The world’s major central banks and monetary authorities have commenced studies into central bank digital currencies (CBDCs) in recent years. The Monetary Authority of Singapore and Swedish central bank Sveriges Riksbank have undertaken or contemplated related pilot projects. The People’s Bank of China (PBoC) is also actively exploring the possibility of introducing its CBDC into the second-largest economy in the world. This article puts forward some thoughts on issuing CBDC in China.
1. China should adopt a two-tier CBDC model
Issuing CBDC in an economy such as China is a complex undertaking. It is a large and populous country, with significant regional differences in economic development, natural resources and public education. This means that a national CBDC must be carefully designed, issued and distributed, taking into account the diversity and complexity of various systems and institutions – including, for example, how a CBDC should be used in remote areas where internet access is limited.
A one-tier system – where the central bank directly interacts with the public – would not be viable in China. A two-tier model, on the other hand, where intermediaries are involved, could help the central bank to optimise the convenience and accessibility of a CBDC and relevant services, thereby improving the public’s willingness to use it.
A two-tiered model also allows more effective exploitation of existing business resources, human resources and technologies, promoting innovation and competition through market-driven development. Financial institutions, such as commercial banks, have fully developed IT infrastructure application and service systems, with strong processing capacities. They have acquired a considerable amount of experience in fintech applications as well as large numbers of qualified staff. To build a separate system would be a tremendous waste of such existing resources. Instead, while ensuring operational safety and reliability, the central bank can leverage ‘market forces’ to optimise related systems through close co-operation with commercial banks and other organisations, without imposing any prescriptive technology path in advance. This would facilitate resource integration, synergistic collaborations and innovation, as well. Furthermore, as the public is accustomed to using commercial institutions for financial transactions, a two-tier model could also boost the public’s acceptance of a CBDC.
A two-tiered model could also diffuse risks. The central bank has accumulated considerable experience via the development of interbank payment and settlement systems. But the system is designed for financial institutions, and the CBDC would be used directly by the public and would affect all members of society. It would be unrealistic to expect the PBoC to develop such a massive system all by itself, while ensuring a high level of transaction security, efficiency and reliability, and user satisfaction at the same time. It would be a very challenging undertaking, to say the least, especially considering the budgetary, resource, personnel and technical constraints facing the central bank.
In addition, the proposed model would help to avert disintermediation in the financial sector. Under the one-tier model, the central bank would issue the CBDC directly to the public, so the CBDC would go into competition with bank deposit money. Endorsed by the central bank, the CBDC would obviously offer a higher degree of credibility than deposit money from commercial banks, and the banks could be crowded out from the personal savings market, which would, in turn, affect their lending capacities. Consequently, it would raise the commercial banks’ reliance on interbank borrowing, and the resulting increase in cost of funding and social financing might lead to disintermediation, thus adversely affecting the real economy. The central bank would have to subsidise commercial banks to restore their lending capacities and stabilise the financial market. In an extreme scenario, the existing financial system could evolve into one dominated by the central bank.
A two-tier model comprising the PBoC and commercial banks could optimally secure the support of commercial banks without wasting existing resources
A two-tier model comprising the PBoC and commercial banks serving as operating agencies would therefore be a suitable approach to CBDC operation in China, and could optimally secure the support of commercial banks without wasting existing resources. Firstly, it would not change the current creditor-debtor relationships in currency circulation. The commercial banks would need to pay the central bank 100% reserves against the CBDC issued, so the money issued to the public would remain as the central bank’s liability backed by central bank’s credibility, thus qualifying it as legal tender. Secondly, it would not change the existing currency circulation system and two-tier account structure or create competition with commercial banks in the savings market. In other words, a two-tier CBDC would not increase banks’ reliance on interbank borrowing or affect their lending capacities, so disintermediation could be avoided. Thirdly, since it would not affect the existing monetary policy transmission mechanism or intensify procyclicality in different stress scenarios, issuing CBDC would not lead to any negative impact on the way the real economy operates. Lastly, the recommended model would make currency operation more cost-effective, improve money circulation efficiency, and ultimately enhance the user-friendliness and security of related payment services. Also, endorsement by the central bank would smooth out potential spikes in consumers’ demand for the crypto assets.
2. Under the two-tier model, the CBDC should be issued with ‘loosely coupled account links’ and centralised management retained
As dictated by the nature of the national CBDC as legal tender, to make sure it can achieve its monetary and macro-prudential policy targets, the PBoC should pursue a two-tier strategy that is different from the ‘decentralising’ model underpinning many crypto assets. Firstly, the digital money would be liabilities in the central bank’s book, meaning that the creditor-debtor relationship would not change with the introduction of the new form of fiat money – so the PBoC must assume a central position in the operation process. Secondly, efforts should be made to guarantee and strengthen the central bank’s functions in terms of macro-prudential and monetary policy execution. Thirdly, the existing two-tier account system should be kept to retain the current monetary policy transmission mechanism. Lastly, the central bank must be able to track, monitor and supervise CBDC operation to avoid oversupply by the authorised operating agencies.
Centralised management must be realised for CBDC. However, the centralised model here is different to that associated with traditional electronic payment systems. In the latter case, a transfer of funds necessarily involves moving money between two accounts, between which a strict account-to-account correspondence must be established. By contrast, circulation of the PBoC’s CBDC should be based on ‘loosely coupled account links’ so that transactional reliance on accounts could be significantly reduced. This way, the new money could attain a similar function of currency to cash and be used on a controllably anonymous basis. The public could use it directly for various purchases, and it would prove conducive to the yuan’s circulation. It is worth pointing out that without third-party anonymity, CBDC transactions may jeopardise personal data and privacy, but complete third-party anonymity may encourage criminal activities such as tax evasion, terrorist financing and money laundering. The only way to strike a balance between the two is to keep the degree of anonymity within a controllable range – namely, disclosing transaction data to the PBoC as the sole third party. With the loose coupling of accounts, the operating agencies should submit transaction data to the central bank via asynchronous transmission on a timely basis. This would allow the central bank to keep track of necessary data to implement prudent regulation and crack down on money laundering and other criminal offences, as well as easing the workload for commercial banks.
3. China’s CBDC at this stage should be developed as a surrogate mainly for M0, rather than M1 or M2
Today, M1 (cash and current account deposits) and M2 (M1 plus savings accounts and money market accounts) in circulation in China have already been digitalised based on commercial bank accounts, so it is unnecessary to redigitalise them by issuing a CBDC. The aforementioned forms of money are circulated via interbank payment and settlement systems (the High-Value Payment System, Bulk Electronic Payment System and Internet Banking Payment System, for example), commercial banks’ intra-bank systems and payment services offered by non-banking payment institutions. All these systems and services have become increasingly efficient in line with economic growth and demand through frequent upgrades. Replacing them with the PBoC’s CBDC would not increase payment efficiency, and would cause a tremendous waste of existing systems and resources.
On the other hand, there is a pressing need to digitalise cash and coins (M0) because:
i) cash and coin issuance, printing/production, withdrawal and storage are expensive;
ii) cash and coin circulation is based on multiple layers;
iii) cash and coins are not very convenient to use;
iv) it is relatively easy to counterfeit cash or coins, and they are used anonymously and thus may be used for illegal purposes.
Furthermore, non-cash payment tools, such as traditional bankcards and electronic payment, are reliant on strict account coupling, meaning they cannot meet the public’s needs for user-friendly and anonymous payment services. These tools cannot substitute M0 completely, especially in areas with limited account services and telecommunication services, where cash and coins are still the prevalent means of payment. The PBoC’s CBDC would retain the main characteristics and properties of cash. It would be very convenient to use and could guarantee user anonymity, making it an ideal surrogate mainly for cash and coins.
Non-cash payment tools, such as traditional bankcards and electronic payment, are reliant on strict account coupling, meaning they cannot meet the public’s needs for user-friendly and anonymous payment services
The CBDC would be introduced to substitute M0, meaning that no interest would be paid. Therefore, it would not cause disintermediation or lead to a rise in inflationary expectations, and neither would it have any significant impact on the current monetary and financial systems or on the real economy.
Furthermore, defined as a replacement of M0, the CBDC would be subject to existing cash management, anti-money laundering and counter-terrorist financing regulations of China’s financial intelligence unit and the global Financial Action Task Force. Of course, the CBDC would observe all State Administration of Foreign Exchange capital management regulations. The PBoC could require relevant organisations to report large and suspicious transactions to clamp down on money laundering activities. To avoid the ‘crowding out’ effect on bank deposits, arbitrage trading and a rise in procyclicality, the use of the CBDC should be limited to small retail transactions by setting maximum daily and yearly limits, and introducing policies that CBDC conversions exceeding a certain amount can only be processed by appointment. If necessary, multi-tier charges may be introduced – small-sum and low-frequency transactions could be processed free of charge, and service fees could be charged on large-sum or high-frequency transactions to increase the exchange cost and system friction. Such arrangements would also make it easier for the central bank to implement a negative interest rate policy if the need arose in future.
4. PBoC should exercise due caution in the use of smart contracts with CBDC
A ‘smart contract’ is defined by expert Nick Szabo as a set of promises, specified in digital form, including protocols within which the parties perform on these promises. They are embedded in codes readable by computers and automatically executed once the pre-set conditions are triggered. They may contain preconditions such as time limits and credibility status, and can be used to ensure compliance with tax payment and counter-terrorist financing activities.
However, as mentioned earlier, the PBoC’s CBDC is intended as unlimited legal tender to substitute M0. In other words, it would inherit the main functions of cash, such as unit of account, medium of exchange and store of value. Cash does not perform any other social and administrative functions. The Renminbi Management Regulations of the People’s Republic of China prohibits any person from deliberately damaging the yuan. Arguably, imposing more social or administrative functions on cash could cause damage to it.
Besides, the CBDC should not assume any other social or administrative functions other than the currency functions specified above, otherwise it may not qualify as legal tender. By attaching smart contracts to it, the CBDC could lose its status as legal tender. Even worse, it could be reduced to a form of negotiable securities, affecting its free usability. Using smart contracts with the CBDC would also slow down the velocity of currency circulation, hamper monetary policy transmission and execution of the macro-prudential policy by the PBoC. Another drawback of such a practice is that it may compromise personal information and privacy.
This article was originally published in 2018 by CBN Newspaper, part of Yicai Media Group, which supplied this People’s Bank of China-approved English language translation
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