Answer Writing Practice for UPSC IAS Mains Exam: Paper - IV (General Studies – III) - 24 October 2018


Answer Writing Practice for UPSC IAS Mains Exam


UPSC Syllabus:

  • Paper-IV: General Studies -III (Technology, Economic Development, Bio-diversity, Environment, Security and Disaster Management)

Q. What is a digital currency? Discuss the potential benefits, risks and implementation challenges associated with the crypto currency.

Model Answer:

Approach:

  • Why in news?
  • Digital currency
  • Benefits
  • Risks
  • Implementation Challenges
  • Conclusion

Why in news?

The Reserve Bank of India (RBI), like many of its global peers, has decided to look into the possibility of issuing a central bank digital currency (CBDC). Such initiatives are in response to the recent popularity of cryptocurrencies and the mind space this phenomenon has acquired.

Digital currency

Digital currency is a type of currency available only in digital form, not in physical (such as banknotes and coins). It allows for instantaneous transactions and borderless transfer-of-ownership. Examples include virtual currencies and crypto currencies. Like traditional money, these currencies may be used to buy physical goods and services, but may also be restricted to certain communities such as for use inside an online game or social network.

Benefits

  • Privacy Protection:The use of pseudonyms conceals the identities, information and details of the parties to the transaction – perquisites for privacy enthusiasts.
  • Bitcoin protocol cannot be manipulated by any person, organization, or government. This is due to Bitcoin being cryptographically secure.
  • Cost-effectiveness:They have single valuation globally, and the transaction fee is extremely low, being as low as 1% of the transaction amount. Crypto currencies eliminate third party clearing houses or gateways, cutting down the costs and time delay. All the transactions over cryptocurrency platforms, whether domestic or international, are equal.
  • Lower Entry Barriers: The users of Crypto currencies do not require any disclosure or proof for income, address or identity unlike a bank account or a debit/credit card user.
  • Alternative to Banking Systems and Fiat Currencies:Cryptocurrencies offer the user a reliable and secure means of exchange of money outside the direct control of national or private banking systems.
  • Open Source Methodology and Public Participation:A majority of the cryptocurrencies is based on open source methodology, their software source code is publicly available for review, further development, enhancement and scrutiny. The ecosystem of cryptocurrencies is primarily participation based, as software development, bug reporting and fixing, testing etc. are driven by the wider user base, rather than a closed set of individuals or an institution.
  • Immunity to Government led Financial Retribution:Governments have the authority and means to freeze or seize a bank account, but it is infeasible to do so in the case of cryptocurrencies. For citizens in repressive countries, where governments can easily freeze or seize the bank accounts, cryptocurrencies are immune to any such seizure by the state.
  • It a kind of new gold — a commodity whose value would be determined purely by demand and supply, not by the actions of central banks.
  • It is possible to send and receive any amount of money almost instantly anywhere in the world at any time — no borders, no limits imposed by governments, no holidays.
  • In countries where inflation is high as a consequence of government policies, for example, Bitcoin allows individuals to insulate themselves. Argentinians, for instance, invested in Bitcoin to avoid rampant inflation, as did Cypriots during the country’s 2011 financial crisis.

Risks

  • The RBI points out that user expose themselves to potential financial, legal and security-related risks when they deal in virtual currencies like bitcoins.
  • The apex bank highlights problems such as losses arising out of hacking, no sources of customer recourse and the general financial volatility surrounding Bitcoins.
  • They also have the potential use for Illicit Trade and Criminal Activities and can be used for Terror Financing.
  • Bitcoin, after all, records transactions only between digital addresses, not explicitly identified individuals therefore it is a useful tool for money laundering and tax evasion.
  • Cryptocurrencies are being denounced in many countries because of their use in grey and black markets. There are two sets of interconnected risks; one being to the growth and expansion of these platforms in the uncertain policy environment, and the other being the risks these platforms pose to the users and the security of the state.
  • A number of India-based trading platforms and exchanges are catering to Indian users by allowing them to purchase Bitcoin in rupees. As per RBI, no regulatory approval has been obtained by any entities that carry out such activities.
  • Assets are not backed by tangible entities such as land.
  • Crypto currency works on distributed ledger technology (DLT). In DLT, the transaction processing takes a lot of time, sometimes in hours, and computation power.
  • Several instances of security breaches and loss of cryptocurrencies over the network have surfaced in the recent period.
  • Crypto currency wallets and exchanges, which are a point of centralization in an otherwise decentralized network, have become more susceptible to double-spending attacks. The most famous example of this is the Mt Gox hack.
  • Encourages anarchy.
  • It’s very much still an experimental currency and is a high-risk environment for consumers and investors at the moment.

Implementation Challenges

Security breaches, loss of cryptocurrencies over the network and limited or no tracing and linkability result in the loss of money.

A lack of legislation regulating digital currencies and user protection is a great challenge. Educating people about protecting personal data is of core importance here. However, insurance protection and clear legislation needs to be put in place.

Cryptocurrencies have limited social acceptance since they are neither issued by central banks nor are they a liability for anyone—even private entities, forget governments.

Globally, governments are striving to make monetary transactions trackable to prevent illicit activities whereas digital currencies make online transactions untrackable.

Conclusion

RBI’s recent move to look into the possibility of issuing a central bank digital currency (CBDC) is appreciable because as a first step it has to be decided if the issuance of CBDC is desirable or not. The technology will hopefully, evolve to address the operational inefficiencies in the long term.

Not a part of the question but it’s a good piece of information

Currency is a subset of a broader economic concept of money. Currency is the “token” which facilitates movement of money, shifting its purchasing power from the current holder to its future holder. Currency facilitates the exchange feature of money, that is, payment. Currency, driven by technology, has evolved into several forms; from good old cash/coins, to electronic money and, more recently, cryptocurrency. Currencies are typified by key features, namely physical existence, issuer, ultimate liability, universal accessibility and peer-to-peer exchangeability. Cash ticks most boxes—it exists physically, is issued by central banks, with the ultimate liability being that of the government, it’s universally accessible within the jurisdiction, can be used anonymously at zero cost, and can be used in peer-to-peer exchange. Electronic money represents electronic payments facilitated by banks and payment networks differ from cash in lacking physical existence and peer-to-peer exchange being trackable by authorities, thus not being anonymous.

Cryptocurrency addresses the need to enable peer-to-peer anonymous transactions on the lines of cash. However, cryptocurrency provides this anonymity in online/electronic transactions which credit card/debit card/internet banking-based payments cannot. This explains the “crypto” aspect of the cryptocurrency. However, cryptocurrencies have limited social acceptance since they are neither issued by central banks nor are they a liability for anyone—even private entities, forget governments. Thus comes the demand for digital currency which is expected to have the anonymity feature of cash but can be used in electronic transactions, while being backed by government.

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