Cryptos and a CBDC are not the same thing

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Context: Despite arguing against legitimising cryptos and calling them as Ponzi schemes, the RBI has announced that it will float a Central Bank Digital Currency (CBDC).

RBI is clearly worried over the increasing popularity of Cryptos among Indian masses.

But, a CBDC will not solve the RBI’s concerns regarding Crypto since it can function as a fiat currency and not a crypto. However, cryptos can function as money. This difference needs to be understood.

What are the RBI’s worries with the proliferation of Cryptocurrencies?

Cryptos threaten the RBI’s place in the economy’s financial system.

This threat emerges from the decentralised character of cryptos based on blockchain technology which central banks cannot regulate and which enables enterprising private entities to float cryptos which can function as assets and money.

What is curreny and what enables Cryptos to act as money?

A currency is a token used in market transactions.

Historically, commodities (such as copper coins) have been used as tokens since they themselves are valuable.

– But paper currency is useless till the government declares it to be a fiat currency. It is only then that everyone accepts it at the value printed on it. So, paper currency derives its value from state backing.

Cryptos are just a string of numbers in a computer programme and have no inherent value. Furthermore, there is no state backing.

Their acceptability to the well-off enables them to act as money. Paintings with little use value have high valuations because the rich agree to it. It is similar for cryptos.

Moreover, a limited supply of the most popular Cryptocurrency i.e. Bitcoin has caused its price to rise over the years, giving massive returns to those who bought in early. This has fuelled the speculation around Cryptos, thereby lending them value too.

RBI has likened the popularity of Cryptos to the Tulip mania.
Why a CBDC cannot act like a Cryptocurrency?

Centralised control of a CBDC: Blockchain enables decentralisation. That is, everyone on the crypto platform has a say. But, central banks would not want that.

Further, they would want a fiat currency to be exclusively issued and controlled by them. But, theoretically, everyone can ‘mine’ and create crypto. So, for the CBDC to be in central control, solving the ‘double spending’ problem and being a crypto (not just a digital version of currency) seems impossible.

The double spending problem is a phenomenon in which a single unit of currency is spent simultaneously more than once. Blockchain and encryption have solved this problem by devising protocols such as ‘proof of work’ and ‘proof of stake’.

A centralised CBDC will require the RBI to validate each transaction — something it does not do presently. Once a currency note is issued, the RBI does not keep track of its use in transactions. Keeping track will be horrendously complex which could make a crypto such as the CBDC unusable unless new secure protocols are designed.

What is the way forward?

Due to the reasons listed above, CBDCs at present cannot be a substitute for cryptos that will soon begin to be used as money. This will impact the functioning of central banks and commercial banks.

Further, a ban on cryptos requires global coordination, which seems unlikely. Ms. Georgieva has said, “The history of money is entering a new chapter”.

The RBI needs to heed this caution and not be defensive.

Source: This post is based on the article “Cryptos and a CBDC are not the same thing” published in The Hindu on 19th Apr 22.

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