Digital Rupee: Is It Cash? Is It A Card? No, It's A CBDC!

Digital rupee: What is it? How will it work? What are the risks and what are the benefits?

Indian rupee coins are arranged for a photograph in Mumbai. (Photographer: Adeel Halim/Bloomberg)
Indian rupee coins are arranged for a photograph in Mumbai. (Photographer: Adeel Halim/Bloomberg)

No cash. Just digital money. That day may still be far away but it is approaching a little quicker than we all thought it might.

India will introduce a digital rupee during the course of the year, said Finance Minister Nirmala Sitharaman as part of her Union Budget speech on Feb.1. Details are scant but we know the central bank has a small pilot project underway. A public rollout at a material scale, though, may still be some time away.

India is one of many countries researching central bank digital currencies. In doing so, they are finding themselves facing near-existential questions about the nature of money, the role of banking and central banking. BloombergQuint spoke to Eswar Prasad, professor at Cornell University and author of the book 'Future Of Money - How the Digital Revolution Is Transforming Currencies and Finance' to discuss some of these issues.

Is A Digital Rupee Simply Digital Cash?

Many of us pay using digital means. Cards. Applications based on Unified Payments Interface. Digital banking apps. So what is a CBDC? Is it simply a digital version of cash?

A retail CBDC could take one of two forms, said Prasad. One could be a prepaid card, except it would be an account with a prepaid balance that you would have on your phone. This is the approach that some Latin American economies like Uruguay have taken in their CBDC experiments.

A second form gathering prominence, according to Prasad, is where a CBDC essentially functions as a token in a payment system. This would take the form of a digital wallet where one could hold CBDCs, which would essentially be like accounts, but non-interest bearing accounts, he said.

It would be very similar to a bank account from which you can make electronic transfers, except this would be provided by the central bank at very low cost and even to those who may not have a bank account or a credit card.
Eswar Prasad, Professor, Cornell University & Author - Future Of Money

Will It Co-Exist With Cash?

Most central banks considering CBDCs see it co-existing with cash, said Prasad. "My view is that cash will eventually organically disappear but no central bank is talking about eliminating cash when it introduces a CBDC."

Conceptually, a CBDC will be very similar to cash. It will be a liability of the central bank but will be distributed by commercial banks, similar to cash. The commercial banks or other entities at the front-end may take on functions such as establishing know-your-customer norms needed to hold a digital wallet for CBDCs.

"Most central banks also talk about it as being a zero interest bearing instrument. In theory, though, a CBDC has the potential to bear either negative or positive rate of return," Prasad said.

Wholesale CBDC Or Retail CBDC — What's More Useful?

While the concept of a retail CBDC has gained more attention, a CBDC can also be wholesale. This, however, may not be "transformative", said Prasad.

A wholesale CBDC would be a slight improvement over the wholesale money that central banks already provide, which are essentially reserves that enable commercial banks to conduct payment and settlement transactions among themselves, said Prasad. "Those sorts of reserves are already digital so one might ask what is new about a wholesale CBDC."

What the wholesale CBDC might do is make the inter-bank payment and settlements more efficient using newer technologies like blockchain. Some countries like Singapore have conducted experiments with a wholesale CBDC.

It tells us there are some efficiency gains to be had (via a wholesale CBDC) but it may not be transformative. It is really a retail CBDC which may be transformative because so far central banks have provided retail money only in physical form. So that's going to be a real dramatic change.
Eswar Prasad, Professor, Cornell University & Author - Future Of Money

What Have We Learnt From Global Experiments?

The Bahamas is the first country to issue a nationwide CBDC — the Sand Dollar. Nigeria has also issued a CBDC. China, Sweden and Japan are also experimenting with a retail CBDC, with China and Sweden being the farthest along in terms of their experiments.

These experiments are throwing up learnings on how to balance the risks and benefits, said Prasad, adding that while there are many potential benefits, there are also risks.

He lists some of these risks:

  • A central bank providing a low-cost payment option could squelch private sector innovation.

  • An account-based CBDC could lead to commercial bank deposits migrating to a central bank, specially in times of financial peril.

  • As you move away from cash to digital money, we lose whatever vestige of privacy and confidentiality we may have left in our financial lives.

"Experiments around the world are showing us ways to mitigate some of these risks," Prasad said.

For instance, the Bahamian CBDC has found that by putting a cap on what you can hold in CBDCs can block the possibility of a wholesale flight of money from commercial bank deposits. China and Sweden are experimenting with a two tier-CBDC, which might be the most likely form that will take hold.

In a two-tiered system, the central bank provides the payment infrastructure at the back-end, while at the front-end, it is still private payment providers such as commercial banks and others who are innovating on the most-effective payment mechanism.
Eswar Prasad, Professor, Cornell University & Author - Future Of Money

What Are The Potential Risks To Banks?

One of the serious risks of a CBDC could be to the banking sector, if deposits migrate at a large scale from banks to the CBDC accounts. "Disintermediation of the banking system in any country would not be a desirable outcome," said Prasad.

These risks could play out if people decided that even if central bank currency accounts do not pay interest which bank deposits do, they are safer because they are maintained by a central bank, which, in turn, is backed up by the government. Such risks could emerge particularly in times of financial sector strain.

"This would put central banks in a very difficult spot of being the ones who have to allocate credit in an economy and it would mean significant risk to the commercial banks," said Prasad. "No central bank and none of us really want this outcome."

Options such as limiting the amount of money that can be held in CBDC accounts and making sure that the digital wallets are maintained by commercial banks can mitigate these risks. In effect, non-interest bearing CBDC accounts would run parallel to banks' own interest bearing deposit accounts.
Eswar Prasad, Professor, Cornell University & Author - Future Of Money

What Are The Implications For Monetary Policy?

A CBDC could also make monetary policy implementation and transmission more challenging, said Prasad. For instance, the policy rate set by central banks is effectively the inter-bank borrowing rate. "If commercial banks can do a lot of these payments between themselves without involving the central bank, using a wholesale CBDC, that could mean that traditional monetary policy instruments become less effective," said Prasad.

If commercial banks become less important in the financial system because of the introduction of a CBDC, transmission of monetary policy through the banking channel could also undergo a change, Prasad said.

CBDCs could also lead to more efficient international payments, which would be a good thing, but it could make it much harder to manage capital flows.

A CBDC would lead to, potentially, much greater capital-flow and exchange-rate volatility. So for emerging market central banks, there are many benefits to be had, but certain elements of volatility are going to come with it as well.
Eswar Prasad, Professor, Cornell University & Author - Future Of Money

Does India Really Need It?

One of the motivations of introducing a CBDC is improved ease of payments and greater scope for financial inclusion. For a country like India, which already has a large number of real-time payment options, is a CBDC really needed?

India and China have done a fantastic job in providing low-cost digital payment options to a wide spectrum of their population, said Prasad. In India's case, there is a payment system that does provide open access and interoperability. "So, 'what is the user case' is a legitimate question to ask for a country like India."

One can think about a digital rupee as an additional payment instrument and perhaps it can go into corners of the country where existing options have not made inroads. But certainly, the user case for a retail CBDC is much weaker.
Eswar Prasad, Professor, Cornell University & Author - Future Of Money

However, just like in the case of Sweden, it may be good to have a CBDC as a backstop to private payment systems, Prasad said. Other use-cases such as using CBDCs to make lump sum transfers to citizens may also be valid in the case of India, he said.

Watch the full conversation with Eswar Prasad below: