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Understanding China’s Central Bank Digital Currency
Date:12.13.2020 Author:ZHOU Xiaochuan, President of China Society for Finance and Banking; Former Governor of the People’s Bank of China

Abstract: In this paper, the author explains what China’s DC/EP is, and the respective responsibilities of the central bank and second-tier institutions in the system. He also discusses the difference between DC/EP and CBDC, and explains the technological path of DC/EP.

I. Responsibilities of the central bank and commercial banks in a DC/EP two-tier operating system

China’s DC/EP (Digital Currency/Electronic Payment) is a two-tier R&D and pilot project, not a payment product. It may include several payment products that can be tried and promoted. These products have been named e-CNY, or digital CNY.

The DC/EP is a two-tier operation system. The first layer is the central bank, the People’s Bank of China (PBC), and the second layer includes commercial banks, telecom operators and third-party online payment platforms. At present, China’s four major banks, i.e. Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China and China Construction Bank, as well China Mobile, China Telecom, China Unicom, Ant Group, and Tencent are at the second tier and have already started trial operation.

The second-tier institutions should shoulder the following responsibilities. First, they must have sufficient capital to cushion risks. Second, they must follow due KYC (know their customer) procedures, and on top of which bear the responsibilities of anti-money laundering and data privacy protection. Third, they need to invest in technology and equipment, and ensure the continued operation of equipment.

The central bank, being the first-tier entity, has the following duties:

The first is to maintain the stability of the digital CNY. The central bank can achieve this goal by imposing capital or reserve requirements on second-tier institutions.

The second is to build reliable settlement and clearing infrastructure. Theoretically, the central bank should also engage in R&D, but it should focus on the construction of reliable settlement and clearing infrastructure instead of digital currency products.

Third, the central bank has the obligation to promote the interoperability of different payment products. The central bank should coordinate among payment products with different standards or parameters to improve their interoperability, a move that will benefit consumers.

Fourth, the central bank must have emergency and contingency plans to deal with a dynamic system. In the event of either a system failure or an upgrade, contingency plans are needed to ensure no disruption to the payment function, otherwise the entire market may be affected. From this perspective, the central bank itself should also develop a digital currency that can play a substitute role in emergency.

In general, in the two-tier DC/EP operating system, the central bank needs to design its role in a way that fully mobilizes the enthusiasm and strength of all other entities involved.

II. DC/EP and CBDC are built on different ideas

The idea behind DC/EP is not completely the same with that underlying CBDC (central bank digital currency) that has been popular internationally. DC/EP is not a form within the CBDC system. The main differences are as follows:

First, the second-tier institutions in DC/EP actually have the ownership of e-CNY and offer guarantee of payment, as well as own the corresponding systems, technology and equipment.

This arrangement has borrowed ideas from the three note-issuing banks in Hong Kong (HSBC, Standard Chartered and Bank of China Hong Kong). These banks are required to give the Hong Kong Monetary Authority 1 US dollar for every 7.8 Hong Kong dollars issued, and in exchange receive from a 100% reserve certificate. From the balance sheet’s perspective, the banknotes issued by the banks are their liabilities, their assets are reserves, and the liabilities of the central bank are the reserve certificates issued. Therefore, from this perspective, this issuance model is different from that of CBDC where the currency ownership and liability responsibilities all belong to the central bank.

In order to maintain the stability of currency, the central bank can adopt different methods. For example, requiring 100% of cash reserves, providing certificates like Hong Kong does, or issuing comfort letters. It should be noted that under different schemes, the degree of central bank support also varies. In addition, even with 100% reserve, it is only for cash which is M0 in China, and other quasi-cash types are not included, let alone M1 and M2.

Secondly, the relationship between the entities of the two tiers in DC/EP is not one in which the central bank engages in wholesale and the second-tier institutions engage in retail as some people have thought. As mentioned earlier, the second-tier institutions need to perform a series of compliance responsibilities including KYC, anti-money laundering, and data privacy protection. However, CBDC in the general sense considers these responsibilities to be a part of the role of the central bank. Under the DC/EP model, in order to better maintain system stability and understand the operating status of the system, the central bank should have access to the transaction data it needs, which is only for the purpose of backup. The central bank should not be involved in direct commercial interests.

There is a metaphor explaining the relationship between the central bank and the second-tier entities: commercial banks issuing central bank digital currency is like giving out envelopes; the banknotes in the envelope are the banknotes of the central bank, but commercial banks can have different envelop designs and anti-counterfeiting features; but in essence, what’s in the envelope is the currency issued by the central bank. This is an interesting though not exactly accurate metaphor.

What’s inside the envelope can be the currency of the central bank, or a reserve certificate or comfort letter issued by the central bank, or even something designed by a commercial bank. But in any case, ultimately it must maintain stability and effectiveness. From this perspective, the first responsible entity is the second-tier institutions, not the central bank.

III. How does the central bank select the technological path?

In fact, the PBC first presented the idea of building such a two-tier system to the international community in as early as 2015 or 2016. The major consideration behind was that a competition-based, multi-solution operating system, one that is dynamic and continuously evolving, would better accommodate China’s economic reality.

Does the PBC have the ability to identify and choose an optimal technological path? It’s definitely not an easy task. Besides, shifting from one technical solution to another would be extremely time-consuming for huge economies like China. Past experience shows that the average time it took to circulate a new edition of Renminbi was 10 years, and each update has left many problems to be solved over the long run. But in the meantime, China’s super-large market could accommodate the implementation or experiment of multiple technical solutions. Therefore, a competition-based, multi-solution CBDC system would be more suitable for China.

In addition, DC/EP is a dynamic, evolving system. The payment system needs to constantly evolve and upgrade with the fast development of fintech. Of particular note, it’s important to prevent against monopoly which could pose barriers to new technological paths.

One important feature of blockchains and distributed ledger technology (DLT) is decentralization. But decentralization may not be necessary, and even could be detrimental to building a modern payment system.

Existing systems, especially the ledger system, are very unlikely to be altered; however, technologies should at the same time allow reasonable amendments in the event of errored transactions. “Errors sometimes occur in payments, and need to be corrected. However, the corrections should not only offset the wrong records with reversal transactions, but also wipe them out completely, or the incorrect information could be misused, such as being mistakenly incorporated into the credit reporting system. Yet, this has been made difficult by the tamper-proof nature of blockchains.”

Blockchains and DLT have always been part of the PBC’s toolkit to establish a digital currency system, but there remain technological bottlenecks to break, especially their insufficient capacity for payment processing. These technologies need to improve before they can become mainstream solutions for retail transactions.

IV. Retail use should be the focus of digital currency in cross-border payments

With regard to data privacy, digital currency transactions need to maintain controllable anonymity. That is to say, anonymity is necessary, but only to a certain degree. Data should be accessible by regulators, especially anti-money laundering authorities while maximum possible protection is provided for user privacy. In this regard, China could study and draw on some of the rules in the General Data Protection Regulation (GDPR) of the European Union.

A tricky issue in China is there was already a great deal of privacy leakage when big data-based transactions prevailed, and many people are even unaware that their personal data has been leaked or sold. To stop their losses, users can delete some of their information or change their account names and passwords, but these operations are complicated and time-consuming, and cannot guarantee data safety. Therefore, certain risk control measures need to be in place to protect data privacy, e.g. multi-tiered quota management of accounts.

As to the use of CBDC in cross-border payments, some schemes such as the Libra are mainly focused on cross-border remittances, but this could be problematic. Instead, the application of digital currencies should focus on retail transactions, in particular payment related to current account items such as cross-border travel.

In addition, use of CBDC in retail payments should respect the policies, laws and regulations of different countries. If a country attaches great importance to its currency sovereignty, exchange rate regime and regulations on currency exchange and cross-border remittances, it is important to heed these considerations when promoting digital currency. Some countries worry about the trend of “dollarization” or “yuanization”. To address this concern, the central bank should focus the use of digital currency on settlements in cross-border payment cooperation programs.