In-depth | Five “cans” and “cannots” of central bank digital currency

Author: Yang Xiaochen, Researcher at the Center for Global Economics and International Finance, Institute of International Finance, University of Science and Technology of China

According to media reports, the central bank's digital currency is currently being piloted by some large state-owned banks in Suzhou and Xiong'an, which has attracted great attention from the market. The central bank's digital currency is referred to as DCEP (Digital Currency Electronic Payment) or CBDC (Central Bank Digital Currency). Judging from the current public statements of the central bank, it is positioned as an attempt to digitize paper money, mainly used to replace M0.

There are many different opinions on DCEP in the market, and the discussion angles are quite diverse. Some moderate views believe that it is launched more as an official payment method to ease the impact of third-party payment platforms such as Alipay and WeChat on the traditional banking industry; other radical views believe that the central bank's move is to use technical means to overtake, which may challenge the status of the US dollar and end the US dollar hegemony. The author believes that the application scenarios are the surface and the technical capabilities are the inside. By sorting out the real capabilities of DCEP, a more objective conclusion may be drawn.

1. Overall structure and business process

1. Overall structure

The central bank has previously built a prototype system for digital currency, emphasizing that the overall structure of the digital currency system is "one currency, two databases, and three centers" (Yao Qian, 2018). Specifically, "one currency" refers to the central bank's digital currency, which is the core and purpose of the entire system. "Two databases" refer to the "digital currency issuance database" and the "digital currency commercial bank database." The two are databases for the central bank and commercial banks to store digital currency data, respectively, and are maintained by the central bank and commercial banks, similar to the central bank's issuance database and commercial bank business database in the process of paper currency issuance. The "three centers" include the authentication center, the registration center, and the big data analysis center. The main function of the authentication center is to authenticate user identities and issue certificates. The registration center is responsible for the registration of the entire process of digital currency (issuance, transfer, withdrawal, etc.), and publishes the registration results through a distributed ledger. The big data analysis center is an important component of the risk management of the entire system, responsible for KYC (Know Your Customer), AML (Anti-Money Laundering) and other tasks, and can add other risk control functions as needed.

The prototype system demonstrates several basic concepts of the DCEP system. First, the system adopts a "central bank-commercial bank" binary issuance architecture, which can avoid the impact of the central bank on commercial banks when facing end users directly, and reuse the existing infrastructure of banks. Second, in the future, digital currency registration will most likely adopt a distributed ledger method, and synchronize between different databases of the system in a blockchain-like manner. Third, the issuance of digital currency in the prototype system adopts a mode of equal exchange with commercial bank deposit reserves, that is, the issuance of digital currency corresponds to an equal deduction of deposit reserves, and the withdrawal of digital currency corresponds to an equal increase in deposit reserves. This process is consistent with the current paper currency issuance procedure, and further clarifies the concept that digital currency only replaces M0 and does not affect the total amount of currency issuance. Fourth, the system includes an interface with the digital bill trading system, which is intended to realize the DVP (delivery versus payment) function of digital bill trading. This shows that although the central bank currently states that digital currency will not appear with smart contracts, it does not prevent it from actively participating in the market application of smart contracts as a payment medium.

The above prototype system results were released to the public in 2018. In August 2019, the Digital Currency Research Institute of the Central Bank submitted a series of patent applications directly related to the structure of the digital currency system, covering the main links of currency generation, circulation, verification, recovery, and quota issuance.

Figure: Simplified structure of the central bank’s digital currency prototype system

Image source: Drawn by the author after appropriate simplification based on the "Experimental Research on Central Bank Digital Currency Prototype System".

The new system has four nodes: the central management system, the digital currency delivery system, the quota control system, and the currency terminal. Among them, the central management system is responsible for receiving the currency generation request from the digital currency delivery system and allocating the digital currency quota according to a series of verification rules. After sending the request and being approved, the digital currency delivery system is specifically responsible for generating digital currency and sending it to the currency terminal. The quota control system is responsible for verifying the quota voucher sent by the central management system to the digital currency delivery system, and applying different rules to check whether the obtained quota exceeds the preset standard. The currency terminal is the carrier for users to receive and use digital currency.

The digital currency release system and the quota control system together constitute the "first release system". The first release system is combined with the central management system to form the "second release system".

Compared with the prototype system, the new system model further clarifies the functions of each node. Although the description of the new system does not clearly state the relationship between each node and the original "two banks and three centers", a reasonable guess is that the central management system is located on the central bank side, the first release system is located on the commercial bank side, and the currency terminal is located on the end user side. The functions of each node are reintegrated to a certain extent with the original design.

Figure: Patent application proposal for the central bank’s digital currency system

Image source: Drawn by the author after appropriate simplification based on relevant patent disclosure content.

The author believes that the prototype system and the new system are not simply upgraded, but each has its own focus. The prototype system focuses more on the modeling of the internal functions of the central bank of the digital currency system, outlining the general picture of the internal system. In the new system, how to model the commercial bank side of the system has become the focus of attention. A series of patents mainly focus on how the "first release system" interacts internally and how to transmit information to the outside. The central management system representing the central bank side is in a secondary position in the discussion. From this perspective, combined with the time progress, we can reasonably speculate that the prototype system architecture provides a model basis for the research and development of the formal system within the central bank, and a series of patent specifications are launched in the early stage of commercial bank research and development, so as to make a relatively general provision of the system interface and interaction process, and guide the research and development work of commercial banks. Of course, the actual system is still in the research and development test stage, and the system framework and interaction process are still highly confidential. The final form of the system may not be carried out according to the two publicly available system models. We can only speculate based on the existing public information.

2. Business Process

From the perspective of business processes, the new system is more of a refinement of the business processes of the prototype system. Taking the issuance process of digital currency as an example, the prototype system description only mentions that commercial banks must first submit an application for digital currency, and after approval by the central bank system, they will withhold deposit reserves to the currency issuance fund. After that, the central bank system will send an equal amount of digital currency to the commercial bank's digital currency issuance library, completing the issuance procedure. In the new system, operations such as withholding reserves are downplayed, and the relevant quota approval process is emphasized. Specifically, the digital currency issuance system submits a currency generation request to the central management system. After multi-dimensional verification and preset condition approval, the corresponding quota voucher is issued back to the issuance system. However, this does not mean that digital currency can be generated. Instead, the quota voucher must be transmitted to the quota control system corresponding to the issuance system for quota verification. If the verification result shows that the approved quota does not exceed the preset quota limit for the issuance system, a quota control bit is generated to instruct the currency generation module in the issuance system to generate digital currency and transmit it to the currency terminal.

It is not difficult to see from the process that the currency generation process of the prototype system completely imitates the production and transportation process of paper money, that is, the complete digital currency is generated by the central bank system and then transmitted to commercial banks as a whole. Commercial banks are only responsible for receiving, verifying and distributing to customers. However, the process of the new system is that the central management system issues quotas to each digital currency delivery system, and the specific production process is moved down to each delivery system, which reduces the burden of the central management system to a certain extent and is more in line with the characteristics of digital currency being non-physical.

It is worth mentioning that the new system demonstrates a completely new circulation method that is completely different from traditional paper money and Bitcoin. Paper money circulation is based on physical delivery. Bitcoin completes transactions by uploading transaction records to the blockchain and confirming them through the consensus mechanism of mining. DCEP transactions take a different approach. The old holder applies for transactions to the delivery system. After approval, the digital currency is not transferred to the new holder, but the old currency is destroyed and the new holder generates an equal amount of new currency. This allows the system to achieve an appropriate compromise in terms of traceability and storage space requirements, which is also an important aspect that distinguishes DCEP from existing digital currencies such as Bitcoin.

2. What DCEP can and cannot do

Central bank-led, blockchain, trade war, RMB internationalization, Libra, currency circle... These labels seem to be more or less related to DCEP. In addition, there is a certain distance between technological innovation and the daily cognition of ordinary people, which naturally produces a mysterious effect of various opinions. Based on the above technical analysis and other information publicly released by the central bank, the author will analyze the real capabilities of DCEP in response to hot issues of market concern.

1. DCEP can protect privacy, but it cannot be completely anonymous

DCEP is mainly positioned to replace M0, and paper money has become its main replacement. The circulation process of paper money is almost traceless, which also brings the characteristics of anonymous paper money payment and no replacement if lost. On the one hand, this provides convenience for protecting citizens' daily personal privacy, but it also becomes a hotbed for some illegal transactions. Although big data technology has enabled large cash transactions to be traced through the serial numbers on banknotes in recent years, there are still large blind spots.

DCEP itself is a string of numbers that carries the holder's personal identity authentication information. In the case that each transaction link requires system confirmation, every node that a DCEP goes through from creation to extinction will theoretically be recorded. These records are strictly encrypted and will not be obtained by unauthorized institutions, so the user's privacy can be fully protected. However, if the user is involved in illegal activities, the flow path of his funds can be fully presented, which will provide a powerful weapon for combating illegal crimes. Therefore, what DCEP achieves is "limited anonymity", that is, anonymity to the public and visibility to authorized law enforcement agencies. This is an important feature that paper money does not have.

2. DCEP can make the payment market more competitive, but it cannot completely replace WeChat, Alipay, etc.

3. DCEP can make a large number of transactions more intelligent, but it will not directly carry smart contracts

However, in the prototype system, the central bank has added the interaction between DCEP and the digital bill exchange, mainly to realize the function of bill payment in bill transactions. This shows that DCEP has considered the use of digital media to optimize various existing transactions at the beginning of its design. In other words, DCEP is naturally a high-quality carrier for intelligent transactions. Although it cannot directly carry smart contracts, it does not prevent DCEP from participating in the optimization process of various current transactions only as a liquid currency. Its distributed accounting, offline payment and other functions can indeed improve the reliability of transactions in quite a few application scenarios. Therefore, DCEP is likely to become an important component of various intelligent transactions.

4. DCEP can help the internationalization of the RMB, but it is difficult to significantly affect the dominant position of the US dollar

The author believes that the international status of a currency depends mainly on the country's comprehensive national strength and economic stability, rather than on the form of existence of the currency itself. It is true that the central bank's digital currency can greatly enhance the convenience of the RMB in the field of electronic payments. But it should not be ignored that convenience is only one of the factors people consider when using a certain currency. In addition, factors such as the stability of the currency value itself and the degree of recognition of counterparties are equally important. It is undeniable that although the US economy has experienced greater fluctuations this year under the dual pressure of the new crown epidemic and the oil crisis, the US dollar is still the most important currency in the international market. It is indeed a good wish to weaken the hegemony of the US dollar. However, hard work and strengthening one's own strength are the only way to enhance the international status of the RMB. It is not appropriate to place too many extraneous implications on the innovation of the circulation form of the RMB, which is beyond the design capabilities of DCEP itself.

5. DCEP can improve the efficiency of monetary policy transmission, but it cannot solve the financing problems of small and medium-sized enterprises once and for all.

However, we should also see that the problem of financing difficulties and high costs for SMEs originates from China's financial market structure dominated by indirect financing. It is a complex structural problem that has been formed over a long period of time and is difficult to change substantially in a short period of time. Therefore, the improvement in the observability of M0 has not touched the root of the problem, nor can it be cured. For the sake of risk control and management costs, the concerns of commercial banks in SME business still need systematic reforms to gradually resolve. As a perception channel, DCEP can provide the necessary data support and innovation basis for such reforms, but it is undoubtedly beyond its capabilities to expect DCEP to directly solve the problem.

3. DCEP brings a new perspective to currency management

DCEP is an attempt to digitize the RMB, but it is not just about transferring physical banknotes online into virtual form. It also gives it many innovative perspectives through a series of system designs, bringing new possibilities for monetary management.

1. The monitoring of capital flow will be able to shift from post-event statistics to pre-event and in-event approval.

This improvement in capabilities means that currency management is no longer limited to post-event supervision, greatly enhancing the real-time nature of management. On the other hand, it also greatly improves the precision of management, and in theory, it can be down to each specific transaction. Traditional post-event reports can only count the total amount and cannot cover paper currency transactions. In the future, currency management will most likely shift from post-event statistics to real-time monitoring before and during the event, which will greatly improve management methods.

2. Monetary policy will have the ability to fine-tune in real time, gaining new leverage in terms of timeliness and path control

To solve this problem, the central bank patent explores a new model: the central bank issues digital currency to financial institutions, but sets it to an ineffective mode, which is equivalent to issuing a standby quota. If a financial institution needs to use the quota (issue a loan, etc.), it needs to send a currency effectiveness request to the central bank. After receiving the request, the central bank reviews the request based on real-time economic conditions, money market conditions, flow entities and other conditions. If the application conditions meet the usage conditions agreed by the central bank at the current time, the corresponding quota will be set as effective, and the financial institution can truly complete the business launch, and the central bank has officially completed the money launch.

The biggest feature of this model is that it moves the monetary policy decision-making point to the time when the money is actually released to the end user, avoiding the problem that the previous decision is not suitable for the current time point after a long transmission path, and using the unique advantages of digital technology to provide a new idea for the implementation of monetary policy. Under this framework, the verification conditions involved have greater flexibility, and can accurately guide and constrain the release conditions of financial institutions from many angles such as interest rates, release objects, terms, and quotas. The transmission and implementation of monetary policy will undoubtedly enter a new stage.

From the description, the concept of currency involved in this model is not limited to M0, but can be extended to the M2 field, so it may not completely correspond to DCEP. In the early stage of application, DCEP should mainly replace paper money to realize payment functions, and other functions may not be tried in the short term. However, this model is an interesting new idea, which may bring new implementation tools to monetary policy.

3. The relationship between monetary policy and fiscal policy may need to be re-examined

The emergence of DCEP may bring a new turn to this issue. Since DCEP can realize the above-mentioned functions of prior approval and precise delivery, monetary policy will go directly from total control to investment direction and structural control, that is, the functional gap with fiscal policy will be significantly narrowed. In this case, the relationship between monetary policy and fiscal policy has undergone a fundamental change compared with the traditional view. The boundary between the two is also becoming increasingly blurred. From the perspective of policy research, how the functions of the central bank and finance are divided, and how monetary policy and fiscal policy can be rebuilt from a new perspective. The coordination model may be a new topic we are about to face.

In summary, the central bank's digital currency is currently positioned as a digital replacement for M0, but through a technical review, it is not difficult to find that it has many unique advantages over paper money. The author believes that digital currency will indeed bring new opportunities and challenges to currency management, but the market should view it objectively, respect its technical limitations, and not impose too many additional expectations and burdens on it. At the same time, the promotion period of new technologies often brings new scams. We must guard against new types of hype and fraud in the name of the central bank's digital currency, and prepare for China's healthy path to currency digitization.

Author's note: This article was first published on FT Chinese on April 28, 2020. Please indicate the source when reprinting.

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