From UPSC perspective, the following things are important :
Prelims level : Bitcoin
Mains level : Paper 3- How CBDC is different from Cryptocurrencies?
Cryptocurrency will be discouraged via taxation and capital gains provisions. This was the message from the Finance Minister during the Budget discussion in Parliament.
Growing worry about the cryptocurrencies
- 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).
- 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 to float cryptos which can function as assets and money.
- The total valuation of cryptos recently was upward of $2 trillion — more than the value of gold held globally.
- Challenges in banning it: 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.
Crypto as currency
- 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.
- Paper currency derives its value from state backing.
- Cryptos are a string of numbers in a computer programme. And, there is no state backing.
- Their acceptability to the well-off enables them to act as money.
- So, cryptos acquire value and can be transacted via the net.
- This enables them to function as money.
- Solving 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’.
Why CBDC is not a solution
- A Central Bank Digital Currency (CBDC) will not solve the RBI’s problem since it can only be a fiat currency and not a crypto.
- Blockchain enables decentralisation.But, central banks would not want that.
- Further, central bank 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.
- Validating transaction: 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.
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.