Should RBI issue a new digital Bharatcoin?

The various prerequisites for an eventual move towards a cashless economy are gradually falling
into place. India already has a new digital platform for mobile payments that is perhaps one of
the best in the world. A new report by the Boston Consulting Group estimates that digital
payments in India would touch $500 billion by 2020. Rajan Anandan, Googles vice-president
for South-east Asia and India, told this newspaper on Tuesday that the Indian digital payments
industry is at an inflection point.
Few would remember that the Reserve Bank of India (RBI) had begun taking a serious look at
the future way back in 2003, when a working group on the use of electronic money submitted its
report. The central bank later seemed to have grown wary of new digital currencies such as
bitcoin; it even issued formal warnings about the risks of using them. It has now decided to join
the revolution through a joint committee with the finance ministry on cashless payments.
Most of the current thinking is about using digital technology to make payments that still use the
old monetary system. All the optionssmart cards, mobile payments, electronic walletsare
merely an attempt to make rupee transactions digitally. But this is also a good time to ask a more
radical question: Should RBI take the next step and issue its own digital currency using
blockchain technology or some other form of consensus network?
China seems to be already considering such a possibility. Its central bank governor said in
February that China will move towards issuing a digital currency, though he was vague about the
details about when the shift will take place, if at all. He did say that blockchain technology may
not be able to handle the entire transaction needs of a large economy because the technology
requires massive computational and data storage capabilities.
The move to a digital currency issued by a central bank rather than a private sector entity can
have profound effects on the financial system. In a recent note that deserves to be read in full
because of its radical conclusions, Bank of England economist Marilyne Tolle has explained
some of the consequences. She has focused on a few important issues.
First, banks could lose their dominant position in the payments business if individuals have
direct access to the central bank clearing house for a digital currency. Second, people directly

holding base money with the central bank will undermine bank business models that are based
on credit creation through the fractional reserve system. Third, the existing monetary policy
consensus could be overturned as central banks shift back to directly targeting money supply
rather than interest rates.
These are still early days. Digital currencies still have a lot of issue, and the wild swings in
bitcoin prices are not exactly a good advertisement as far as those who are bothered about
monetary stability are concerner. These are teething problems in what could be a dramatic shift
in the way the world transacts, if the technology needed for digital currencies keeps pace with
demand from the new payments ecosystem. These are interesting times for monetary thinkers.
RBI will have a new governor in a little more than a month. He will have a lot of immediate
problems to deal with, from the recent rise in inflation to the capital outflows that are expected in
September to establishing a working relationship with the government. These will obviously be
his main tasks. However, he would also do well to position the Indian central bank at the cutting
edge of thinking on digital currencies. Maybe he should ask his staff economists to begin work
on figuring out whether RBI will be in a position to issue its proprietary digital currency within a
decade. And whether the legacy banking system is in a position to adapt to the times.
A bit of futurism would not be a bad idea at all. A few US economists have talked about a
Fedcoinor a Fed version of the bitcoin. Maybe it is time for a similar discussion on a
Bharatcoin.
Will a digital currency affect banks position in the payments business?
Marilyne Tolle.
Central banks (CBs) have long issued paper currency. The development of Bitcoin and other private
digital currencies has provided them with the technological means to issue their own digital
currency. But should they?
Addressing this question is part of the Banks Research Agenda. In this post I sketch out how a CB
digital currency call it CBcoin might affect the monetary and banking systems setting aside
other important and complex systemic implications that range from prudential regulation and
financial stability to technology, operational and financial conduct.

I argue that taken to its most extreme conclusion, CBcoin issuance could have far-reaching
consequences for commercial and central banking divorcing payments from private bank deposits
and even putting an end to banks ability to create money. By redefining the architecture of payment
systems, CBcoin could thus challenge fractional reserve banking and reshape the conduct of
monetary policy.
The next big question for central banks?
Digital currency is no longer the preserve of cypherpunks and crypto-anarchists. Economists and
central bankers alike have been pondering whether CBs should issue their own digital
currency. Koning (2014) and Andolfatto (2015) have discussed the idea of Fedcoin, Ben Broadbent
recently spoke on the possible technological underpinnings and consequences of a CB digital
currency, and the Peoples Bank of China has announced it is looking into the idea.
Show me the money
Cash is simply coins and notes embodiments of money. Because banknotes and coins circulate in
the economy, they are also referred to as currency. Yet currency is only a very small part of money
(see McLeay et al (2014)). Money mostly consists of electronic deposits: broad money consists of
(currency and) households and firms deposits with commercial banks, while base or CB money
consists of (currency and) commercial banks deposits with the CB (CB reserves).
On the face of it, customer bank deposits and CB reserves are very similar. They are both current
account balances. But there is a crucial difference. CB reserves are risk-free. Bank deposits are not,
because banks engage in lending that incurs at least some risk. As Mervyn King (2010) remarked, the
pretence that risk-free deposits can be supported by risky assets is alchemy. Commercial banks
fallibility is the reason behind the existence of public deposit insurance and lending-of-last-resort by
the CB an attempt to enforce one-for-one convertibility between bank deposits and CB money.
What might happen if the CB were to issue digital currency?
Now assume a CB issued CBcoin, a digital currency with one-for-one convertibility with paper
currency and CB reserves. The issuance of CBcoin would simply create a third CB liability, risk-free
and irredeemable.
The first step would be to decide whether, and at what interest rate, CBcoin might be remunerated.
CB reserves are the means by which most CBs today implement monetary policy, by setting the
interest rate paid on the reserves (or via the rate on repo transactions).

If CBcoin were remunerated at the same rate as CB reserves, it would be interchangeable with
reserves. And if the CB chose to replace cash with CBcoin, it could then charge a negative interest
rate on deposits to bypass the dreaded zero lower bound, as considered by Kimball
(2013) and Haldane (2015). In this scenario, the overall quantity of CB money would stay the same,
only the composition of the CB liabilities would change.
But even if the CB didnt use the price or quantity of CBcoin as an additional monetary policy
instrument, CBcoin issuance could have much wider ramifications, as a by-product of its impact on
the payment system.
An overhaul of transactions settlement?
CB reserves currently play a central role in payment systems. If two parties need to settle a
transaction but hold deposits at different banks, the payment requires a transfer of funds between
the two banks. Banks net out such transfers and settle the residual amount using CB reserves as the
medium of exchange. This makes CB money the ultimate settlement asset (see Rule (2015)). While
some intermediated electronic payments such as the UKs Faster Payments Service are fast,
traditional systems can be slow, taking up to three business days to settle a transaction (see Kroeger
and Sarkar (2016) and Yermack (2015)).
If households and firms were given access to CBcoin accounts at the CB, banks dominant role as
providers of payment services would be called into question. As a risk-free, interest-bearing asset,
CBcoin would be preferable to bank deposits (and even paper currency, presuming anonymity
concerns were addressed), encouraging households and firms to convert their bank deposits into
CBcoin deposits. The appeal of CBcoin vis--vis deposits would likely depend on the relative interest
rate payable.
In effect, retail payments (and securities transactions) would no longer have to be mediated by
banks, as the funds would be transferred directly from one partys CBcoin account to anothers. A
disintermediated payment system could gradually replace the current centralised system and its
associated credit and liquidity risks (see BIS (2003)). The main benefit to CBcoin account holders
would be access to cheap and fast peer-to-peer transactions.
An end to traditional banking?
Commercial banks currently have the power to create money. When a bank makes a loan, it
simultaneously creates a deposit, adding to broad money. So, by extending credit, banks not only

create their own funding (deposits), they also control the level of broad money in the economy
(see McLeay et al (2014)). Banks hold a fraction of the loans they extend as CB reserves, so as to back
a fraction of their deposit liabilities with CB reserves a setup known as fractional reserve banking.
This fractional backing of deposits means that if all households suddenly wished to convert their
deposits into hard currency, banks would not have enough reserves to repay them, so would either
need to sell off their loan books in exchange for currency or utilise the CBs lender-of-last-resort
facilities.
If households and firms converted their bank deposits into CBcoin, commercial banks depositfunded model would come under pressure. Broadly speaking, there are two possible delimiting
scenarios. In the first, banks would compete with CBcoin by offering higher interest rates on their
customer deposits. How much higher would of course be an empirical matter. By raising banks
funding costs other things equal this could dent bank profitability and lead to tighter credit
conditions. But banks would continue to issue loans and create broad money. In a recent paper,
Barrdear and Kumhof use a DSGE model that accommodates fractional reserve banking to study the
macroeconomic consequences of CB digital currency issuance.
Another scenario would see a large-scale shift of customer deposits into CBcoin, forcing banks to sell
off their loan books. Bank deposits could still exist but as saving instruments, no longer used to make
payments. Banks could still originate loans, provided they lent money actually invested by
customers, say, in non-insured investment accounts that couldnt be used as a medium of exchange.
Banks would operate like mutual funds, losing their power to create money and becoming pure
intermediaries of loanable funds, as described in economic textbooks.
Under this scenario, the contraction of broad money (bank deposits), and the attendant emergence
of private-sector base money made of CBcoin would mark the demise of fractional reserve banking
(see Sams (2015)). The conversion of bank deposits into CBcoin deposits at the CB would amount to
100% reserve backing for deposits. This could usher in a system similar to the Chicago Plan, a set of
monetary reforms proposed by Irving Fisher during the Great Depression and recently revisited
by Benes and Kumhof (2012). The Plans call for the separation of the credit and money-creating
functions of private banks would be addressed with 100% reserve backing, banks could no longer
create their own funding deposits by lending. Similar narrow banking proposals have emerged
since the financial crisis, such as that of Kay (2009), KotlikoffsLimited-Purpose Banking (2012) or
the Vollgeld initiative (2015), recentlyrejected by the Swiss government.
A new framework for monetary policy?

The conflation of broad and base money, and the separation of credit and money, would allow the CB
to control the money supply directly and independently of credit creation, calling for a reassessment
of monetary policy along two dimensions. First, the prospect of direct control of the money supply
might alter the relative merits of using interest rates or the money supply as the main policy
instrument. If so, this newfound CB power could reopen the debate between advocates of rules
versus discretion in the conduct of monetary policy. For instance, the signers of the Chicago Plan, in
particular Milton Friedman, envisioned a constant money growth rule rather than the discretion over
interest rates that has prevailed since CB independence in the 1990s.