Since 2014 Chinese monetary authorities have conducted research on a digital yuan, leading to the creation of the Digital Currency Research Institute (DCRI) in mid-2017 under the People’s Bank of China (PBOC). The digital yuan, officially designated as the Digital Currency Electronic Payment (DCEP), is now being tested in various trials launched throughout China. Once the DCEP is freely available as legal tender, its technological characteristics could usher in a monetary revolution with significant global impact.
I have already laid out the major characteristics of the digital yuan in a prior piece. Here, the focus rests on the reasons why Chinese monetary authorities have put such emphasis on this novel technological format to furnish money. After all, the DCEP is likely to be the world’s first major state-backed digital currency or Central Bank Digital Currency (CBDC) in actual use.
All digital currencies, such as Bitcoin and Ethereum, differ from physical cash and traditional electronic payments in that they are digital tokens that use distributed ledger technology (DLT). Such technologies promise to provide money with much greater security, much lower costs to run financial infrastructure, and much greater transparency and traceability regarding financial transactions.
Various objectives have been attributed to Beijing’s digital yuan initiative. The first is the fear that a private digital currency such as Bitcoin or Diem (formerly known as Libra) could destabilize monetary conditions. Diem, a private stable coin that Facebook is developing, will be based on various existing government-backed currencies. It could thus act as a true competitor to sovereign state-issued legal tender. Its convenience and potential for widespread use might drive consumers away from traditional instruments and thus complicate monetary management.
Extensive adoption of private digital tokens would also give private entities massive realms of information about consumers and their spending, creating national security and privacy concerns. Consequently, the PBOC has cracked down on trading in cryptocurrencies, saying they represent potential sources of financial instability. China has by now banned all private digital currencies and in October 2020 legally formalized the DCEP’s status as the only digital legal tender.
Another fear attributed to accelerating the development of the DCEP is the rapid rise of payment apps like Ant Group’s Alipay and Tencent’s WeChat Pay. These apps dominate retail transactions in China, and Chinese authorities clearly feel that this situation is concentrating too much power and information in private hands. Recent regulatory initiatives reining in Chinese fintech firms are just one step forward in trying to control these increasingly powerful entities.
While both of the above fears are certainly important considerations for Chinese monetary authorities, the development of DCEP is being driven by other more significant rationales and strategies. Beijing wants to hasten the development of digital money and use it as a tool to transform the country's economy. The DCEP will give the PBOC the ability to trace and track economic activity in real-time. As with so much else in the 21st Century, data is king.
China is therefore preparing for what they predict is the future of money. The DCEP will be issued by the PBOC, meaning it is just like paper money, free to use and transact. It will be based on a wallet app that is free to download. Moreover, a chip-based wallet device is being developed that can run on battery power and transact DCEP without an Internet connection.
DCEP is clearly more like cash than the present electronic payment tools. It truly promises a new level of convenience for consumers. At the same time, it will also enhance monetary control for Chinese authorities. The use of DLT technology combined with Artificial Intelligence to analyze the mountains of data generated could substantially boost the supervision of monetary operations and with it, state authority.
For example, in an economic downturn, such as the one created by the COVID-19 pandemic, monetary authorities could pinpoint areas of the economy in most dire need of support. Restaurants whose revenue has dropped (evidenced by DCEP transactions) could be given direct payments to continue furnishing wages and rent. Other businesses that have seen no drop-off in business would receive no or less support.
In contrast, monetary operations undertaken in the Eurozone, the United States, or elsewhere, such as Quantitative Easing (QE), are crude tools that push money out into the economy regardless of need. Support for the most impaired sectors continues to depend on the rather cumbersome process of government fiscal expenditure. And there are big risks to employing such crude tools. Currency over-issuance that pushes interest rates towards zero or even negative as under QE can create rapid asset inflation, such as with real estate and equities, and thus asset bubbles and financial instability.
Specifically, the ability to monitor DCEP transactions will radically lower financial risks, since banks can better track and analyze non-performing assets. In this manner, the PBoC could solve many chronic problems in the Chinese financial system, such as shadow banking, loan bias, and too much informal financing. The DCEP could also make it easier to fight financial crimes including money laundering and the financing of terrorism. Finally, as with all new technological inventions, the DCEP could create the conditions for an array of new tools and applications.
There are drawbacks to this brave new world of money. Some commentators in the West see the digital yuan as another effort by the Chinese Communist Party to exert greater control over Chinese citizens. Monetary surveillance would allow authorities to track how money is spent in real time, since DCEP is built on the idea of centralized control. This is quite unlike Bitcoin, which is predicated on decentralization and autonomy from the financial system and state authority.
Based on information released so far, it looks like the PBoC will be able to trace every movement of the DCEP given its electronic footprints, though anonymity will be assured in smaller transactions between users. DCEP thus fails to afford users the complete anonymity of cash transactions. No wonder that the introduction of digital money raises distinct privacy concerns. Even in China these are likely to create some societal pushback to total surveillance.
The PBoC seems aware of these concerns and is trying to reach a delicate balance between privacy and security issues, creating a tiered system of anonymity. The Bank has also promised to continue issuing traditional cash as well as to set up a regulatory framework for managing various aspects of the DCEP.
In the end, the jury on who wins the competition for furnishing new forms of money – mass public adoption – is still out. There are a host of uncertainties, technical challenges, and regulatory issues, such as how to handle high concurrent transaction demands with sufficient computing power, how to overcome new payment bottlenecks, or how to encourage innovation and support smaller players in this new technology ecosystem. Already, the DCRI has taken out over a hundred new patents to support the digital yuan’s infrastructure. New regulations have been issued that outline the consensus mechanism, privacy protection, identity management, regulatory support, nodes of communication, and other facets of the DLT infrastructure needed to support the DCEP.
One of the most important dynamics to watch is how the competition to furnish a widely used digital currency will play out internationally. The PBoC has reassured other countries that the DCEP is not a threat to existing national currencies. Nonetheless, the race is clearly on to be a first-mover in this crucial new era of financial innovation.
This brings us to perhaps the most important rationale for developing the world’s first major state-backed digital token: China’s need to internationalize the yuan and reduce its dependence on the global U.S. dollar payment system. The hope is that the DCEP will become a mechanism by which the yuan can be used in everyday transactions all around the world, giving Beijing monetary autonomy. The strategy behind this major effort to reshape the international monetary system will be the topic of the last installment of my analysis of the DCEP.