RBI Concept note on CBDCs: Nature, Programmability and Privacy

A welcoming note but no straight answers for crypto-enthusiasts

CBDC is distinctly different from Cryptocurrencies

a. CBDC as Risk-free Crypto

RBI seems to swap the idea of cryptocurrencies with their own sovereign currency. RBI is interested in giving us risk-free “Bitcoins” which are not as volatile as private cryptocurrencies like Bitcoin and Ethereum.

The following text from the RBI report on CBDCs makes their stand somewhat unambiguous:

“The proliferation of crypto assets can pose significant risks related to Money Laundering & Financing of Terrorism. Further, the unabated use of crypto assets can be a threat to the monetary policy objectives as it may lead to creation of a parallel economy and will likely undermine the monetary policy transmission and stability of the domestic currency. It will also adversely affect the enforcement of foreign exchange regulations, especially, the circumvention of capital flow measures.

Further, developing 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. Thus, safeguarding the trust of the common man in the Indian Rupee vis-à-vis proliferation of crypto asset is another important motivation for introducing CBDC.” [Chapter 3 - Motivations for issuance of CBDCs]

b. CBDC as Sovereign Currency

RBI explicitly states that CBDC is a sovereign currency that can be issued by only government entities.

“In a nutshell, the economic design of a CBDC should be least disruptive to the existing financial system. Moreover, CBDCs are electronic forms of sovereign currency and should imbibe all the possible features of currency.” [Chapter 4 Design Consideration for CBDC]

c. Against Mining

RBI states that Central Banks shall be issuing CBDCs based on algorithm-driven processes rather than mining through competitive reward methods. It indicates that competitive reward methods consume energy and is bad for the environment. This is only partly true as there are mechanisms other than Proof-of-Work (which consumes lots of energy like Bitcoin) like the Proof-of-stake mechanism, which are energy efficient (e.g. Ethereum).

d. No Distributed Ledger Technology

In fact, RBI is not even sure if the currency should be decentralized and Distributed Ledger Technology (DLT) should be used, when it states that:

“The infrastructure selected for implementing CBDC could be based on a conventional centrally controlled database, or on a distributed ledger. Conventional and Distributed Ledger Technology (DLT)-based infrastructures often store data multiple times and in separate physical locations. However, the key difference between conventional and DLT-based infrastructure lies in how data is updated. In conventional databases, resilience is ensured by storing data over multiple physical nodes, which are controlled by one authoritative central entity, i.e., the top node of the hierarchy. On the other hand, in DLT-based systems, the ledger is usually managed jointly by multiple entities in a decentralised manner and each update needs to be harmonised amongst the nodes of all entities without the requirement of a top node. This consensus mechanism requires additional overhead which is the primary reason why DLTs enables lower transactions than conventional architectures. Given the above, DLT at this point of time, is not considered suitable technology except in very small jurisdictions, given the probable low volume of data throughput.” [Chapter 5: Technology Considerations for CBDC]

Programmability of CBDCs

An interesting point RBI made is the potential programmability of CBDCs. That can facilitate welfare schemes in a significant way. Government can ensure that the CBDC they are giving to a BPL card-holder can only be used for buying daily needs goods in a government-mandated store, or for paying fees in a government school. It can even tackle problems of corruption. For instance, an IAS officer gets tokens that could be used only in specific places for the procurement of public goods and services. Or banks could give loans in form of tokens to business customers which could be only used for business purposes and not their lavish vacations.

One interesting application of CBDC is the technical possibility of programmability. CBDCs have the possibility of programming the money by tying the end use. For example, agriculture credit by banks can be programmed to ensure that is used only at input store outlets. [Chapter 5: Technology Considerations for CBDC]

Privacy implications

RBI noted that transacting CBDCs can have privacy implications as in their own words, ‘every digital transaction leaves a trail.’ It considers an intermediate level of privacy like that provided European Central Bank in 2019 where anonymity is only provided for users performing smaller transactions only to a certain threshold. Once that threshold is reached, anonymity is removed and authorities get the information about who is transferring their tokens to whom. Different countries have different approaches to the aspect of anonymity but none (which RBI has recorded in the report) is leaning towards complete anonymity on such transactions.

For CBDC to substitute currency as a medium of exchange, it needs to incorporate all the features that physical currency represents – anonymity (that currency transactions can be carried out without maintaining evidence of transacting parties), universality (that currency can be used for any transaction) and finality (that payment of currency unconditionally settles the transaction). Ensuring anonymity for a digital currency particularly represents a challenge, as all digital transactions leave a trail. Clearly, the degree of anonymity would be a key design decision for any CBDC and there has been significant debate on this issue. Most central banks and other observers have, however, noted that the potential for anonymous digital currency to facilitate shadow-economy and illegal transactions, makes it highly unlikely that any CBDC would be designed to fully match the levels of anonymity and privacy currently available with physical cash. An intermediate degree of privacy may be thought of and can also be possible. For example, the European Central Bank (2019) has experimented with the concept of a CBDC with elements of programmable money, by which individuals could be allotted a certain amount of ‘anonymity vouchers’ that could be used for small transactions, with larger transactions still visible to financial intermediaries and the authorities, including those responsible for AML and CFT. [Chapter 4 Design Consideration for CBDC]

While CBDC as a distinct invention is a welcoming change in the Indian financial system. It can assist in financial inclusion, seamless cross-border payment, tackling corruption, and a host of features (not discussed in the post), it is not a great news for crypto-enthusiasts and gives no clear answers about the regulation of private cryptocurrencies and the blockchain ecosystem (which is far more extensive than financial currency) around it.

The introduction of CBDC may be followed by a ban on private cryptocurrencies, howsoever impractical and self-defeating that may be.