Smith Brain Trust / October 14, 2020

The Central Bank Digital Currency Pivot

Assessing China’s Trial Run and the Broad Outlook

The Central Bank Digital Currency Pivot

SMITH BRAIN TRUST – By the end of 2022, the collective G20, IMF, the World Bank and the Bank of International Settlements will have a structure in place to use central bank digital currencies (CBDC) in banking systems.

According to the Financial Stability Board, an international body that monitors and makes recommendations about the global financial system, this structure will involve completed regulatory stablecoin frameworks, as well as the research and selection of CBDC designs, technologies and experiments.

CBDC also is referred to as DCEP (Digital Currency Electronic Payment), as it involves commercial banks converting some deposits into digital currency for distribution to consumers -- mirroring the distribution of physical cash. And China has been out in front.

William LongbrakeExecutive-in-Residence in finance at the University of Maryland's Robert H. Smith School of Business, recently examined China’s nascent CBDC plunge.

In the following, he writes about its milestones, viability and answers questions about its broader economic implications:

Simply put, a central bank digital currency (CBDC) is an alternative to cash and eventually a replacement for cash. That means the digital renminbi has the same legal status and functions as coins and paper currency, but resides exclusively in an electronic payments network. China’s central bank, the People’s Bank of China, launched its digital currency project in 2014. It received formal approval from the State Council in 2017 to research the creation of a digital currency in cooperation with commercial banks. In 2017, the PBOC established the Institute of Digital Money to engage in research on digital currencies. By May 2020, PBOC governor Yi Gang confirmed that top-level design, formulation of standards, research and development of functions and debugging tests had been completed and that live trials were proceeding in Shenzhen, Suzhou, Xiong’an and Chengdu.

In researching the design of a digital currency, the PBOC articulated several goals:

  • Replace physical cash to eliminate production costs and counterfeiting risks
  • Control illegal financial transactions such as money laundering
  • Enforce financial regulations and capital controls
  • Crowd out private sector digital currencies such as bitcoin which facilitate capital flight and undesirable financial speculation
  • Do no harm to the established commercial banking and deposit gathering system

As the PBOC’s research progressed it made two critical design decisions consistent with its goals:

1) Accounts at the PBOC vs. Accounts at Banks. The PBOC decided to issue digital renminbi only through the existing banking system and rejected the alternative of establishing accounts directly at the central bank. This occurs through a two-tier approach. Individuals obtain a digital currency/electronic payment (DCEP) account from a distributor of their choice. Distributors can be commercial banks or operators of electronic payment platforms such as AliPay and WeChat Pay. The distributor deposits 100% of the funds in reserves at the PBOC. This approach eliminates money-creation by private sector entities and enables the PBOC to control the supply of money.

An additional advantage of the two-tier system is that the PBOC will not have to develop its own payment systems infrastructure because DCEP accounts will be managed through already established payment systems of banks and online payment platforms.

2) No Interest Paid on DCEP Accounts. The PBOC realized that if interest was paid on DCEP accounts, these accounts could become more attractive than regular bank deposits, disintermediate banks, and impair their ability to extend credit. Thus, DCEP accounts are simply an exact replica of physical cash with the only substantive difference being one of greater convenience for individuals and businesses in handling electronic cash transactions versus physical cash transactions.

Adoption of DCEP accounts by individuals, businesses and vendors is likely to occur quickly because pervasive use of electronic payments is well established – the PBOC reported that in 2018 82% of adults used electronic payments and even in rural areas the percentage was 72%. In major urban areas almost all small-value transactions are already conducted through mobile payments – primarily through AliPay and WeChat. The mobile apps for DCEP account holders will have the look and functionality of existing mobile payment apps – payment through a DCEP account will simply be just another option.

Furthermore, because no interest will be paid on DCEP accounts they will not compete directly with banks and AliPay and WeChat, which do pay interest. In time, it is the objective of the PBOC to eliminate physical cash entirely and this will benefit providers of mobile payment accounts.

What’s the potential impact of a CBDC on a national economy?

Because of the careful design of CBDC through DCEP accounts, which rely on existing distributors and use existing mobile apps payment systems technology and infrastructure, and which avoid direct competition by not paying interest, DCEP accounts are likely to achieve broad acceptability and usage quickly. Overall, the Chinese economy will gain from improved efficiency in the payment systems and an enhanced capability to control criminal activities. A potential concern in some national economies could involve loss of financial privacy by individuals. This is unlikely to be a problem in China but could discourage adoption of CBDC in other countries.

Could a movement like that of China’s CBDC Pilot trigger disputes over monetary sovereignty? 

In a 2018 article authored by Fan Yifei, a deputy governor of the PBOC, he stated that a digital renminbi “will help curb public demand for private encrypted digital currencies and consolidate our monetary sovereignty.” Cryptocurrencies are not a stable store of value. Only currency controlled by the central bank can serve well the objectives of a widely accepted medium of exchange and a stable store of value.

Could China’s trial run accelerate the internationalization of its currency?

Making payments through DCEP accounts will be faster and cheaper than other methods, such as wire transfer, and thus could be attractive for handling international settlements. However, managing exchange-rate risk and the absence of interest is likely to outweigh efficiency advantages of DCEP accounts. DCEP accounts are unlikely to have any material impact on boosting the renminbi as an international currency. The design of DCEP accounts is a solution to make China’s domestic payments system more efficient; it is not a precursor of a new global payments infrastructure. DCEP accounts do not deal with currency exchange risk. It is notable that the share of renminbi transactions in the SWIFT interbank payments system peaked at 2.7% in 2015 and has declined to less than 2% since then.

A Broader Outlook

Besides CBDC, two other digital currency systems have been emerging: Stablecoins for open-loop transactions that can be made outside of their issuing platforms and Libra for closed-loop transactions limited to its issuing platforms.

But developments such as news about the use of digital currencies in questionable markets has hindered its diffusion, says Joseph P. Bailey, associate research professor of decision, operations and information technologies, and executive director of the QUEST Honors Program. “If we focus on the price of the different currencies, we can certainly see that it is often two steps forward and one step back.”

On the other hand, Bailey says, developments like the G20-fronted initiative to mainstream digital currency “are assuredly validating and increasing the velocity towards more widespread acceptance and use.”

“In order to develop in a more sustainable way, digital currencies need to improve their design, governance, accountability, and relationship with national governments,” he says. “Although the blockchain technology that underpins digital currencies is inherently distributed, the overall system must align better like a healthy private-public partnership to thrive.”

If digital currency can become more global and stable, it may become the preferred place to keep cash-on-hand for multinationals, Bailey adds. “Granted, we are a long way away from this reality, but if digital currency can gain widespread and global adoption, it may be able to withstand shocks to disturbances in national economies, which often affect the U.S. dollar, euro or yuan,” he says. “If digital currencies become more stable than national currencies, it might be a great way to diversify risk.”



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