Why CBDC may not be the silver bullet to address crypto assets risks

Globally, central bankers are divided in opinion on whether the emergence of crypto assets led to an acceleration of their CBDC projects: in a May 2022 survey by the Bank for International Settlements, six out of ten respondent central banks agreed.

This may have been because a clear assessment of the adoption of crypto assets for different use cases and their impact on the economy appears to have so far eluded policymakers: the same survey indicated that a majority of central banks largely characterized the use of crypto assets in their jurisdictions – both in relation to domestic payments and cross-border payments, as “use by niche groups” and “trivial or no use”.

Earlier in February 2022, the Financial Stability Board (FSB) had acknowledged significant data gaps that made an assessment of the impact of crypto assets on financial stability difficult to identify and quantify.

The RBI’s stated expectation is that the e₹ will provide the benefits of virtual currencies but at the same time protect financial consumers and avoid the ‘damaging social and economic consequences’ of crypto assets. If it’s too good to be true, it usually is, and this appears to be the case with the RBI’s projection of the e₹ as being a panacea to the many risks associated with crypto assets and stablecoins.

Several motivations drive the adoption of crypto assets, which do not overlap with the e₹ alone. Customers who feel the pinch of a depreciating Rupee (under present foreign exchange rates) are more likely to turn towards asset-backed stablecoins linked to a global currency reserve such as the US dollar.

This brings direct dollarization risks, as identified by the G7 working group on stablecoins. The e₹ is unlikely to offer compelling reasons to prevent this instance of dollarization by conversion of the Indian Rupee into US dollar-denominated stablecoins.

Stablecoins could also offer a faster, cheaper, and easier channel for cross-border remittances that broadly sidesteps the formal financial system (and by extension, foreign exchange laws). An e₹ may not address that directly until India is a member of the many cross-border remittance projects being built around CBDCs and the projects come to fruition.

Retail investors in private crypto assets (not stablecoins) typically do so for the potential upsides that arise out of wild volatility and arbitrage opportunities between different crypto exchanges. The promise of relatively higher returns in relation to de-fi staking (crudely similar to fixed deposits) or de-fi lending (similar to P2P lending) that motivates retail investors in private crypto assets cannot be matched by a non-interest bearing instrument such as the e₹.

For the RBI and the government to address risks that crypto assets bring to the economy, a legal framework to govern various aspects of crypto assets is still the need of the hour. Regulation of crypto assets in India is still too uncoordinated and scant: it is a CERT-In (the Indian Computer Emergency Response Team) circular that requires virtual asset service providers to follow KYC norms framed by the Reserve Bank of India and the Securities and Exchange Board of India (in the interests of cyber security).

In parallel, state enforcement agencies have proceeded against crypto assets exchanges under the Foreign Exchange Management Act, 1999, and the Prevention of Money Laundering Act, 2002, even if there is ambiguity over the nature and extent of application of these laws over crypto assets.

It is unlikely that one legislation may govern all these aspects related to crypto assets and stablecoins – but without a framework that identifies and empowers different regulators and agencies to act, delegated legislations – rules and regulations by specialized agencies needed to implement the provisions of the legislation in practice, cannot move forward. Underpinning all this is the fundamental issue: the primary question of whether to ban or regulate both crypto assets and stablecoins is steadfastly undecided. This comes with more than its fair set of challenges.

The RBI’s duty under the Reserve Bank of India Act of 1934 is to secure monetary stability in India and to operate the currency system to its advantage. This duty may cause it to view stablecoins and crypto assets in a harsher light that may not necessarily align with the Ministry of Finance’s views, which arguably may have broader macroeconomic objectives. In this potential divergence between the roles of the regulator and state, the nature of the outcome remains unclear.

But this could also mean that the RBI and the government reach a more conservative position on stablecoins, arguably a more direct threat to currency, as opposed to cryptocurrencies, which may potentially be regulated, subject to there being sufficient regulatory interventions such as measures for registration/ licensing of exchanges, business continuity requirements, KYC, rules around the listing of tokens, disclosure requirements, circuit-breakers during volatility, governance norms, and so on, to target possible points of market failure.

This approach is not novel, and the FSB, in particular, provided impetus towards solving this conundrum: On October 11, the FSB and other standard-setting organizations reviewed the FSB’s earlier high-level recommendations for regulation, supervision and oversight of ‘global stablecoins’ as these assets provided were more likely to be adopted towards use-cases such as payments and as a store of value.

On the same day, the FSB separately published its submissions to G20 on approaches to regulating, supervising and sufficient oversight over crypto asset activities and markets were published.

While the FSB leaves room for regulators to independently decide the regulatory approach (including pursuing a conservative approach like a prohibition or a ban), it broadly prescribes high-level principles aimed at helping regulators and governments frame regulations built on proportionality and regulatory coordination.

The FSB principles aim to guide governments to frame laws that appropriately

regulators with the right powers and tools and help regulators design comprehensive governance frameworks and direct intermediaries to implement effective risk management frameworks. In some ways, the messaging is clear: should the government decide to embark on a regulatory approach (as opposed to prohibition), the FSB guidelines show that there is a path to regulation that satisfactorily mitigates the harms associated with stablecoins and crypto assets.

However, it remains to be seen whether RBI views this message through the same lens: in any case, the e₹ will be an inadequate answer.

Arjun Goswami, Head – Public Policy; and Ganesh Gopalakrishnan, Senior Associate, Cyril Amarchand Mangaldas