From UPSC perspective, the following things are important :
Prelims level : Blockchain technology and its applications
Mains level : Paper 3- Central bank digital currency
The article discusses the advantages of central bank digital currency which could combine the advantages of both fiat money and cryptocurrency.
India’s suspicion of the cryptocurrencies
- In 2018, the Reserve Bank of India prohibited regulated entities from providing services to anyone who deals with or settles trades in any virtual currency.
- This was effectively banning Bitcoin trading in the country.
- The Supreme Court lifted this restriction in 2020.
- There were rumours earlier this year that a new law was in the works that would make it a crime to possess, issue, mine, trade or transfer crypto assets in India.
Thinking of digital currencies as asset not currency
- There are concerns over the speculative nature of cryptocurrencies.
- There are also law enforcement concerns around how digital currencies make it hard for the police to track down criminals.
- One of the most important attributes of a currency is that it should be a stable store of value, and Bitcoin is anything but.
- To deal with this difficulty, it will be helpful to think of digital currencies as just another asset—the digital equivalent of a scarce commodity that, like gold, certain collectors prize.
Difference between working of banks and cryptocurrencies
- Our financial system relies on banks to record transactions.
- It is a ‘permissioned’ ledger system in that only trusted intermediaries-registered banks under the supervision of the central bank-can make changes to the ledgers to certify that a given transaction has been completed.
- Cryptocurrencies, on the other hand, are ‘permissionless’ systems that need no intermediary.
- Instead of a centralized ledger, transactions are recorded on a distributed database.
- A purely permissionless system has no need of banks.
Role of banks in maintaining financial health
- Central banks are not just intermediaries managing the great big financial ledger of the country, they are responsible for its financial health.
- To perform this function, they need to be able to take money out of the system when required or put money back into economic circulation.
- None of this is possible in a purely permissionless system.
Advantages of digitally native currencies
- Digitally native currencies are programmable and capable of being incorporated into smart contracts, offering various opportunities for innovative digital solutions.
- Since they can be directly allotted to citizens who don’t have a bank account, they are ideal for financial inclusion.
- Being digitally auditable, transactions can be audited, reducing the scope for illicit activity.
- The challenge is one of integrating the best that digital currencies have to offer into the traditional financial paradigm.
Central bank digital currencies as an alternative
- CBDCs are a completely re-engineered form of money that use a distributed ledger as their underlying technology layer, but are backed by suitable amounts of monetary reserves, just like normal fiat currency.
- Many countries have been toying with the idea of a central bank digital currency (CBDC).
- They are run by central banks along with select financial entities responsible for managing the distributed ledger.
- The best CBDCs will converge the best of both worlds—the programability and security of cryptocurrencies and the reserve-backed stability of fiat currency.
- Several countries are already testing this concept.
How central bank digital currency differs from cryptocurrency? What are its advantages?”
Banning technology has never made it go away. Instead, let’s make an effort to better understand it, and having done so, do all we can to create the digital currency our country needs.