Currencies have existed in many forms – metal and leather coins, paper currencies issued by sovereigns, credit issued by banks, and even informal ledger entries kept and agreed upon by a group of businesspeople - over the centuries. Digital currencies, such as Bitcoin, Ethereum, and most recently digital currencies issued by central banks, are relatively recent. I explain how Digital Rupee, issued by the Reserve Bank of India in late 2022, works.
A currency must have three properties to serve as a medium of exchange and perhaps also as a store of value. It must be in limited supply, must be standardized, and a consensus must exist among a large group of users that it will be accepted by others as a currency. A gold coin weighing 10 grams, for example, satisfies all three properties and indeed, gold coins have been used all over the world as currencies over the centuries. A 500 rupee note issued by the Reserve Bank of India is another example. The number of such notes are printed in limited supply by RBI and they cannot be easily copied or forged which maintains the limited supply. The denominations are standardized and there is usually a consensus that it will be accepted by others, at least within the country, as a medium of exchange. Digital Rupee is designed to replicate the properties of physical currency note in a digital form which poses several challenges.
First, let us consider how would a 500 rupee note exist in a digital format and be possessed by any person. The answer is that there is an app that will reside on your smartphone where the 500 rupee note can be stored in a digital format. Just as a physical 500-rupee note cannot be possessed by more than one person at any given time, nor can it be copied and forged easily, technology must replicate this property in a digital 500 rupee note as well. This is not so easy to do. The very ease with which digital documents can be created make them also be copied easily.
A solution then is to track, on a centralized server who owns that 500 rupee note at any moment in time. This requires a digital identity and binding that digital identity, to that 500 rupee note. Let us say a particular 500 rupee note has been bound to Anas’s digital identity, say his Aadhar number. If Anas wants to transfer that note to Bhagwan, his smartphone will need to send a message to the server, that 500-rupee note should now be bound to Bhagwan’s digital identity. The server will first ensure that indeed there is a record that Anas was the legitimate owner of that note – and that he has not already transferred that note to someone else previously (to prevent what is called the double-spend problem in digital currencies). It will then make a record that that particular 500-rupee note is now bound to Bhagwan’s digital identity.
This requires internet connectivity from the smartphone to the server. Moreover, we are also keeping track of the ownership and movement of the particular 500-rupee note in the centralized server. The physical 500-rupee note does not have either of these disadvantages. The ownership stays anonymous and it requires no connectivity.
The digital rupee solves these issues in the following way. First, RBI issues currency notes not to individuals directly but rather to commercial banks. Commercial banks then in turn issue notes to individuals digitally – which is akin to you withdrawing some physical notes from an ATM. When Anas transfers a 500 rupee note from him to Bhagwan, the server at RBI only sees movement of that note from someone at SBI, where Anas has an account, to someone at ICICI, where Bhagwan has an account. Of course, SBI knows that it was Anas who transferred that note and ICICI knows that Bhagwan received a note but they keep this information only for a limited period of time – 48 hours for redressal and to reverse any mistakes or errors in transactions. This information is destroyed after this period of time so that it will not be possible to trace where the 500-rupee note was before that time.
A question that is often asked is how the digital rupee is different from UPI based digital transactions. Anas could also transfer money from his SBI bank account to Bhagwan’s ICICI bank account. There are a few differences. First, when Anas transfers 500 rupees, his SBI account is debited and Bhagwan’s ICICI bank account is credited. This amount could have been 514.32 rupees or any other amount. No notes of specific denominations are transferred. Second, a record of Anas’s transaction is permanently kept with the two banks. Bhagwan gets to know that the money came from Anas who has an account with SBI, and Anas knows that the money was sent to Bhagwan who has an account with ICICI. These transactions and their metadata are recorded and are available for any future audits.
In the case of the digital rupee, the transaction happens at two levels. A specific 500 rupee note, which can be identified uniquely, is transferred from Anas’s digital rupee account to a centralized system. Once this is done, SBI’s system is informed that this note is no longer part of their custodianship and is to be deleted from their system. After RBI’s centralized system gets to know about the transfer, it first checks to find out if the recipient is valid and then moves the note to ICICI bank’s digital rupee server. ICICI bank digital rupee server then assigns the specific digital rupee note to Bhagwan’s digital rupee account upon which it is synced to Bhagwan’s device or online account where it resides. So like a physical note the amount will always be 500 and banks’ systems are not worried about auditing the amount of the transfers but rather keeping count of 500 rupee tokens that they have in their custodianship. The RBI on other hand keeps track that custodianship of all the notes in the circulation are valid.
The backbone to the digital rupee system is a Blockchain layer set up to keep track of changes in custodianship of digital notes (also called tokens) across banks. This Blockchain infrastructure allows RBI and banks to communicate on a separate channel about the movement of notes across banks when a customer transacts. This Blockchain infrastructure is used by RBI to produce and issue the notes to the various banks who then pass them to different bank customers. Any transaction where the bank custodianship changes, it gets recorded on Blockchain. This is done without recording the personal identity of the end user. Thus, a degree of anonymity of digital rupee transaction is maintained making it closer to a physical cash compared to digital money transferred using UPI.
In the digital rupee system, the transaction is tracked in two different layers. First, on the centralized layers where high-speed transactions are recorded – these can be scaled. Second, on Blockchain, which ensures data integrity and minimizes fraud risks. This layering allows the digital rupee to scale to huge retail customer volume while still tapping into the value and security mechanism brought forth by Blockchain.
To address the limited connectivity issue, the app will also allow offline transfers using near-field-communication (NFC) protocol available on smartphones. The transactions will be reconciled on the servers as soon as either the sender’s or the receiver’s phone gets connected to the servers. So, the transactions remain dark only for a short period of time and to prevent widespread and large frauds, the offline transactions will be limited in value.
Creating CBDC in an electronic form opens a possibility of programmability. With adequate and effective redressal systems in place, CBDC has the potential of extending it for cross-border transactions and other use cases where challenges posed by physicality can be limiting.
The author is a Professor of Finance who heads the Digital Identity Research Initiative (DIRI) at ISB.