China is a pioneer in the world of Central Bank Digital Currencies (CBDCs), but even with the e-CNY we are only starting to get glimpses of how profoundly it is going to change the financial landscape both within the mainland‘s borders and beyond.
The People‘s Bank of China (PBC) has been working on designing digital renminbi from scratch for almost a decade and the architecture it has settled on is likely to shape the decisions of the more than 100 other countries – including 19 of the G20 economies – that are considering their own Central Bank Digital Currencies.
This is partly because Beijing‘s pragmatic approach has come up with a solution that is working in real time, but also because many of the potential benefits of CBDCs will only derive seamless interaction with other central bank currencies. When it comes to facilitating trade, other markets see the benefits of following China‘s lead.
Designing a workable CBDC
The PBC had three aims when it set out to design the e-CNY: to create a state-backed form of digital cash at least in part to support financial inclusion; to “support fair competition, efficiency and safety of retail payment services;“ and lastly, to make cross-border payments more efficient.
CBDCs need to be secure, but scalable in terms of both customer base and transaction size; they need to preserve users‘ privacy, while allowing the authorities to take advantage of their clear advantages when it comes to fighting financial crime; and they need to be inter-operable with other CBDCs if they are to realise their full potential to create faster, cheaper and more secure settlements.
CBDCs have more in common with bank notes than with other digital tokens such as cryptocurrencies or stablecoins. Although they may use distributed ledger technology (DLT) to verify transactions – the e-CNY uses a system it calls “centralised DLT“ – their value is backed by the full power of the state and does not diverge from the value of the national currency.
China‘s solution is a two-tier system. The PBC issues e-CNY and verifies transactions, but retail and wholesale customers either transact with each other directly through an app, or through commercial banks or payments services which provide exchange and circulation services to the public. Crucially e-CNY deposits do not earn interest, and commercial banks must hold the e-CNY at a 100% reserve ratio to prevent over-issuance.
These measures ensure that commercial banks can still attract deposits and thus continue to fulfil their role of recycling savings into investment to drive economic growth. The PBC also holds details of intermediaries‘ client accounts so it can maintain system integrity in the case of a problem.
Retail e-CNY and privacy
At the retail level, the e-CNY mimics much of the functionality of physical cash – the app even works to transfer funds offline when two mobile devices are near each other – and from a user's perspective is almost indistinguishable from other forms of digital money, such as accounts held at banks or with payment services, except that it does not earn interest. In China's model, it also confers a level of anonymity. “The e-CNY follows the principle of ‘anonymity for small value and traceable for high value,‘ and attaches great importance to protecting personal information and privacy,“ the PBC says.
Changchun Mu, the director-general of the Digital Currency Institute at the PBC, explained in a paper how the system of “managed anonymity“ works. “The PBC only processes inter-institutional transaction information and does not hold personal information. ID anonymisation technology is used between e-CNY wallets and the personal information exchanged between all wallets is anonymous to counterparties and other commercial institutions.“
For the lowest level of wallet, which has a transaction limit of RMB2,000 (US$300), users only need to provide a telephone number, but as authorised transaction limits rise, the level of disclosure rises.
Although it is clear that users want a degree of anonymity, it is generally accepted – by the U.S. Federal Reserve and the European Central Bank among others – that a purely anonymous CBDC is neither feasible nor desirable. Central and commercial banks are on the front line in the fight against money laundering and terrorist financing and it would be irresponsible to open a new, instantaneous and highly liquid way of transferring funds with no checks on illegal activity, and in many ways the identification requirements of the e-CNY are less burdensome than existing digital payment channels.
The digital yuan is still in its early stages of development. It is only available in some parts of 17 provinces, although that includes the whole of Guangdong, Hebei, Sichuan and Jiangsu. The PBC released data earlier this year showing that e-CNY comprised roughly 0.13% of RMB10.47 trillion (US$1.54 trillion) in circulation at the end of 2022.
China's digital payments ecosystem is currently dominated by Alipay and WeChat Pay, which accounted for 94% of third-party mobile payments in China in 2021, but we believe that as it is rolled out across the rest of the economy it will reach critical mass and rapidly become a popular and viable alternative to other forms of cash and digital payments.
Looking forward: wholesale e-CNY
To date, most of China’s e-CNY project has focused on retail payments, but the most far-reaching impact of digital renminbi and other CBDCs is likely to be felt in the wholesale space, particularly when it comes to trade and cross-border settlements.
The physical side of global trade has become immeasurably more efficient over the past half century: from widespread containerisation to bigger ships to just-in-time delivery, cargo delivery has become cheaper, faster and more reliable.
The payments system that supports it has not evolved at the same pace. Smart contracts, for example, are starting to become commonplace, but they are grafted onto what is essentially 20th-century payments systems.
CBDCs have the potential to deliver a future of almost instantaneous, risk-free, low-cost settlements, with the buyer transferring funds directly into the seller‘s wallet in a digital transaction that is ultimately validated by the central bank.
But the most powerful impact of CBDCs is likely to be felt in cross-border payments by shortening the transaction chain, encouraging greater efficiency in the foreign exchange markets, and reducing counterparty risk. Since CBDCs are validated by central banks, there is huge potential to streamline international transactions, including through smart contracts, to make them faster, cheaper and more secure.
But to fulfil that potential there need to be standardised protocols that allow different CBDCs to speak to each other – what is known in the jargon as “inter-operability.“
Taking CBDCs international
The PBC is already exploring how the e-CNY might link with other CBDCs. It is a member of mBridge, a project run by the Bank for International Settlements along with the Hong Kong Monetary Authority, the Bank of Thailand, and the Central Bank of the United Arab Emirates.
The mBridge project, which piloted over 160 payment and foreign exchange transactions totalling US$22 million across the network during a six-week trial in the third quarter of 2022, is a blockchain-enabled platform that supports real-time, peer-to-peer, foreign exchange transactions and cross-border payments using CBDCs.
Its key feature is a fully connected network of central banks to validate wholesale transactions on behalf of domestic commercial bank participants, making the payments system faster and cheaper by cutting out much of the correspondent bank infrastructure.
CBDC infrastructure like mBridge has enormous potential: it reduces counter-party risk; it enables significantly faster transactions; and the technology also would bring currency into the digital age, empowering fintechs by lowering the barriers to entry, and opening the door to advances like the tokenisation of assets, enabling vital cost-saving techniques such as smart contracts to be fully exploited.
New opportunities for Hong Kong
For Hong Kong, the rollout of e-CNY will bring new opportunities as soon as the PBC gives the green light for cross-border operations.
Hong Kong is a natural nursery for fintechs looking to integrate Hong Kong‘s unique cross-border investment channels with digital technology; a conduit for the PBC‘s drive to use digital renminbi to make “cross-border trade more efficient;“ and potentially usher in a new phase of renminbi internationalisation, where the city already holds a dominant market position.
The HKMA is ensuring that we have the regulation needed to maintain our position at the leading edge of the revolution in digital finance and attract fintech innovators. China's lead in establishing a digital currency is our opportunity to establish a global first-mover advantage by developing new financial tools for the digital age.
For China's international trade customers wanting to take advantage of the e-CNY‘s faster and cheaper settlement options, Hong Kong is a natural destination. Hong Kong is one of the world's most efficient financial centres and has unrivalled yuan liquidity with 60% of the world's offshore renminbi deposited here, and the government is committed to expand the renminbi product suite.
Accelerating renminbi internationalisation
Although the e-CNY project is not specifically designed to help the PBC‘s long-standing project to internationalise renminbi, it will accelerate the process. The biggest brake on widespread adoption of RMB has been controls designed to prevent destabilising capital outflows.
e-CNY gives the PBC much more precise targeting of illegal capital flows. They can delay validation of suspicious transactions pending further investigation, or in extreme cases, deauthorise illegally exported currency.
The current blanket restrictions create bottlenecks and uncertainty: they could be relaxed for cross-border payments denominated in e-CNY, perhaps in a smart contract that is coordinated with the State Administration of Foreign Exchange to guarantee legitimacy for the recipient.
This increase in convertibility combined with the growing pool of offshore renminbi, presents Hong Kong with the opportunity to become a clearing house for one of the world‘s most relevant trading currencies.
The e-CNY is the world's most advanced Central Bank Digital Currency, and is setting the standards that others will have to follow. At the moment it is domestically focused, but the PBC has signalled clearly their ambition to expand it to the international sphere.
Hong Kong has a once-in-a-lifetime chance to grasp the opportunity presented by the development of the digital renminbi. The outline of how it will function internationally is starting to become clearer. We need to start preparing the digital infrastructure so we can hit the ground running as soon as it arrives here.
By David Liao, Co-Chief Executive, The Hongkong and Shanghai Banking Corporation Limited