This report is authored by Nikita Kwatra, Principal at Artha Global; Vikram Sinha, Senior Consultant at Artha Global; and Hemant Adarkar, Senior Fellow and Director Artha Centre for Technology and Innovation.

Report name

CBDCs as a tool for financial inclusion

Who wrote this report?

Artha Global is a policy organisation that supports global partners to design, implement, and institutionalise practices that promote prosperity and resilience, with a primary focus on the developing world. We provide actionable research, support policy implementation and work to institutionalise change.

Over the next few decades, the developing world will negotiate overlapping transitions: from rural to urban, farm to factory, informal to formal, brown to green, analog to digital. We help governments manage these transitions, and the inevitable dislocations they cause, in order to secure long-term prosperity and social stability for citizens.

We believe that the multiple challenges of the 21st century require new thinking that cuts across the traditional boundaries of geography, disciplines and interests. Therefore, we leverage our global network of experts to help craft new development agendas, create consensus and build broad coalitions across governments, business, academia, philanthropy and civil society.

Artha's work is housed in six centres: Emerging Cities, Access to Justice, Technology and Innovation, Rapid Insights, Public Health, and Inclusive Growth.** **

Best quote(s)

Regardless of the policy priority or the motivation for issuing a general purpose CBDC, all central banks have an overarching objective: to provide trusted money to the general public and ensure monetary and financial stability in their jurisdictions.

**Key takeaways: **

  1. Financial exclusion is a feature of the markets in emerging economies, not a bug: Emerging economies lack high quality, easily accessible electronic commercial bank money, and its corollary, a secure, efficient digital payment system. This points to a mismatch between physical infrastructure and population density. Hence, when it is unviable for financial institutions to offer services in poor or thinly populated areas, they won’t do so.

  2. Fragmentation of data in India’s UPI ecosystem has remained a barrier to cash-flow enabled lending: Cash-flow based lending holds promise for improving financial inclusion by accurately assessing individuals' repayment abilities. Despite its promise to create cash-flow records for its users, UPI has struggled to facilitate the necessary data flow for cash-based lending due to limitations posed by its fragmented data architecture.

    Users tend to switch between different payment applications which creates incomplete data for companies, complicating risk assessment for financial products like cash flow-based lending. Transaction details are also scattered across various entities, such as the payment application, the acquiring bank, and the issuing bank, making it challenging to gain a comprehensive understanding of users' financial behaviour. If the CBDC data architecture is able to overcome this challenge of data fragmentation, it may be able to create a financial identity and payment history for people who have been historically excluded from private institutions, thus enabling their access to cash-flow based lending.

  3. Trade-off between anonymity and privacy: CBDCs can offer anonymity to users, ensuring their privacy, which may in turn expand their acceptability, adoption and usage. However, this opacity creates a potential risk of money laundering and unlawful activities in the digital ecosystem. Central banks are left with an important task to decide where on the spectrum of complete traceability to complete anonymity, should the CBDC system sit.

The design elements that need to be built in the CBDC architecture to enable financial inclusion:

  1. Addressing access barriers: Given that a large population in India still does not have access to or does not actively use traditional bank accounts, bank accounts should not be the only gateway to issuing a CBDC wallet. This can be done through: a. Instituting a two-tier CBDC model, where the central bank issues the digital currency but it is distributed through intermediaries better equipped to handle KYC and other transactional functions. b. Bridging the last mile financial inclusion by leveraging innovations in digital payment infrastructure, and the banking correspondent model which would help overcome the lack of mobile phones as a barrier and help overcome consumer distrust in electronic money by acting as a trusted human point of interaction. c. Use of mobile money accounts which would allow users without a formal bank account to send, store and receive money through telecom operators which act as cash-in, cash-out gateways. d. Leveraging mobile money architecture which will allow individuals without a formal bank account to store, send and receive money. e. Simplify the enrollment process through the use of eKYC and exempting certain marginalised groups up to a certain transaction or value limit (tiered KYC).

  2. Addressing usage barriers by: a. Enhancing the ability to transact at any time, at very low cost - this will be a critical feature in the CBDC ecosystem to enable greater user participation. b. Creating an architecture designed to handle low value, high volume transactions to mirror the cash payment ecosystem of the low income groups that often have low funds and transact in smaller quantities. c. Developing offline and feature phone capabilities: The offline capabilities of a CBDC could reduce dependence on the quality and availability of mobile and broadband networks, thus overcoming the problem of the digital divide.

  3. Improving access to formal credit by: a. Creating data-backed financial footprint of users: A central bank digital account can help create a financial identity and payment history for people who have been historically excluded from private institutions and enable their access to cash-flow based lending. b. Allowing data portability: CBDC design could enable approaches for giving users control over data generated by payment transactions, which might otherwise remain for exclusive use by a few players in concentrated markets. c. Building an account aggregator model which maintains data for CBDC users based on their consent. This could allow for the users’ personal financial data to be managed in a “privacy-preserving” way.

Why should you read this report?

The global payment landscape has undergone a profound transformation from physical to digital, with the emergence of private digital currencies like Bitcoin challenging pre-existing notions of physical currency and the global payments system. The evidence of feasibility and technical ideas provided by digital currencies have led to the development of Central Bank Digital Currencies (CBDCs) across countries. At its core, a CBDC is cash held in a digital format. Currently, CBDCs are at an advanced stage of exploration in 64 countries; the motivation to adopt CBDC is varied across countries, and is shaped by a range of factors such as preserving monetary sovereignty, enhancing payment efficiency, and fostering a more inclusive financial ecosystem.

Financial inclusion has emerged as an important motivation for deploying CBDCs in emerging economies, like India. This paper unpacks the potential of this use case by examining the existing challenges to financial inclusion, assessing the initiatives taken to address them, and explores how a CBDC could bridge remaining gaps. Further, it discusses the design features that could be built into the CBDC design architecture to make it an effective tool to address financial inclusion challenges in India. These considerations are made within the regulatory framework of Anti-Money Laundering (AML) and Combating the Financing of terrorism (CFT) by detailing the trade-offs between inclusion imperatives with security and privacy concerns.

Who is this report for?

This paper is an important read for government officials, policymakers, regulatory bodies and researchers who are broadly concerned with the challenges of financial inclusion. By unpacking the potential for CBDC as a use case for financial inclusion, this paper would also be of interest to those in the fin-tech space, along with those concerned with the growth and welfare effects of CBDC. In addition to the insights captured in the theoretical underpinnings of this paper, it moves to praxis by identifying the design considerations that are needed to be built into the CBDC for it to comply with the AML/CFT regulations. While the focus of this paper is within the domestic payments landscape of India, its findings can be extrapolated to be useful for governments and organisations across the globe that are looking to think through the feasibility of introducing CBDC and assess its associated trade-offs within the ambit of data governance and data privacy.

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