Just a few short years ago, the idea that digital currencies would be seriously considered by central banks and their governments was quite far-fetched. The world was not prepared to accept any potential systemic disruption that digital currencies and other unregulated digital assets such as bitcoin could have on the international monetary system.
This position drastically changed with the announcement by Facebook to launch its own digital currency called libra in June 2019. This was a shot heard around the world and served as a wakeup call for governments and financial institutions. If a private company with 2.3 billion users (more than the populations of China and India combined) can issue their own digital currency that can potentially circumvent the sovereignty that nations have over controlling their money supplies, what effect could this have on the international monetary system?
China’s e-CNY journey
The Libra announcement catalysed governments and central banks around the world to take notice and seriously reconsider their stance on digital currencies. Even as the EU and US governments widely denounced the Libra project, which has since stalled, central banks all began to investigate their own digital currency strategies in earnest. In particular, the People’s Bank of China (PBOC) had been quietly developing their Digital Currency Electronic Payment (DCEP) initiative since 2014.
After the Libra announcement, China decided to accelerate the timetable for deployment of the digital RMB, officially announcing its intention late October 2019. Since that time, testbeds on the mainland have scaled from sporadic testing at a handful of locations (originally Shenzhen, Hainan, Suzhou, and Chengdu) in early 2020, to pilots in the most important economic zones across China and scaled stress testing. Now referred to as the e-CNY, it is anticipated that a commercial release will commence by the start of the Beijing Winter Olympics in 2022.
The design of the digital RMB was architected as a two-tier system. The first tier is a centralised account-based system for issuances and redemptions, very similar to how central banks traditionally transmit money to their commercial banks. In general, central banks are very wary of disintermediating their commercial banks, which they depend on for transmitting their monetary policy. Thus, the system was explicitly designed to go through the commercial banks even though in theory it would be possible for consumers to have direct accounts with the central bank.
In the second tier, the commercial banks are responsible for redistributing the digital RMB as the consumer-facing interface to the broader financial ecosystem. The second tier is intentionally left open-ended in implementation, notably allowing for more decentralised infrastructure such as distributed-ledger/blockchain technology. This two-tier system is both flexible and pragmatic, and other central banks, notably the US, are researching similar frameworks.
Much has been reported about the Chinese government’s ability to monitor transactions on the network, given the full end-to-end digitalisation of money. There has been concern that it is potentially possible through the new digital currency infrastructure for China to monitor transactions all the way through to the individual transactions between consumers’ digital wallets. However, in actuality, there is not too much difference in the implemented level of tracking compared to what already exists as a global standard for the international monetary system. All governments require that their financial institutions gatekeep consumers through KYC (know your customer) checks and monitor all financial transactions for AML (anti-money laundering), CTF (counter-terrorist financing), and other regulatory compliance. For example, banks typically flag transactions over a certain size (e.g. $10,000) for compliance checking.
Similarly, in the new digital RMB system, consumer KYC needs to be conducted and the on-ramps into digital wallets need to be properly monitored. However, once approved by the system, it is not necessary to further track individual transactions. The PBOC has designed into the framework what it refer to as “pseudo-anonymity,” whereby transactions between consumer wallets are not tracked.
These transactions can in fact be conducted in a peer-to-peer way, completely offline without the presence of internet connectivity through technologies such as NFC (near field communications). As such, the government is actually physically incapable of tracking such transactions at all. In such a way, there has been thoughtful balance of proper regulatory monitoring while respecting consumer privacy.
Internationalisation of the RMB
The digital RMB has catalysed the rest of the world to play catch up with their digital currency strategies. In the Bank of International Settlement’s (BIS) recent third annual CBDC survey, 86% of central banks reported that they are actively researching or piloting the development of their own central bank digital currencies (CBDCs). According to BIS, central banks collectively representing a fifth of the world’s population are likely to launch CBDCs in the next three years. China represents the bulk of this estimation, itself representing 18% or the world’s population.
The Bahamas was the first in the world to issue a live general-purpose CBDC called the sand dollar in October 2020. The most conservative financial ecosystems in the world, including Switzerland, Singapore, Hong Kong SAR, and Germany, are all vying to become ecosystem leaders in this brave new world of digital money. Beyond that, the European Central Bank has announced its intentions to develop a digital euro within the next few years, and the US has accelerated development of its digital dollar strategy.
There is a great deal of media scrutiny about the impending internationalisation of the digital RMB, and whether this would represent a challenge to the existing international monetary system which is currently dominated by the US dollar. There is a sentiment that there is a first mover advantage to implementing a CBDC and would give China’s RMB an asymmetric advantage in competing with the US dollar as a global reserve currency.
However, international reserve currency status depends heavily on the depth, efficiency, and overall dependability of a country’s financial markets, as well as trust in its legal and regulatory ecosystems. China’s financial markets are still in an intermediate stage of development and just beginning to open up more fully to the world. It is simply not realistic that the implementation of the digital RMB would be singularly influential in propelling the RMB to become a dominant global reserve currency any time soon. A much more important consideration is China’s willingness to open up its capital accounts, as market participants will not use a currency that cannot be easily convertible. The decision to allow currency convertibility is a very big decision requiring a nuanced strategy, one that is likely to play out over decades rather than the next few years.
The myopic focus on just US-China dynamics really misses the boat on the broader disruptive impact digital currencies will have on the global economic ecosystem. Digital currencies will render obsolete many of the existing standards and rules of the international monetary system, blurring the lines that define conventional geographies, economies, industries, regulatory regimes, and geopolitics.
In a few years, it will be a foregone conclusion that the international monetary ecosystem will be populated with digital currencies from countries around the world, not just the digital RMB. In such a world, countries will be able to directly exchange digital currencies in a bilateral way and without going through outdated clearing and settlement systems such as SWIFT. The appropriate analogy would be requiring the use of the postal service to transmit information when the world has moved on to email. When the technology allows seamless and instantaneous convertibility from one sovereign currency into another, the practical need for a dominant global reserve currency is obviated.
Scaling CBDCs globally
The 2020 bull market of bitcoin and associated explosion of stablecoins because of the decentralised finance (DeFi) movement has further accelerated global adoption. Stablecoins are privately-issued digital currencies that peg their value to a stable price reference, such as the US dollar or other internationally-recognised currencies. Stablecoins are typically directly asset-backed by real-world assets such as actual fiat currency sitting in a bank account or short-term commercial paper.
These stablecoins are critical for use in cross-border trade settlement as well as settlement transactions of crypto assets such as bitcoin and ethereum. The global market capitalisation of stablecoins has reached roughly $100 billion with a daily trading volume of over $200 billion at the time of writing of this article. Tether’s USDT is both the first issued and as well as the dominant stablecoin in the market, with roughly 60% of the overall market share. Crypto-native stablecoins designs, such as the DAI, are asset-backed by cryptocurrencies and dynamically balanced algorithmically.
Indeed, the global consensus on digital currencies and digital assets has surpassed a critical inflection point with both institutional adoption and massive retail demand. Some of the top global financial institutions, ranging from investment banks such as J.P. Morgan and Goldman Sachs, payment companies such as Visa and Paypal, asset managers such as Blackrock, insurance companies such as Mass Mutual, and endowments such as MIT, Stanford, and Yale, have all mobilised to embrace the world of digital currencies and digital assets. Some projections estimate that as much as $24 trillion in digital currencies may be deployed by 2027, roughly one-fourth of the world’s broad money supply.
Key to enabling the exchange and scaled commercial use of digital currencies is both technology and regulatory interoperability. On the technology side, distributed ledger interoperability has become an important enabler to allow CBDCs that are developed on different blockchain ecosystems to talk to each other. Blockchain interoperability frameworks such as Polkadot, Cosmos, and the Blockchain-based Service Network (BSN) have become key infrastructure enablers to allow these siloed ecosystems to connect more seamlessly with each other.
The regulatory rules for digital currency clearing and settlement across borders are also worth considering. International organisations such as the Financial Action Task Force (FATF) have issued broad guidelines for how transaction metadata needs to be passed along with digital currencies in order to enable compliant financial transactions. By the end of 2022, the G20 members, the IMF, the World Bank and the BIS will have completed regulatory stablecoin frameworks and research and selection of CBDC designs, technologies and experiments. These rules need to be further refined into best practices and implemented.
Already, various world-class financial centres around the world are jockeying for favourable position to lead the charge in developing into the digital asset ecosystems of the future. Switzerland was one of the earliest to establish meaningful frameworks for regulating digital assets. Hong Kong SAR has engaged in testing multi-CBDC interoperability with Thailand and recently added the UAE. Singapore has led the world in developing various use cases and testbeds for digital assets after successfully completing Phase 5 of Project Ubin. The imminent commercialisation of this project aims to make Singapore a global clearing house of digital currencies, recently announced in partnership between Temasek, DBS, and J.P. Morgan as a new company called Partior. In short, the international monetary system is already rapidly evolving into a more multi-polar decentralised ecosystem driven more by practical bilateral trade dynamics and less dominated by geopolitical considerations.
Importantly, the current dynamics allow for the international monetary system to evolve in a graceful way as many of the critical global economies and trade blocks around the world all simultaneously adopt digital currencies over the next few years. Every country, no matter how dominant or modest, can have a seat at the table and participate in a more resilient global economy without friction or lack of access.
Critically, this new international monetary system would not only just be available to traditional financial institutions but also to participants representing the whole spectrum of the economy, notably small to medium enterprises as well as the two billion individuals who are currently unbanked. Universal access to cross-border payment and remittances, banking services, as well as financial investment products will allow the whole world to participate in the globalised economy in a much more fair and equitable way.
The brave new world of digital money is on the horizon, just in time to help provide more resilience to the international monetary system, connect the world economies more harmoniously, and driving massive financial inclusion for the benefit of all global society.
By Michael Sung, co-director of the Fudan Fanhai Fintech Research Center at Fudan University, and Charles Chang, member of the finance faculty at the Chinese University of Hong Kong
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