Article/ Li Guoquan, Professor of Financial Technology and Blockchain, Singapore Sun Yue Social Sciences University, and Yan Li, Senior Lecturer, Department of Strategy, Nanyang Business School, Nanyang Technological University, Singapore
In recent years, countries around the world have attached great importance to the development of central bank digital currencies. This paper outlines the important position of central bank digital currencies in the future development of digital economy, and explains the design ideas and best practices of central bank digital currencies from a global perspective. At the same time, suggestions are made for the future development of digital currencies and the digital economy. The paper argues that Asian countries should cooperate more closely in the digital economy and digital finance to further solidify their leading position in this field.
The International Monetary Fund (IMF) has defined the global crisis caused by the new coronavirus pneumonia (Covid-19) as “The Great Lockdown”. The world’s major economies have been hit hard by the outbreak. We found that countries and regions with a strong national discipline were better able to implement measures against the epidemic and achieved more remarkable results; at the same time, countries and regions with a well-developed digital economy were less affected during the epidemic and recovered more quickly. The importance of the digital economy was fully reflected in the epidemic.
Countries with more remarkable results in fighting the epidemic, such as China and Singapore, actively fought the epidemic on the one hand and worked hard to ensure smooth economic operation and the implementation of major policies on innovation on the other. The epidemic has greatly contributed to the development of Singapore’s digital economy, with frequent interactions between key economic sectors in Singapore and China during the epidemic, especially in areas related to the digital economy, such as the digital currency sector. In the future, the two countries can continue to strengthen cooperation in the area of digital finance and Central Bank Digital Currency (CBDC) (e.g. starting from retail payment business) and replicate the successful experience to ASEAN countries.
In recent years, countries around the world have placed a high priority on the development of central bank digital currencies. 2020, the Bank for International Settlements reported that more than 80% of member countries are conducting research on central bank digital currencies. Among them, Cambodia and the Bahamas have issued central bank digital currencies for retail operations, Ukraine, Uruguay and Ecuador have largely completed testing, and six other countries, including China and Singapore, are in the final stages of validation and testing.
The development of central bank digital currencies in each country, however, requires countries to clarify the attributes of their respective central bank digital currencies, as well as consider the payment system arrangements that accompany them. Asia is currently leading the way in this area, and European countries are also actively researching it, and there have been some successful attempts.
The history and current status of central bank digital currencies
Government control over money can be traced back to ancient Egypt, more than 4,000 years ago. The Swedish central bank (Sveriges Riksbank) is the world’s oldest central bank and has managed the Swedish monetary system since 1668. The Wisselbank in the Netherlands laid the foundation model for the modern central bank, whose key role is to provide the financial system with risk-free money and secure payment methods, both retail and wholesale. Although legal tender has not been around for very long in the true sense, it has evolved from simple cash and banknotes to a broad concept through different forms of payment, which also includes digital currencies now issued by central banks.
It is difficult to give a precise or widely accepted industry definition of a central bank digital currency. The International Monetary Fund defines it as “a digital representation of a sovereign currency issued by the central bank or monetary supervisory authority of a jurisdiction”; the European Central Bank defines it as “a central bank currency that is managed by the central bank and used by the public in electronic form “The Bank for International Settlements defines it as “a digital form of central bank money that is different from the balance in a traditional reserve or settlement account”.
In a traditional centralized trust system, financial institutions create money by providing third-party trust, thereby guaranteeing them excess profits in this highly complex payment system. This creates competition between different stakeholders, and the result is counter to the original intent of “risk-free and secure”. The emergence of digital currencies presents a new opportunity to improve the traditional payment system. It is safe to say that the separation of the wholesale and retail payment systems will be rewritten. A number of central bank managers and scholars have suggested the use of distributed ledger technology and blockchain technology to design and structure central bank digital currencies and their payment systems. A central bank digital currency can be understood as a digital pass-through issued by a central bank or monetary regulatory authority that has the same status as a fiat currency. The difference with fiat currency is that the central bank digital currency allows users to store the value of the central bank currency directly and pass the value directly to the third party they want to pay, thus freeing them from the dependence on commercial banks in the original payment system and achieving “de-mediation” in a real sense.
Thus, the central bank digital currency can improve payment efficiency, support payment innovation, meet the future payment needs in the digital economy, and enhance the accessibility and convenience of the central bank currency. That is, the creation of central bank digital currency can both reduce cash circulation and solve the problem of cash shortage, act as a better cross-border payment infrastructure, and build a more resilient and risk-resistant payment system.
Another major reason for countries to actively research and experiment with central bank digital currencies is to circumvent the challenges of stablecoins such as Libra. Facebook and its sub-brand social media have over 2 billion users worldwide, and once users accept Libra, it is likely to expand rapidly around the world, possibly leading to a repeat of Facebook’s domination of Western social media, “riding alone” in the digital currency space, and possibly even It could even significantly weaken the position of some countries’ central banks. This has led central banks to accelerate the demonstration and development of central bank digital currencies.
However, not all central bank digital currencies will use distributed ledger and blockchain technology, and there is still debate about the pros and cons of using this emerging technology. Singapore’s Project Ubin, which aims to launch a central bank digital currency based on blockchain and distributed ledger technology for wholesale operations, primarily for interbank and inter-country clearing operations, is in its fifth trial phase and has already conducted validation experiments with countries such as Canada. The digital Singapore dollar is essentially a pass-through government security that can be used for payment and value storage for wholesale business, utilizing distributed ledger technology to enable peer-to-peer payments without banks as intermediaries. China’s Digital Currency Electronic Payment (DCEP), which is being tested, does not use blockchain technology, but borrows the design idea from Bitcoin’s UXTO (Unspent Transaction Output) The design idea is based on Bitcoin’s UXTO (Unspent Transaction Output) bookkeeping method. Currently, the digital renminbi mainly emphasizes retail business to meet the needs of personal and commercial payments, and it can also enable offline peer-to-peer payments, which is exactly the same as the function of cash.
Unlike payment systems and international settlement systems in traditional financial systems, central bank digital currencies and their payment systems are very diverse in design, with Thailand, Cambodia, Japan, Hong Kong, China and Canada all adopting different approaches to designing their digital currencies. Different designs bring different benefits and of course potential risks, the implications of which are not yet fully understood and are subject to further study by academics and industry. But some benefits are clear: central bank digital currencies allow for offline transactions similar to physical cash; allow for value transfers via e-wallets; can be used without an account or connection to any financial institution and without docking any debit or credit cards; ensure and enhance the efficiency and security of the payment system without the need to settle through a clearinghouse or real-time settlement system, while Ensures more accurate recording of economic activity not currently included in national accounts statistics; can withstand the impact of other non-sovereign cryptocurrencies on the fiat currency system, thus avoiding weakening the influence of fiscal policy; enables better tax collection; reduces the cost of manufacturing and circulating physical banknotes and coins; better protects privacy while having the ability to manage anonymity to prevent money laundering, terrorist financing, tax evasion, and terrorist financing, tax evasion, and other criminal activities; enable the use of digital or smart contracts to reduce the cost of trust; and enable inclusion and provide better access to financial services for a wide range of people who do not have access to financial services or adequate financial services in traditional economies.
Digital currency: different perspectives and practices in Europe and Asia
Central banks in developed economies are focused on maintaining the stability of economic development and the effectiveness of monetary policy. While reduced cash usage will drive the development of electronic payments in Europe, existing regulations, legal tender systems and payment channels can sway the innovation of digital currencies and payment systems. At the same time, Europe’s monetary system and payment systems are relatively well established, so it will take a big leap of thought to revamp this system.
Although the Bank of England initiated global discussions on the prospect of introducing a central bank digital currency in 2017, it was not until 2019 that the Swiss financial markets regulator “dared to be the first”, with Switzerland becoming the “first to eat”, in a way that ensured no Switzerland was the first country to take the plunge, issuing two cryptocurrency banking licenses, while ensuring no major impact on the traditional payments sector, by establishing guidelines for payments via blockchain systems and strict measures to combat money laundering on the blockchain. The two crypto banks are Sygnum and SEBA, which can offer services related to cryptocurrencies. One of the main services is the management of private keys for cryptographic digital currencies, which requires the development of a whole new set of crypto compliance management processes. As algorithms and cryptographic governance evolve, such “banks” are enabling users to communicate with cryptocurrencies through open Application Program Interface (API) and Decentralized Application (DAPP). DAPP) to enable decentralized data exchange between users and crypto banks. Although it is not yet possible to achieve distributed trust in the full sense, the emergence of such new entities in the cryptographic digital currency space to provide private key management trust services is a significant development in itself. While it is not yet disruptive, it is a new business model that challenges the business model of commercial banks in the traditional financial industry.
The Swiss financial market regulator recognizes the innovative potential of “trust transfer”, but only applies the laws and regulations of the traditional financial markets to financial activities in the new cryptocurrency space in a technology-agnostic way. It does not allow cryptocurrency banks to circumvent the existing regulatory framework, with a particular emphasis on combating money laundering and terrorist financing. Because the inherent anonymity of distributed ledger and blockchain technology increases such risks, the use of blockchain technology for financial activities related to cryptographic digital currencies requires strict compliance with the International Financial Action Task Force (The Financial Action Task Force, or FATF) guidance on financial services. Institutions under the supervision of the Swiss Financial Market Supervisory Authority are only allowed to send cryptocurrencies or other passwords to an external wallet belonging to their own customers, whose identity must first be verified, and are only allowed to receive cryptocurrencies or other passwords from this authenticated external wallet. Both crypto banks also offer their services only to institutional and professional clients. Despite these limitations, it is still considered a huge leap forward for Europe in the digital economy and digital payments.
To the surprise of many observers, Asia is advancing the digital economy and digital payments at a much faster pace in terms of revisions and codification of laws and regulations, technological innovation and application trials. Back in 2014, the People’s Bank of China was one of the first major national central banks in the world to focus on the future prospects of digital currencies and to launch a digital currency research group. Singapore was the first country in the world to initiate and launch an open-source central bank digital currency. Several major international banks, such as Merrill Lynch, Credit Suisse, HSBC, JP Morgan, Mitsubishi Financial Group, as well as two local Singaporean banks and several blockchain companies, are involved in Singapore’s central bank digital currency Umin Island project. Meanwhile, Japan’s Financial Services Agency (FSA) clarified the legal status of bitcoin and other digital currencies in the country’s Payment Services Law, confirming that bitcoin and several cryptocurrencies are legally recognized payment methods in the country. With active promotion from Asian countries, the International Monetary Fund began studying the potentially innovative nature of digital currencies (crypto assets) in 2018 and publicly supported CBDC’s innovative payment solutions.In 2019, the World Bank also issued pass-through debt.In October 2020, China’s CBDC project Digital Currency Electronic Payments (DCEP) launched live testing; Cambodia officially launched central bank digital currency Bakong; and in November 2020, Singapore’s DBS Bank announced the launch of its digital asset ecosystem. Meanwhile, the legal validity of electronic signatures was confirmed in the newly signed Regional Comprehensive Economic Partnership (The Regional Comprehensive Economic Partnership, or RCEP), driven by Singapore and China, which will greatly accelerate the cross-border digital economy and digital payments in the signatories of the agreement This will greatly accelerate the development of cross-border digital economy and digital payment in the signatory countries of the agreement.
Central Bank Digital Currency Design Ideas
The three basic aspects of digital currency design are assets, payments, and applications. Most international discussions have focused on the first two aspects, with the exception of the People’s Bank of China, which has mentioned the use of a central bank digital currency for the pass-through of currently untraded services and goods. One thing that needs to be made clear is that while most CBDCs and China’s DCEPs can usually be considered legal tender, there are actually significant differences between central bank digital currencies and legal tender digital currencies. To date, the People’s Bank of China has never officially referred to DCEP as a legal tender, but only as a digital currency. one of the purposes of DCEP is to stimulate trade in services and goods, and the central bank has given DCEP enough flexibility to facilitate the flow of products and services that are not currently actively traded in the marketplace. There are important components of economic activity that are not yet included in statistical calculations of real gross domestic product (GDP), but which may account for a significant portion of economic activity, particularly in China, where there are long-standing and significant cash transactions, such as time-based services and the flow of stable proof of assets with underlying value, that can be pass-through. So, while early discussions in China on CBDC centered around payment functions, more recent discussions have shifted to legal tender in the form of digital pass-throughs and assets. Research has gone beyond the simple concept of money, speculation and prevention of speculation, and has extended to “pass-throughs as a form of money”, which can be a measure of value, a means of circulation, a means of storage, a means of payment, and even a future world currency. This meets all the theoretical characteristics of “money”, which must be durable, portable, divisible and difficult to counterfeit. The People’s Bank of China has expanded the discussion to include pass-through services and illiquid commodities.
The pass-through of assets and services, and peer-to-peer payments, are the most important potential innovations in digital currency design. Any form of asset and service can generate a pass-through associated with it, giving value through the tangible asset, legal entity status, physical object or everyday service associated with it. Digital currencies or pass-throughs can be incentives to be created in the form of assets, rather than liabilities in the traditional sense of fragmentation. Peer-to-peer payments allow for the direct transfer of value between the parties involved in economic activity, without the need for a third party to participate and provide trust services.
Previous discussions have focused on improving the efficiency of existing regulated entities (e.g. banks) by creating decentralized payment systems between providers of services to improve the efficiency of back-office clearing and settlement processes. End users do not need to understand digital currencies and distributed ledger technology, but such entirely new mechanisms have already changed the way assets are stored and how payments are executed. Society’s perception of money will gradually change, and economic activity that was not accounted for in GDP statistics will be recorded very accurately. These latest discussions have gone beyond earlier ideas for a central bank digital currency and have greatly expanded the scope of thinking about the design of a central bank digital currency. The People’s Bank of China has intentionally left the second tier of the architecture (the first tier is responsible for creating and issuing digital currencies) to the private sector to allow companies to innovate and work hand-in-hand with the central bank. While China’s DCEP architecture design is considered a best practice in central bank digital currency design, not all central bank digital currency research teams agree and adopt such an approach.
The design of central bank digital currencies typically considers a two-tier (Two-tier) architecture: the first tier is the method of currency issuance, i.e., how the digital currency is issued; the second tier is the method of payment between wholesale banking and retail. The central bank can adopt a fully centralized governance approach or allow the payment system to operate in a decentralized manner once the digital currency is in circulation.
The main pain point of cash or cash in circulation (M0) is the high cost of printing, withdrawing and storing associated with issuing it as physical money in the form of bills and coins. Physical cash lacks portability, traceability, inadequate anonymity management features, and is susceptible to counterfeiting and exploitation for money laundering, terrorism financing and several other criminal acts. At the same time, existing non-cash payment instruments (e.g., credit cards, debit cards, Internet and online banking application payments) are not likely to replace M0, as these rely on trusted third-party payment services. In addition, none of these payment methods can support offline and anonymous payment services. The main advantage of using Bitcoin UXTO is the ability to make offline payments, anonymous escrow and peer-to-peer payments without a centralized ledger. We can think of this design as a new “M0.5” concept. Because it retains the peer-to-peer offline anonymity of M0, but with traceability, which is similar to M1. This “M0.5” could replace M0 with the added advantage of anonymous custody, but most central bank designs, with the exception of the Chinese central bank, lack this “M0.5” concept.
There is no necessary conflict between decentralized ledger technology and the centralized governance of central banks. The “M0.5” concept combines the best features of a distributed system such as blockchain with the centralized governance of a central bank very well. While blockchain technology does not rely on centralized forms of governance, it does not necessarily mean that centralized governance is antithetical to distributed operations. If designed properly, blockchain and distributed ledger technologies can effectively integrate distributed operations to better enable centralized governance and control of CBDCs. There is no necessary conflict between the two.
China then attempts to achieve this balance by utilizing a three-tier generic framework to understand and design its CBDC: the first tier decision is the issuance of the CBDC; the second tier decision is the core of the linked users – the satellite payment system; and the third tier decision is the authentication, registration and query functions. The design of other central bank digital currencies could draw on Chinese best practices.
The first layer can choose between centralized or distributed technology, determining the issuance of a digital currency secured by the central bank. This layer would only allow the central bank to create and issue digital currencies or pass-throughs. However, it is also possible to create these digital currencies on a unimodal or multimodal blockchain or distributed ledger at a core node controlled by the central bank.
The second layer is the underlying payment system. The core nodes of this system can be controlled by the central bank, while other nodes can be managed directly by retail companies or delegated to commercial and wholesale banks for management. The core node of the central bank can be regarded as the cash operation management system of the central bank, and the satellite nodes of the users can have their own payment systems on the cloud. Also, the system design can be completely split into two parts, with 100% reserve accounts and partial reserve accounts co-existing. The latter can create new credit mechanisms.
The third layer includes three clients: pass-through, registration, and system query and analysis. Whether the issuance is based on actual assets or on liability items in the balance sheet, pass-throughs are designed to control the total amount of issuance.
To make central bank digital currencies more attractive and accessible to more businesses and individuals, the new system must be more convenient and less risky than the current payment system. Therefore, several points should be key to the design of a new generation of CBDCs: first, central bank digital currencies should be government-guaranteed and have a clear legal tender status. Not all digital fiat currencies are legal tender, and the central bank digital currency must be directly backed by the government to ensure universality. Second, the use and preservation (deposit) of the central bank digital currency should be independent of the credit risk of financial institutions, even if different institutions are authorized to operate the central bank digital currency, the risk is different among financial institutions. If there is a link to the risk of financial institutions, there is a risk of a run or other usage problems. Finally, cooperation between the public and private sectors is critical to the design of a new central bank digital currency. From both a technical and social perspective, the collaborating parties should not assume that they unilaterally hold the solution for system scaling (up-scaling). At the same time, it is important to leave room for innovation in a strict regulatory environment for cross-border remittances and exchange.
The Board of Directors of the Bank for International Settlements (BIS) has established BIS Innovation Centers with Switzerland, Hong Kong, China, and Singapore with the goal of fostering international cooperation among national or regional central banks in innovative financial technology: first, to identify and gain insight into key trends affecting central bank technology; second, to develop public products in the area of technology to improve the functioning of the global financial system; and third, to serve as central banks’ innovation nodes of a network of experts. To better understand what non-central solutions are the most acceptable design solutions for national banking systems, central banks share research results on the above-mentioned platform, and many countries provide open source code for their respective test projects. Now that a new round of private payment solutions is beginning to emerge, the issue is even more pressing for countries, as innovation in these private payment systems may leave existing financial institutions unable to keep up with the changes. As a result, the Central Bank of China and the Central Bank of Singapore have introduced a number of private sector companies to participate in the design process.
The complexity of the structure of central bank digital currency payment systems and the constraints of internal and external conditions have caused the progress of design development, validation testing and actual roll-out for use to vary from country to country. The peculiarities of China’s financial environment as the world’s second largest economy have accelerated the design development and validation testing of DCEP. Currently, China’s DCEP system does not involve international trading instruments. At the same time, the increasing adoption of RMB denomination in international trade has brought more advantages and urgency to DCEP. Another important fact is that RMB internationalization policy needs to exert some control over the RMB exchange rate and its reserves. On an international scale, central banks in mature financial centers and many developed countries do not dare to test the risk-resilience of central bank digital currencies easily and therefore delay their launch because of the incalculable cost of loss and the damage to international reputation in case of service disruption after the launch.
As discussed earlier, centralized governance and decentralized operations are not only compatible, but also mutually reinforcing. The purpose of a central bank is to provide a fair, secure, and efficient payment system for both the retail and wholesale sectors. The design architecture of China’s DCEP fully reflects the unification of the two forms.
We have always believed that the digital economy and fintech will definitely evolve towards pervasiveness and decentralization. However, the 6D attributes of blockchain and distributed ledger technology have also been fully reflected in all aspects of fintech, namely Digitalisation, Disintermediation, Democratisation, Data Privacy , Decentralisation and Selflessness. Decentralisation and Disappearance, which should also be the design principles of the central bank’s digital currency. In the digital economy, the current successful companies have taken the first three points to the extreme, but we have seen frequent data security incidents and a high degree of industry centralization that has produced mega-applications with almost monopolistic positions.
Recently, countries around the world have been taking some corresponding measures against potential monopolies in the digital economy. in November 2020, China’s State Administration of Market Supervision and Administration (SAMSA) issued the “Anti-monopoly Guidelines on the Platform Economy (Draft for Comments)”. A fully centralized third-party payment system can easily lead to a situation of “big, but not down, winner takes all”. As the digital economy evolves, central banks are concerned that private sector payment systems may take advantage of their unique market position to increase fees and raise lending rates. If the public relies exclusively on private money or third-party payment systems, there could be significant risks in terms of privacy protection and data security.
Therefore, the future of the industry must be to work on the latter three points. The CBDCs in China and Singapore both adopt a centralized governance and decentralized operation architecture. Centralized governance safeguards system security and enhances data and privacy protection; decentralized operation allows banks and other private parts to fully participate and continue to innovate. The open design of the second layer of China’s DCEP is also the best expression of the “no-self spirit”, because DCEP or CBDC should not be a digital version of the original monetary system and payment system, i.e. it is not intended to squeeze the existing “third-party payments” or to CBDC and the existing digital payment system can fully compete, and the first layer of DCEP is the infrastructure, while the second layer is the “fertile ground” for financial institutions and other private sector enterprises to “compete in the Central Plains. “. With China’s DCEP trials in Shenzhen and Suzhou, more than 6,000 private sector companies have participated, including some U.S. companies such as Walmart, Starbucks and McDonald’s. At the same time, China is also actively building a global Block-chain-based Service Network (BSN) to launch an interoperable blockchain federation network.
Recently, there have been more and more discussions about DCEP going to sea. As early as the design of DCEP was launched, I believed that, as a new payment system, it would definitely complement the RMB internationalization policy in the traditional financial system and promote the “Belt and Road” economic belt and the “21st Century Maritime Silk Road” in a two-pronged way. Singapore’s system advantages in the field of public and federated chains are particularly obvious, and the Singaporean industry’s understanding of DCEP with RMB internationalization is “one belt, one road, one initiative”, “one network, one financing One Network, One Certificate”. Singapore looks forward to working with China to build a “21st Century Digital Silk Road for the Global Economy” and believes that the digital Singapore dollar will play an active role in this cooperation.
The new pneumonia epidemic since 2020 could trigger further financial crises and massive corporate bankruptcies. The public will suffer as a result, and payments and settlements to some financial institutions are likely to be disrupted. As we saw in the 2008 global financial crisis, the lessons are profound as a result of the massive bank failures and the collapse of the international letter of credit system, which led to a severe trade and supply chain contraction for nearly three months worldwide.
Ultimately, central bank digital currencies are a unification of legality and convenience, innovation and regulation, cost and security. A central bank digital currency will also improve the efficiency of the international payments system, but at the same time, regulation must evolve with the times. Decentralization and universality will be the main direction of future development.
In the next 10 years, we will open the door to the fourth industrial revolution. Digital currencies and payment systems will be the infrastructure of the future digital economy and will bring us a paradigm shift in finance and economics. This is the first time in history that Asia has the opportunity to participate in an industrial revolution in its entirety and stand in a good position to do so. Asian countries should work more closely together in the digital economy and digital finance to further solidify their leadership in this area.
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