Take care on digital currency: A phased introduction, like what was done for UPI, is needed

With UPI and QR-based transactions already successful in increasing the reach of cashless payments, we need to understand what new proposition a CBDC can offer.

The debate around a central bank digital currency (CBDC) is getting louder and RBI is mulling one of its own, as gleaned from a speech by deputy governor T Rabi Sankar last month. To begin with, we need to be clear about the purpose behind a digital currency. With UPI and QR-based transactions already successful in increasing the reach of cashless payments, we need to understand what new proposition a CBDC can offer. Also, without dedicated laws on data privacy and cybersecurity, we may not yet be fully prepared for a digital currency; the preparations might entail a whole new KYC process.

Indeed, a CBDC may not be the best means to achieve RBI’s stated purpose of veering people away from private virtual currencies. Even after the currency becomes a widely-used instrument, there might always be a set of people who invest in private virtual currencies as a store of value. The big advantage though would be the greater ease in cross-border transactions. However, for that, the currency would need to be pegged to the dollar, unless central banks across the globe evolve some kind of common framework for cross-border transactions.

RBI must do a good deal of groundwork before it launches even a pilot. An important question concerns the liquidity risk to banks. The business model of traditional banks chiefly is accepting deposits and then deploying them as loans to earn an interest margin. Apart from the authority to accept deposits, banks enjoy exclusive access to payment settlement systems. Now, if RBI were to start issuing currency directly rather than through commercial banks, bank deposits might no longer be needed. Of course, currencies do not offer interest income, but what happens to current accounts held by businesses mainly for settlement transactions, not earning interest anyway?

To an extent, this process of disintermediation has already started with RBI’s July 28 notification on the access for non-banks to centralised payment systems. The notification authorised non-bank payment service providers, such as prepaid payment instrument issuers, card networks, etc, to participate in centralised payment systems as direct members “in the first phase”.

As such, the pool of institutions with direct access to the centralised payment systems is likely to expand. Thus, it is clear that banks are likely to see their cost of funds going up in a peculiar situation where the regulator will end up competing with the regulated entities. A CBDC could pose a bigger problem for banks’ business models than fintechs. RBI had approached that era of change with a good deal of planning and foresight, setting up the National Payments Corporation of India in 2008, with banks themselves as the primary stakeholders. As a result, when nimble-footed digital players began to enter the Indian payments system over a decade ago, Indian banks were not taken by surprise. CBDCs will need a similar phased approach with banks well- prepared.