency poses as all digital transactions would leave some trail. “The appropriate degree of anonymity in a CBDC system is a political and social question, rather than a narrow technical question,” its concept paper on CBDC reads.

An RBI-promoted digital currency needs to be compliant with anti-money laundering provisions and accommodate combating the financing of terrorism regulations. This requires the central bank to keep a record of the currency holders to the extent possible. Moreover, the entire digital game loses its purpose if the government cannot keep track of the currency’s usage.

Dealbreaker for Retail User?

The RBI believes—as explained in the concept note—that to overcome this hesitation, the “CBDC could be designed to protect privacy and give users control over who they share data with, even if CBDC payments are not truly anonymous”.

Aggarwal suggests that to promote CBDC, the government can start distributing subsidies through the digital currency, ensuring mass adoption of the new form of money.

India makes subsidy transfers worth Rs 3.6 lakh crore to various departments for distribution within the economy. Out of this, if a segment meant for the masses is paid in CBDC, it can turn out to be a game changer overnight.

Regulating CBDC

One significant feature of cash is that it is the sole responsibility of the person who holds it; the accountability does not lie with the banking system in case of loss or theft. But, this may not be the case with the CBDC. In the case of banking frauds, the RBI makes banks liable for refund if the victim reports the fraud within a stipulated time frame. But now, after getting directly involved with the issuance of the CBDC, the RBI needs to be prepared to deal with legal cases and provide infrastructure to deal with public queries.

At the same time, any attempt to trace the stolen e-rupee will only be possible if the RBI puts a system to track transactions through it in place, which will defeat its stated goal of maintaining the bearer’s privacy. In its concept note, the RBI talks about two types of models to manage CBDC tokens—custodian model and user-held model. In the custodian model, “[The t]oken service provider (TSP) is responsible for managing the keys of wallet holding tokens on behalf of the user. ... Since the user details are held in custody by the service provider, the security of the tokens shall be dependent on the robustness of security protocols of the TSP. While dependency on external entity shall allow recoverability, it may also compromise with anonymity as the service provider shall always have visibility over the token movements,” says the RBI.

In the user-held model, when implemented, the responsibility of key holding will lie with the user, and the wallet may not be recoverable in case they lose the mobile device, it adds, indicating that such users will not be able to make any direct claim on the issuer or the financial system. However, their access to the criminal system should stay intact. “User awareness will be the key while dealing with CBDC security,” says Gandhi.

From how things stand today, it is clear that bringing in a CBDC was more of necessity as part of the global ecosystem for the RBI. It may have been pushed as a crypto killer, but its real value may be realised sometime in future—just like the UPI—if the central bank and the government have a clear roadmap.