The emergence of virtual digital assets and blockchain technology is reshaping financial services and disrupting many areas such as digital payments, investment management and asset management. These new developments as well as some of the other notable changes such as the transition from LIBOR to alternative benchmark rates, the proposal to completely overhaul the capital calculation for banks from Basel 2.5 to FRTB and the integration of climate risk are all happening simultaneously and led to very interesting results. times in the financial services industry.
Virtual digital assets have gained popularity in recent times and are considered by many people around the world as an investment and payment alternative. A cryptocurrency is a form of virtual digital asset that operates on the basis of a network spread over many nodes. This decentralized structure allows them to exist outside the control of a central authority. These digital assets are secured using cryptography and stored in a decentralized system of record (public ledger) using blockchain technology which enables faster and highly secure transfer of value. Cryptocurrencies also have their own drawbacks in the form of high volatility, high mining costs, and potentially high variable spread charged by exchanges which increase the cost of the transaction.
The total traded volume of cryptocurrencies in 2021 across the globe was approximately $14 trillion. In India, cryptocurrencies saw record trading volumes of over $43 billion. Cryptocurrency trading has seen a lot of new participation in India from Tier 2 cities and Millennial and Gen Z groups.
CBDC and India
Given the high volatility experienced by private digital virtual currencies that have no intrinsic value and no specific issuer, central banks around the world are exploring a general-purpose central bank digital currency (CBDC) that could be used for cross-border payments and transactions. CBDC could be used in conjunction with cash and can help reduce dependence on cash in a growing economy like India. Taking into account these new trends, the Indian Minister of Finance introduced the concept of “digital rupee” during the 2022 budget speech. The idea is to introduce a more efficient, cheaper and more secure currency management system. using blockchain and other digital technologies.
According to the Reserve Bank of India (RBI), a CBDC is legal tender issued by a central bank in digital form. It is the same as a fiat currency and is exchangeable on a one-to-one basis with fiat currency. Only its shape is different. According to the 2022 budget speech, the RBI is expected to issue a “digital rupee” from 2022-23.
The value of CBDC is tied to the national fiat currency, for example, Re 1 cash, i.e. India would be equivalent to Re 1 in CBDC, so CBDC is basically a fiat currency but under digital form that belongs to a central bank and can be exchanged at par with money.
Fiat currencies, virtual digital currencies, and CBDCs have different characteristics in terms of security, speed, stability, associated costs, reliability, currency management system, transparency, and technology. Settlement risk, audit trail and intrinsic value are other key factors to consider for each of these assets.
The Minister of Finance, during the 2022 budget speech, introduced a 30% flat tax on virtual digital asset transfer income with a 1% TDS on transfers and a gift tax on donations.
The implication is that the Minister of Finance is very clear in categorizing private cryptocurrencies as “assets” and not “currencies”. Also, as mentioned in the table above, there is no intrinsic value for private cryptocurrencies, and they are highly volatile. During the Union Budget, the Indian government argued for the introduction of CBDCs which could be exchanged for cash and will potentially help boost the fintech sector.
With the growing number of digital payment providers, the introduction of CBDC needs to be really thoughtful as it could potentially reduce fiat transactions, thereby reducing bank deposits and negatively impacting the Indian financial system. Digital assets will have a major impact on the banking industry, as blockchain technology has the potential to disrupt entire services, including payments, settlements, loans and credits, and trade finance activities.
Global investment banks, which were initially hesitant to trade cryptocurrencies, are now competing to offer cryptocurrency investments to their wealthy clients and have also launched dedicated cryptocurrency trading desks. Indian banks have been slow to adapt to the global trend in offering cryptocurrency services.
Few emerging economies have shown strong interest in adopting cryptocurrencies as legal tender given the hyperinflation in countries that would continue to weaken their currencies. In June 2021, El Salvador became the first country to adopt the Bitcoin cryptocurrency as legal tender. However, there has been a mixed reaction to this development with a high percentage of citizens who are unwilling to accept Bitcoin as legal tender.
The intrinsic value of anything is determined by the trust of the people who use it. Although private cryptocurrencies and CBDCs are digital, the fundamental difference between these two is that CBDCs are still controlled by central banks and their intrinsic value is determined by the Bank. However, the value of private cryptocurrencies is determined by demand and supply in the market.
Cryptocurrency is considered valuable due to its scarcity and lack of a central authority that can alter market supply, potentially devaluing the currency. If the majority of players in the economy adopt private cryptocurrencies, the monetary and fiscal tools will not be available to central banks to regulate and stabilize the economy that would be essential in times of crisis.
Going forward, we see a mixed economy with both private cryptocurrencies and CBDCs co-existing, where private cryptocurrencies can act as an inflation hedge and CBDCs continue to be used as legal tender. . However, if private cryptocurrencies continue their dominance and gain significant market share, the change could be as big as the shift from gold standard to fiat currency. Any downsides to the gold standard may eventually resurface in the financial market, but it may be too late to re-embrace fiat currency.
— The authors, Subrahmanyam Oruganti – Financial Services Partner, EY and Ashish Bhalerao, Director, EY. Opinions expressed are personal