Four Ways In Which China Is Ahead In Its CBDC Experiment
In the global race between countries to design and pilot Central Bank Digital Currencies (CBDCs), China stands ahead of most.
China’s CBDC, coined the Digital Currency/Electronic Payment (DC/EP), was designed as a digital alternative to fiat money and is pegged to the Chinese yuan (CNY) at a 1:1 ratio. The People’s Bank of China (PBoC) introduced the DC/EP in April 2020 in four major Chinese cities, with plans to expand to more cities within a few months and the ultimate goal to initiate a full-fledged launch in time for the Beijing Winter Olympics in 2022.
While China is not the first to pilot a CBDC, theirs certainly stands out as one of the most innovative. This blog post will explore the four ways in which China is ahead of its counterparts in its CBDC project.
1. Six-year research and development phase
China began researching and developing its Digital Currency/Electronic Payments (DC/EP) in 2014 when the PBoC set up a special team to research the digital currency issuance framework and core technologies. This came after a speech by PBoC’s then-governor Zhou Xiaochuan mentioned the need to study the possibility of the central bank issuing a digital currency. Six years later, the DC/EP was piloted for public usage.
This was far ahead of most countries. Only late 2019 and early 2020 saw a renewed global interest in CBDCs with the proposed launch of Facebook’s private stable coin Libra thrusting many countries into looking into engaging in CBDC-related research.
This is still more noteworthy, as a 2020 study showed that around 70% of central banks are still unlikely to issue any type of CBDC in the near future.
The two-tier DC/EP prevents the disintermediation of the financial system.
2. Breaking through traditional dilemmas with CBDCs
As discussed in our previous blog post on Understanding CBDCs, central banks are faced with many dilemmas and challenges in designing the CBDC. There is the primary dilemma of designing either a retail CBDC or a wholesale CBDC. Consequently, there are dilemmas concerning the privacy and anonymity of users and transactions and disintermediation risks. China has tackled each of these dilemmas in unique ways.
To solve the retail-wholesale design dilemma, China opted for a hybrid issuance system. While retail CBDCs are used as a digital replacement of cash by individuals and entities, and wholesale CBDCs are used by commercial banks and other permitted institutions to settle transactions in the interbank market, the DC/EP is operated on a two-tier system that is a hybrid of the wholesale and retail payment systems. Here, the PBoC will retain direct claims on DC/EP units itself, while enabling intermediaries to handle payments. The PBoC issues digital currency to intermediary commercial banks, and the banks circulate currency among the end-users, i.e., their customers. The PBoC has earmarked four large state-owned commercial banks to issue DC/EP to end-users.
Two-tier hybrid issuance closely mimics the manner in which fiat currency is issued, and has several benefits. CBDCs are expensive to issue given the massive scale and infrastructure required, but a two-tier issuance allows the PBoC to fully design but only engage in a few core processes, leaving intermediary banks to handle payment services. China’s banks can leverage their existing infrastructure, and China’s fintech players can leverage their vast user base and technological advancements, to widely circulate the DC/EP. Further, the two-tier issuance of DC/EP also partially resolves the issue of disintermediation of existing financial structures, as explained below.
a) DC/EP prevents disintermediating banks
The introduction of some CBDCs has the potential to render business models of commercial banks and other financial institutions, particularly fintech companies, obsolete. Wholesale CBDCs could initiate deposits to be transferred from commercial banks to central banks, as central banks are automatically conferred with more trust as the primary issuers of the CBDC. This has implications for bank funding and liquidity, with a possible sector-wide reduction in the banks’ assets and liabilities. Interest-bearing deposits would move to central banks due to the inequitable competition created by central banks indirectly holding a more trustworthy deposit.
The two-tier DC/EP would prevent disintermediation of the financial system. Two-tier hybrid issuance employs many tech companies that either provide functional services to end users in the two-tier CBDC system, or provide technology support to the PBoC.
By molding the DC/EP to the existing currency issuance system, the PBoC has ensured that all existing players have significant roles to play in the proliferation of the DC/EP.
Disintermediation has also been addressed by aspects of the technical architecture of the DC/EP. Sign up here for updates regarding the release of our Report Series on China’s Digital Currency that discusses the technical functionality of DC/EP.
b) DC/EP’s approach to privacy
China has molded its hybrid DC/EP architecture to tackle the privacy and anonymity aspects, with a tiered approach to data flows. Additionally, the PBoC has publicly made available its privacy-enhancing method known as “controllable anonymity”. However, there are nuances to what controllable anonymity entails, with continued concerns regarding privacy. This has been examined in detail in the second report in our Report Series on China’s Digital Currency, titled Technical Architecture and Functionality of the DC/EP.
3. Massive production scale
The DC/EP operates on a very large scale, with transactions serving the world’s most populous country and second-largest economy. The PBoC has noted that it needs to have the ability to transact at 300,000 transactions per second (TPS) to accommodate large-scale retail transactions. The underlying Distributed Ledger Technology (DLT) is not mature enough to handle transactions at this scale, requiring China to build a complete underlying infrastructure to support DC/EP transactions.
Thus far, six regions are undergoing pilots for retail CBDCs — Sweden, Cambodia, Korea, the Bahamas, Eastern Caribbean, and China, and three have completed pilots of retail CBDCs — Ecuador, Ukraine, and Uruguay. Around 18 other central banks have published research on retail CBDCs, with possible plans to initiate a pilot launch. In totality, however, only six central banks are running their prototypes on DLT and there is uncertainty regarding the use of DLT in full-fledged large-scale designs.
The PBoC could integrate the DC/EP as a payments layer to new and existing infrastructures, and this could rapidly expand the scope of usage of the DC/EP.
4. Ability to integrate with new and existing technologies
The DC/EP could be layered on to other technologies. The PBoC could integrate the DC/EP as a payments layer to new and existing infrastructures, and this could rapidly expand the scope of usage of the DC/EP. This could vastly upgrade the already formidable existing infrastructure. This has been examined in detail in our introductory report Unraveling China’s Digital Currency: An Overview, which will be made available to download on 14 October 2020, via our sign-up link here.
The possibility of integration caused it to have a high degree of impact on the economy and financial system — more so than other CBDCs. This aspect has been examined in our Report Series, as well as in future blog posts.
In conclusion, there is no doubt about the innovativeness afforded by China in its DC/EP. The full impact of the DC/EP hinges on its proliferation domestically and globally, but China has laid out a roadmap to ensure smooth sailing. China’s strategic environment around the design and launch of the DC/EP will be examined in our upcoming blog this week
