Relevance: GS-3: Indian Economy, mobilization of resources, changes in industrial policy and their effects on industrial growth.

Key Phrases: Central Bank Digital Currency, Cryptocurrency, legitimizing, decentralised character, fiat currency, central bank, Bitcoin, global coordination, defensive.

Why in News?

• The central bank must note that a Central Bank Digital Currency can only be a fiat currency and not a crypto.

Context:

• Cryptocurrency will be discouraged via taxation and capital gains provisions. This was the message from the Finance Minister during the Budget discussion in Parliament. Will this slow the growing use of cryptos in India? Russian kleptocrats have been using cryptos to escape sanctions. Ukraine has been a centre for cryptos trading due to its lax rules and is using them to raise funds for its war with Russia.
• The Governor of the Reserve Bank of India, in February, highlighted two things.
  • First, “private cryptocurrencies are a big threat to our financial and macroeconomic stability”.
  • Second, “these cryptocurrencies have no underlying (asset)... not even a tulip”.
• Soon thereafter, a Deputy Governor of the RBI called cryptos worse than a Ponzi scheme and argued against “legitimizing” them. Yet, the RBI announced that it will float a Central Bank Digital Currency (CBDC). How do we understand all this? The Supreme Court of India has also asked the Government whether or not cryptos are legal.
• The Governor calling cryptos as cryptocurrency has unintentionally identified them as a currency. Clearly, statements from the RBI indicate a growing worry since the proliferation of cryptos threatens 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 (such as Satoshi Nakamoto who initiated Bitcoins in 2009) to float cryptos which can function as assets and money.
• Cryptos which operate via the net can be banned only if all nations come together. Even then, tax havens may allow cryptos to function, defying the global agreement. They have been facilitating the flight of capital and illegality in spite of pressures from powerful nations. The genie is out of the bottle. The total valuation of cryptos recently was upward of $2 trillion — more than the value of gold held globally.

Cryptos as Currency

• A CBDC will not solve the RBI’s problem since it can only be a fiat currency and not a crypto. However, cryptos can function as money. This difference needs to be understood.
• 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 a string of numbers in a computer programme and are even more worthless. And, there is no state backing. So, how do they become acceptable as tokens for exchange? 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.
• Bitcoin, the most prominent crypto, has been designed to become expensive. Its total number is limited to 21 million and progressively requires more and more computer power and energy to produce (called mining, like for gold). As the cost of producing bitcoin has risen, its price has also increased. This has led to speculative investment which drives the price higher and attracts more investors. So, since 2009, in spite of wildly fluctuating prices, they have yielded high returns making speculation successful.

Unlike the Tulip Mania

• The RBI Governor’s statement that cryptos have no underlying asset, not even a tulip, refers to the time when tulip prices rose dramatically before they collapsed. But, tulips cannot be used as tokens while cryptos can be used via the Internet. Also, the supply of tulips can expand rapidly as their price goes up while the number of Bitcoins is limited.
• So, cryptos acquire value and can be transacted via the net. This enables them to function as money. True, Bitcoins are difficult to use, but there are other simpler cryptos that are available.
• The different degrees of difficulties underlying cryptos relate to the problem of ‘double spending’. Fiat currency has the property that once spent, it cannot be spent again except through forgery, because it is no more with the spender. But, software on a computer can be used repeatedly.
• Blockchain and encryption have solved the problem by devising protocols such as ‘proof of work’ and ‘proof of stake’. They enable the use of cryptos for transactions. While the first protocol is difficult, the second is simpler but prone to hacking and fraud. Today, thousands of different kinds of cryptos exist; Bitcoin like cryptos, Alt coins and Stable coins.

CBDC, unlike Cryptos

• 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.
• 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.
• No wonder, Kristalina Georgieva, International Monetary Fund Managing Director, said earlier this year: “All told, around 100 countries are exploring CBDCs at one level or another. Some researching, some testing, and a few already distributing CBDC to the public... As you might expect, the IMF is deeply involved in this issue, including through providing technical assistance to many members.”

Way Forward:

• So, 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: The Hindu

Mains Question:

Q. Why the CBDC cannot be a substitute for cryptos ? How CBDC will impact the functioning of central banks and commercial banks? Critically Examine.