Rapid introduction of a central bank digital currency is fraught with risks, especially for end-users

05 May 2022

Opinion: Barry Eichengreen Poonam Gupta & Tim Marple 

In her February 1 2022 budget speech Nirmala Sitharaman announced GoI’s commitment to issuing a digital rupee. The relevant text ran three sentences in its entirety. ‘Introduction of [a] central bank digital currency (CBDC) will give a big boost to digital economy. Digital currency will also lead to a more efficient and cheaper currency management system. It is therefore proposed to introduce digital rupee using blockchain and other technologies to be issued by the Reserve Bank of India starting in 2022-23.’

These remarks create a sense that time is of the essence and that the RBI must move ahead as quickly as possible. Other central banks notably the People’s Bank of China are already piloting their digital units. The first movers it is said will set design standards not just for themselves but globally. Their digital currencies will dominate international markets. Countries that lag behind will lose digital talent to – who knows? – the Bahamas Dubai or another early entrant. Valuable opportunities to foster financial inclusion and enhance the efficiency of payments will be squandered.

In fact this urgency is overwrought. The case for a CBDC is yet to be coherently made. And premature movement in the direction of issuance would create costs and risks.

To be sure a CBDC would facilitate payments. It would be safer and more sanitary than cash and cheaper than credit and debit cards. But India already possesses an efficient encompassing low-cost electronic payments infrastructure the Unified Payments Interface (UPI) which instantly transfers funds between retail bank accounts using mobile platforms (e.g. smartphones) at negligible cost.

Arguments based on financial inclusion are overdone as well. A wholesale CBDC – where commercial banks act as agents for the central bank – would be available only to those banks’ customers not also to the unbanked. A retail CBDC where the central bank transferred CBDC directly to the mobile phones or smart cards of users would be available also to others. But only if they had a smartphone capable of downloading a digital wallet or an internet connection capable of loading up a smart card.

Can You Run With the Hare?

These interventions would face the same geographic and infrastructural challenges as existing financial inclusion efforts funnelled through the traditional banking system. And further they would not have any clear incentive for uptake among those already included in the banking system. In any case India possesses more direct means of fostering financial inclusion notably basic savings bank deposit accounts (BSBDAs) and the Pradhan Mantri Jan Dhan Yojana.

Some cite the danger that the RBI by failing to issue its own digital unit will lose control of the payments system to private payments platforms and stablecoins. If so then the simple solution is to regulate the latter rather than to introduce costly sovereign competition.

Yet another argument for a CBDC is to provide an encompassing platform for the design and dissemination of smart contracts and other decentralised finance (DeFi) applications. Smart contracts are loans and related financial instruments that do not rely on intermediation and monitoring by a bank. They can be built on a public blockchain whose nodes then verify the transaction and can be executed using     the native coin circulating on that blockchain.

Currently the majority of DeFi transactions run on ethereum’s public blockchain where ether is the native coin. It is argued that a CBDC- based smart-contract platform mounted on a public blockchain would be better. Its native coin would be more stable. It would be universally utilised. It would be a hothouse for financial innovation.

We have our doubts. There have been a number of prominent disasters with smart contracts running on ethereum’s blockchain due to programming errors. Smart contracts have allowed hackers to siphon off funds from naive investors. Programming problems were subtle and remained hidden despite security audits and code reviews. One wonders whether digital auditors working for central banks can do better. And one fears reputational damage to the RBI if it provided a platform for such endeavours.

Finally there are the risks associated with rapid CBDC development specifically implicating end-users especially if the CBDC effectively replaces cash. Vulnerable populations – even in economies rife with digital payments – rely on physical cash as bearer instruments. India’s 2016 experience with the initial rollout of demonetisation demonstrates the pitfalls of rapid changes to cash-based segments of the economy.

Just Hunt With the Hounds

Mandating acceptance among merchants in ways that limit cash transactions could disenfranchise vulnerable end-users from key goods and services. If the CBDC is implemented through an account-access framework its capacity to genuinely expand financial inclusion – a stated goal of several projects including India’s – could backfire without a parallel effort to target other causes of financial exclusion including infrastructure issues.

All these are arguments for proceeding with all deliberate speed and not faster. Cautious not rapid development is the prudent path forward.

Eichengreen is professor of economics and political science University of California Berkeley US Gupta is Director General National Council of Applied Economic Research and member Economic Advisory Council to the Prime Minister (EAC-PM) and Marple is political science researcher University of California.

Published in: The Economic Times, 05 May 2022