Private partners could help RBI run a digital currency

Relevance: Issues in the implementation of a retail CBDC

Synopsis: A two-tiered model for retail issuance of CBDC should be implemented by India. Issues involved and the way forward.

Background

Recently, a deputy governor of the Reserve Bank of India (RBI) announced that RBI is working on a “phased implementation strategy” for the issuance of a central bank digital currency (CBDC), including a possible pilot project in the retail segment.

What is a retail CBDC?

A retail CBDC is a digital version of a fiat currency that’s available to the general public. It will be part of the payments ecosystem, which already consists of banks and payment service providers (PSPs).

Issues involved

One significant issue in the design of a retail CBDC is the role of the private sector. A retail CBDC issuance will include the

• Introduction of public services needed for customer on-boarding
• Systems for due diligence
• Compliance with anti-money laundering laws
• Transaction authorization and maintenance of cyber security

Such activities mark a departure from existing central bank functions that focus on monetary stability and do not require direct interaction with retail users.

Global models

A recent report by the Vidhi Centre for Legal Policy, notes that globally many central banks are exploring a retail CBDC that involves private-sector participation through a two-tiered model.

Let us first understand about the direct model.

Direct model

A direct model will allow the central bank to exercise more control over the CBDC design. It will also require the bank to assume a more active role in payment services for CBDC transactions, raising questions over the institutional capacity of a central bank to undertake such activities.

In economies like India’s that have well-developed digital-payment markets, this may lead to the central bank competing with PSPs, which would raise concerns of disintermediation.

Note: Disintermediation means the removal of intermediaries from a supply chain, or “cutting out the middlemen” in connection with a transaction or a series of transactions.

Two-tiered model

The two-tiered model seeks to address the concerns of disintermediation. Under this model, a central bank develops the core CBDC system and the private sector takes up operational tasks.

Why this model? – Private-sector PSPs are “best placed to use their expertise” to promote innovation and integrate payment services with other financial products and platforms.

Direct model vs two-tiered model

• Differences: In a direct model, the central bank is responsible for all aspects of CBDC issuance and its access to end-users while in a two-tiered model a central bank develops the core CBDC system and the private sector takes up operational tasks.
• Similarities: Under both models, a CBDC remains a direct central bank liability.

Global examples of two-tiered model

• Bahamas: This model has been adopted by the central bank of the Bahamas that launched its CBDC (Sand Dollar) in 2020. Financial intermediaries in the private sector (banks, money-transmission businesses, PSPs, etc) provide wallet services for holding and using the Sand Dollar issued by the central bank.
• China: A CBDC pilot project launched by the People’s Bank of China in 2020 relied on a similar model, whereby it issued its e-CNY (China’s CBDC) through ‘authorized operators’ such as commercial banks and licensed non-bank payment institutions.

What should RBI do?

In India, to take advantage of the potential of the country’s payments sector, RBI should consider a two-tiered model for its retail CBDC.

• Development of oversight & risk management functions: RBI will have to develop oversight and risk management functions vis-à-vis CBDC intermediaries. It will have to establish systems to address operational failures or cybersecurity breaches.
• Appropriate regulatory architecture needs to be established to empower RBI to regulate CBDC intermediaries and oversee the soundness and operational resilience of private entities, while ensuring overall financial stability and the safety of customer funds.

Way forward

A two-tiered model based on public-private partnerships would present us with an opportunity to leverage our private-sector potential to engage customers while promoting CBDC-oriented innovation in the payments sector.

Terms to know

• CBDC