The Hidden Risks of CBDCs: India’s Central Bank Urges Caution

India’s central bank is urging caution, but why? Michael Debabrata Patra, Deputy Governor of the Reserve Bank of India (RBI), has voiced concerns over the potential risks that Central Bank Digital Currencies (CBDCs) could bring to the financial system. While the promise of CBDCs is often highlighted, Patra’s warnings remind us that not all that glitters is gold.

The Allure and the Dangers of CBDCs

CBDCs have been hailed as a revolutionary tool to enhance financial inclusion and reduce settlement risks. By offering a digital version of a country’s fiat currency, central banks like the RBI hope to bring banking services to underserved populations and streamline the settlement process between financial institutions. India’s own CBDC, the e-rupee, launched in December 2022, embodies these aspirations.

However, Patra warns that the very allure of CBDCs could lead to unintended consequences. In times of financial crisis, he argues, people might see CBDCs as a “safe haven” and rush to convert their bank deposits into digital currency. This could trigger a wave of mass withdrawals from traditional bank accounts, leading to what is commonly known as a “bank run.” Such a scenario could destabilise the banking system, particularly if large numbers of depositors, especially those with uninsured deposits, decide to shift their funds to what they perceive as a safer option. Patra’s warning comes at a time when digital currencies are gaining traction globally, and his comments are a stark reminder of the need to carefully balance innovation with stability.

Challenges for Deposit Insurers

Patra’s concerns don’t stop at the potential for bank runs. He also points out that the introduction of CBDCs raises significant questions for deposit insurers—the entities responsible for protecting depositors’ money in case a bank fails. “Given the inherent links between such systems and the objectives and operations of deposit insurers, it is expected that the topic of CBDC will continue to grow in relevance for deposit insurers,” Patra noted.

One of the key issues is the uncertainty surrounding the impact of CBDCs on bank deposits. Patra highlighted that the extent to which CBDCs might replace traditional bank deposits is “unknown as of today.” This uncertainty poses a challenge for deposit insurers, who may need to rethink their strategies and prepare for new risks in a world where CBDCs are increasingly used.

Moreover, the evolving roles of central and commercial banks could further complicate matters, experts claim. As more people potentially move their money into CBDCs, the traditional model of banking—where commercial banks hold deposits and lend them out—could be disrupted. This disruption could have far-reaching implications for the financial system and the insurance mechanisms designed to protect it.

Operational Risks in a 24/7 Digital World

Another concern raised by Patra is the operational risks associated with 24/7 digital payment systems. While the ability to make payments at any time of the day is undoubtedly convenient, it also introduces new challenges. For deposit insurers, this could mean having to deal with a continuous stream of transactions and the associated risks, particularly as banks increasingly attract non-domestic depositors.

These risks are not purely hypothetical. As digital payments become more prevalent, the systems underpinning them must be robust enough to handle the increased load. Any weaknesses in these systems could be exploited, leading to significant financial losses and undermining confidence in the financial system as a whole.

Slow Adoption of India’s CBDC

Despite the potential benefits of CBDCs, India’s own digital currency, the e-rupee, has seen a slow rate of adoption since its launch. By late June 2024, the RBI reported that only 1 million retail transactions had been made using the e-rupee. This sluggish uptake occurred despite local banks offering incentives to clients and even paying a portion of their employees’ salaries using the digital currency.

The slow adoption suggests that while CBDCs may have theoretical advantages, getting people to use them in practice is another matter entirely. This could be due to a variety of factors, including concerns about privacy, a lack of understanding of how CBDCs work, or simply a preference for traditional banking methods.

A Future of Caution and Innovation

Patra’s warnings serve as an important reminder that with every innovation comes a set of risks that must be carefully managed. CBDCs offer the promise of greater financial inclusion and efficiency, but they also have the potential to disrupt the very systems they are meant to enhance.