Decoding the central bank digital currency | LEE Kuo Chuen and Yan Li: The design thinking and development direction of the central bank digital currency from the perspective of globalization

By LEE Kuo Chuen, Professor of FinTech and Blockchain at the Singapore University of Social Science, and Yan Li, Senior Lecturer at Nanyang Business School in Nanyang Technological University.

At present, the global central bank digital currency research is further increasing, and some are entering the development stage. The private sector has not stopped trying to stabilize the currency. What are the new futures of digital currency and the digital economy? What changes will digital currency bring to the financial system and people’s lives? (Click to subscribe) An article in the March 2021 issue outlines the central bank’s digital currency’s status in the future development of the digital economy.

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In recent years, countries around the world have attached great importance to the development of central bank digital currencies. This article outlines the central bank’s digital currency’s important position in the future development of the digital economy and expounds on the design ideas and best practices of the central bank’s digital currency from a global perspective. At the same time, it also made suggestions for the future development of digital currency and the digital economy. This article believes that Asian countries should cooperate more closely in the field of the digital economy and digital finance to further consolidate their leading position in this field.

The International Monetary Fund (IMF) defines the global crisis brought about by the new coronavirus pneumonia (Covid-19) as “The Great Lockdown.” The economies of major countries in the world have been severely hit by the epidemic. We have found that under the influence of the epidemic, countries, and regions with relatively strong national discipline have implemented better anti-epidemic measures and achieved more significant results; at the same time, countries and regions with better development of digital economy have suffered economic losses during the epidemic. The impact was relatively small, and the economy recovered relatively quickly. The importance of the digital economy has been fully reflected in the epidemic.

Countries that have achieved remarkable results in the fight against the epidemic, such as China and Singapore, are actively fighting against the epidemic on the one hand, and on the other hand, working hard to ensure the smooth operation of the economy and the implementation of major innovation-related policies. The epidemic has greatly promoted the development of Singapore’s digital economy. During the epidemic, the main economic sectors of Singapore and China have interacted frequently, especially the cooperation with digital economy-related fields, such as the field of digital currency. In the future, the two countries can continue to strengthen cooperation in the areas of digital finance and Central Bank Digital Currency (CBDC) (for example, starting from retail payment business), and replicate their successful experience to ASEAN countries.

In recent years, countries all over the world have attached great importance to the development of central bank digital currencies. In 2020, the Bank for International Settlements report shows that more than 80% of member countries are researching central bank digital currencies. Among them, Cambodia and the Bahamas have issued retail business central bank digital currencies, Ukraine, Uruguay, and Ecuador have completed testing, and six other countries, including China and Singapore, are in the final stage of verification and testing.

However, the development of central bank digital currencies requires countries to clarify the attributes of their central bank digital currencies and consider the accompanying payment system arrangements. Asia is currently in a leading position in this field, and European countries are also actively studying and there have been some successful attempts.

The history and current situation of central bank digital currency

The government’s control of currency 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 been managing Sweden’s monetary system since 1668. Wisselbank in the Netherlands laid the foundation for a modern central bank. The key role of the modern central bank is to provide risk-free currency and secure payment methods to the financial system, including retail and wholesale. Although the real legal currency has not appeared for a long time, through different forms of payment, the legal currency has developed from simple cash and banknotes to a broad concept, which also includes the digital currency issued by the central bank.

It is difficult for us to give a precise or widely recognized definition of central bank digital currency. The International Monetary Fund defines it as “a digital representation of sovereign currency issued by a central bank or monetary regulatory authority in a jurisdiction”; the European Central Bank defines it as “central bank currency managed by the central bank in electronic form and used by the public in electronic form. “; The Bank for International Settlements believes that it is “a digital form of central bank currency that is different from traditional reserves or balances in settlement accounts.”

In the traditional centralized trust system, financial institutions create currency by providing third-party trust, thereby ensuring that they obtain excess profits in this highly complex payment system. This will generate competition between different stakeholders, and the result is contrary to the original intention of “no risk and safety”. The emergence of digital currency has brought us new opportunities to improve the traditional payment system. It can be said with certainty that the separation of the wholesale payment system and the retail payment system will be rewritten. Many central bank managers and scholars suggest using distributed ledger technology and blockchain technology to design and build central bank digital currencies and their payment systems. The central bank’s digital currency can be understood as a digital certificate issued by the central bank or currency regulatory authority with the same status as legal currency. The difference with fiat currency is that the central bank digital currency allows users to directly store the value of the central bank currency and pass the value directly to the third party they want to pay to, thus getting rid of the dependence on the commercial bank in the original payment system. Realize “de-mediation” in a true sense.

It can be seen that the central bank’s digital currency can improve payment efficiency, support payment innovation, meet future payment needs in the digital economy, and improve the availability and convenience of central bank currency. That is, the generation of central bank digital currency can not only reduce cash circulation, but also solve the problem of insufficient cash, serve as a better cross-border payment infrastructure, and build a more resilient and risk-resistant payment system.

There is another main reason why countries are actively researching and experimenting with central bank digital currencies, which is to avoid the challenge of stable currencies such as Libra. Facebook and its sub-brand social media have more than 2 billion users worldwide. Once users accept Libra, it may rapidly expand globally, and Facebook may once again dominate Western social media. , In the field of digital currency, “one ride, alone seek defeat”, may even greatly weaken the status of some countries’ central banks. This also makes central banks of various countries accelerate the demonstration and research and development of central bank digital currencies.

However, not all central bank digital currencies will use distributed ledger and blockchain technology, and they’re still debating about the pros and cons of using this emerging technology. Singapore’s Ubin Project (Project Ubin) aims to launch a central bank digital currency based on blockchain and distributed ledger technology that focuses on wholesale business. It is mainly aimed at the clearing business between banks and countries. In the fifth phase of the trial phase, verification experiments have been conducted with Canada and other countries. The essence of the digital Singapore dollar is a kind of generalized government security that can be used for wholesale business payment and value storage. It uses distributed ledger technology to realize peer-to-peer payment without a bank as an intermediary. The Digital Currency Electronic Payment (DCEP) system under test in China, although not using blockchain technology, has borrowed from Bitcoin’s UXTO (Unspent Transaction Output) in its design philosophy. Account method. At present, digital renminbi mainly emphasizes retail business to meet the needs of personal and commercial payment. It can also realize offline point-to-point payment, which is the same as cash.

Different from the payment system and the international settlement system in the traditional financial system, the central bank’s digital currency and its payment system design is very diversified. Thailand, Cambodia, Japan, Hong Kong, and Canada have adopted different methods to design their digital currencies. Different designs will bring different benefits, and of course, there will be potential risks. Its impact is not fully understood at present, and further research by scholars and the industry is needed. But there are some advantages that are obvious: the central bank digital currency can conduct offline transactions similar to physical cash; allow value transfer through e-wallets; do not need an account, no need to connect to any financial institution, and no need to connect to any debit card Or credit card; to ensure and improve the efficiency and security of the payment system, without the need for clearing houses or real-time settlement systems for settlement, while maintaining monetary sovereignty; to ensure more accurate recording of economic activities that are currently not included in the national account statistics ; It can withstand the impact of other non-sovereign cryptocurrencies on the legal currency system, thereby avoiding weakening the influence of fiscal policies; achieving better tax collection and management; reducing the cost of manufacturing and circulation of physical banknotes and coins; better protecting privacy and having management The ability of anonymity to prevent money laundering, terrorist financing, tax evasion and other criminal activities; digital or smart contracts can be used to reduce the cost of trust; to achieve inclusiveness, for those who do not receive financial services or do not receive adequate financial services in the traditional economy The general public provides better financial services.

Digital currency: different perspectives and practices in Europe and Asia

The focus of the work of central banks in developed economies is to maintain the stability of economic development and the effectiveness of monetary policies. Although the reduction in the use of cash will promote the development of electronic payments in Europe, existing regulations, legal tender systems, and payment channels can influence the innovation of digital currencies and payment systems. At the same time, Europe’s currency system and payment system are relatively complete. Therefore, to reform this system, a great leap of thinking is required.

Although the Bank of England initiated a global discussion on the prospects of introducing central bank digital currencies in 2017, it was not until 2019 that Swiss financial market regulators “dare to be the first” and Switzerland became “the first country to eat crabs”. Under the premise of ensuring that it will not have a significant impact on the traditional payment field, the guidelines for payment through the blockchain system and strict measures to combat money laundering on the blockchain have been formulated, and the first two cryptocurrency bank licenses have been issued. The two encrypted banks are Signum and SEBA, which can provide services related to encrypted digital currencies. Among them, one of the main services is to manage the private keys of encrypted digital currencies, which requires the development of a new set of encryption compliance management procedures. With the development of algorithms and cryptographic governance methods, such “banks” implement non-compliance between users and crypto banks through open application program interfaces (API) and decentralized applications (DAPP). Centralized data exchange. Although it is not yet possible to realize distributed trust in the full sense, such a new entity appears in the field of encrypted digital currency and provides trust services for private key management, which in itself is a major development. Although there is no talk of subversion, this is a brand-new business model that poses a challenge to the business model of commercial banks in the traditional financial industry.

The Swiss financial market regulator is aware of the innovative potential of “trust transfer”, but only applies the laws and regulations of the traditional financial market to financial activities in the new encrypted digital currency field in a technology-independent way. It does not allow cryptocurrency banks to circumvent the existing regulatory framework, with special emphasis on regulations against money laundering and terrorist financing. Because the inherent anonymity of distributed ledgers and blockchain technology will increase such risks, the use of blockchain technology to carry out encrypted digital currency-related financial activities must strictly comply with the International Financial Action Task Force (The Financial Action Task Force). Force, FATF for short) guidance on financial services. Institutions under the supervision of the Swiss Financial Market Supervisory Authority are only allowed to send cryptocurrency or other tokens to external wallets belonging to their customers. The identity of the external wallet must be verified in advance and only allowed to be authenticated from this. Receive cryptocurrency or other tokens in your external wallet. The two crypto banks also only provide services to institutional and professional clients. Despite the many restrictions mentioned above, it is still considered a huge leap forward in Europe in the field of the digital economy and digital payment.

Many observers are surprised that Asia is advancing the development of the digital economy and digital payment at a faster rate in terms of the revision and compilation of laws and regulations, technological innovation, and application trials. As early as 2014, the People’s Bank of China was one of the first central banks in the world to pay attention to the future development prospects of digital currency and initiate a digital currency research group. Singapore is the first country in the world to initiate and launch an open-source code central bank digital currency. Many major international banks, such as Bank of America Merrill Lynch, Credit Suisse, HSBC, JPMorgan Chase, Mitsubishi Financial Group, as well as two local banks in Singapore and several blockchain companies have participated in Singapore’s central bank digital currency Ubin project. At the same time, Japan’s Financial Services Agency (Financial Services Agency) clarified the legal status of Bitcoin and other digital currencies in the country’s “Payment Services Law” and confirmed that Bitcoin and several cryptocurrencies are legally recognized payments in the country. Way. Under the active promotion of Asian countries, the International Monetary Fund began to study the potential innovative nature of digital currencies (encrypted assets) in 2018 and publicly supported CBDC’s innovative payment solutions. In 2019, the World Bank also issued tokenized debt. In October 2020, China’s CBDC project digital currency electronic payment (DCEP) started the actual measurement; Cambodia officially released the central bank digital currency Bakong; in November 2020, Singapore’s DBS Bank announced the launch of the digital asset ecosystem. At the same time, under the impetus of Singapore and China, in the newly signed Regional Comprehensive Economic Partnership (RCEP), the legal validity of electronic signatures has been confirmed, which will greatly speed up the progress of the signatories of the agreement. The pace of development in the field of the environmental digital economy and digital payment.

Central bank digital currency design ideas

The three basic aspects of digital currency design are assets, payments, and applications. Most international discussions focused on the first two aspects. Only the People’s Bank of China mentioned the use of the central bank’s digital currency to certify currently untraded services and commodities. One thing to be clear is that although most CBDCs and China’s DCEP can usually be considered legal tender there are still significant differences between central bank digital currencies and legal digital currencies. So far, the People’s Bank of China has never officially called DCEP a legal digital currency, but only called it a digital currency. One of the purposes of DCEP is to stimulate trade in services and commodities. The central bank gives DCEP sufficient flexibility to promote the circulation of products and services that are not currently actively traded in the market. Among the important components of economic activities, some have not been included in the calculation of actual gross domestic product (GDP), but they may account for a large part of economic activities. Especially in China, there have been a large number of cash transactions for a long time. , Such as time-based services and the circulation of stable asset certificates with basic value, can all be tokenized. Therefore, although the early discussions of CBDC in China mainly revolved around Payment functions, recent discussions have shifted to fiat currencies in the form of digital tokens and assets. Research has not been limited to simple currency concepts, speculation, and prevention of speculation, and more in-depth research has been extended to “token as a form of currency”, which can be a measure of value, means of circulation, means of storage, and means of payment. Even the world currency of the future. This is in line with all the theoretical characteristics of “money.” Money must be durable, portable, divisible, and difficult to forge. The People’s Bank of China has expanded the scope of discussion to include generalized services and illiquid goods.

The tokenization of assets and services and the point-to-point payment method are the most important potential innovations in digital currency design. Assets and services of any form can produce related certificates, which can be valued through related tangible assets, legal person status, physical objects, or daily services. Digital currency or tokens can be an incentive mechanism, created in the form of assets, rather than fragmented liabilities in the traditional sense. The point-to-point payment method allows all parties involved in economic activities to directly transfer value without the need for a third party to participate and provide trust services.

The previous discussion mainly focused on improving the efficiency of existing regulated entities (such as banks) and improving the efficiency of back-office clearing and settlement processes by establishing a decentralized payment system between service providers. End users There is no need to understand digital currency and distributed ledger technology, but such new mechanisms have changed the way assets are stored and the way payments are executed. Society’s perception of currency will gradually change, and economic activities that were not included in GDP statistics will be recorded very accurately. These latest discussions have gone beyond the previous conception of the central bank’s digital currency, and have also greatly expanded the design thinking space of the central bank’s digital currency. The People’s Bank of China intends to leave the second-tier architecture system (the first-tier architecture responsible for the creation and issuance of digital currencies) to the private sector so that companies can innovate and cooperate with the central bank. Although China’s DCEP architecture design is considered to be the best practice in central bank digital currency design, not all central bank digital currency research teams agree and adopt this approach.

General architecture

The design of central bank digital currency usually considers a two-tier structure: the first layer is the method of currency issuance, that is, how to issue digital currency; the second layer is the payment method between wholesale banks and retail. The central bank can adopt a completely centralized governance method, or after the digital currency is in circulation, the payment system can adopt a decentralized operation method.

The main pain point of cash or cash in circulation (M0) is that it is issued in the form of physical currency such as banknotes and coins, and the related printing, withdrawal, and storage costs are relatively high. Physical cash lacks portability and traceability and has insufficient anonymous management functions. It is easy to be forged and used for money laundering, terrorist financing, and other criminal acts. At the same time, existing non-cash payment tools (such as credit card, debit card, Internet, and online banking application payments) are unlikely to replace M0, because these rely on trusted third-party payment services. In addition, these payment methods cannot support offline and anonymous payment services. The main advantage of using Bitcoin UXTO is that offline payments, anonymous custody, and peer-to-peer payments can be made without a centralized ledger. We can regard this design as a new “M0.5” concept. Because it retains the point-to-point offline anonymity of M0 but has traceability, which is similar to M1. This “M0.5” can take advantage of the additional advantages of anonymous hosting to replace M0. However, except for the Central Bank of China, most central bank designs lack this “M0.5” concept.

There is no inevitable conflict between the decentralized ledger technology and the centralized governance of the central bank. The concept of “M0.5” combines the best functions of distributed systems (such as blockchain) with the centralized governance of the central bank very well. Although blockchain technology does not rely on centralized governance, it does not mean that centralized governance must run counter to distributed operations. If the design is reasonable, blockchain and distributed ledger technology can effectively integrate distributed operations, and better achieve centralized governance and control of CBDC. There is no inevitable conflict between the two.

China uses a three-tier general framework to understand and design its CBDC, trying to achieve this balance: the first-tier decision is the issuance of CBDC; the second-tier decision is the core of linking users-the satellite payment system; the third-tier decision is the identity Verification, registration, and query functions. The design of other central bank digital currencies can learn from China’s best practices:

The first layer can choose between centralized technology or distributed technology, and determine the issuance of digital currency guaranteed by the central bank. This layer only allows the central bank to create and issue digital currencies or tokens. However, these digital currencies can also be created on single-mode or multi-mode blockchains or distributed ledgers of core nodes controlled by the central bank.

The second layer is the basic payment system. The core node of the system can be controlled by the central bank, and other nodes can be directly managed by retail enterprises, or authorized to commercial banks and wholesale banks for management. The central bank’s core node can be regarded as the central bank’s cash operation management system, and the user’s satellite node can have its payment system on the cloud. At the same time, the system design can also be completely divided into two parts, the 100% reserve account and part of the reserve account coexist. The latter can create a new credit mechanism.

The third layer includes three clients: tokenization, registration, and system query and analysis. Regardless of whether the issuance is based on actual assets or based on the liability items in the balance sheet, the tokenization is to control the total amount of issuance.

To make the central bank’s digital currency more attractive for more companies and individuals to use, the new system must be more convenient and less risky than the current payment system. Therefore, the key to the design of a new generation of CBDC should be noted: First, the central bank’s digital currency should be guaranteed by the government, and its legal tender status should be clarified. Not all digital fiat currencies are legal digital currencies. Central bank digital currencies must be directly supported by the government to ensure universality. Secondly, the use and preservation (deposits) of the central bank’s digital currency should not be affected by the credit risk of financial institutions. Even if different institutions are authorized to operate the central bank’s digital currency, the risks between financial institutions are different. If it is related to the risk of financial institutions, there may be a run or other usage problems. Finally, the cooperation between the public and private sectors is essential for designing a new central bank digital currency. Regardless of whether it is from a technical or social point of view, the parties to the cooperation should not think that they have unilaterally mastered the solution for system expansion (up to scale). At the same time, in a strict regulatory environment, it is very important to leave room for innovation in cross-border remittances and exchanges.

The Board of Directors of the Bank for International Settlements (BIS) has established BIS Innovation Centers with Switzerland, Hong Kong, and Singapore. The goal is to promote the international cooperation of central banks in various countries or regions in innovative financial technology: First, identify and deeply understand the impact of central bank technology Key trends; the second is to develop public products in the technical field to improve the functions of the global financial system, and the third is to serve as a node in the central bank’s innovative expert network. To better understand what kind of non-central solution is the most acceptable design solution for the banking systems of various countries, central banks of various countries share the research results on the above-mentioned platforms, and many countries provide open source codes for their respective tests projects. At present, a new round of private payment solutions has begun to emerge. This problem is more urgent for all countries, because the innovation of these private payment systems may make existing financial institutions unable to keep up with the changes. Therefore, in the design process of the Central Bank of China and the Bank of Singapore, many private sector companies have been involved.

The complexity of the structure of the central bank’s digital currency payment system and the limitations of internal and external conditions have caused different countries in the process of design and development, verification and testing, and actual launch and use. As the second-largest economy in the world, China’s financial environment has accelerated the design, development, and verification testing of DCEP. Currently, China’s DCEP system does not involve international trading tools. At the same time, more and more international trade is priced in RMB, which brings more advantages and urgency to DCEP. Another important fact is that the RMB internationalization policy requires certain control over the RMB exchange rate and its reserves. From an international perspective, mature financial centers and central banks in many developed countries do not dare to easily test the anti-risk capabilities of central bank digital currencies, so they will also delay the launch of central bank digital currencies because once they are launched, there will be service interruptions. The cost of the loss is immeasurable, and the damage to the international reputation is also very great.

Conclusion

As discussed earlier, centralized governance and decentralized operations can not only take care of each other but also promote each other. The purpose of the central bank is to provide a fair, safe and efficient payment system for the retail and wholesale sectors. The design framework of China’s DCEP fully embodies the unity of the two forms.

We have always believed that the digital economy and financial technology will develop in the direction of inclusiveness and decentralization. However, the 6D attributes of blockchain and distributed ledger technology have been fully reflected in all aspects of financial technology, namely, Digitalisation, Disintermediation, Democratisation, Data Privacy, and Non-Financial Technology. Centralization (Decentralisation) and disappearance (Disappearance), these six points should also be the design principles of the central bank’s digital currency. In the field of the digital economy, current successful companies have achieved the top three points to the extreme, but we have seen that data security incidents are frequent, and a high degree of industry concentration has produced super applications that are almost monopolistic.

Recently, countries around the world are taking some corresponding measures against possible monopolies in the digital economy. In November 2020, the State Administration for Market Regulation of China issued the “Guidelines for Anti-Monopoly in the Field of Platform Economy (Draft for Comment)”. Fully centralized third-party payment can easily form a situation of “big but not falling, and the winner takes all”. With the development of the digital economy, the central bank is worried that the payment system of the private sector may use its unique market position to increase fees and raise loan interest rates. If the public completely relies on private currency or third-party payment systems, there may be huge hidden dangers in terms of privacy protection and data security.

Therefore, the future development of the industry must focus on the last three points. Both China and Singapore’s CBDC have adopted centralized governance and decentralized operation architecture. Centralized governance guarantees system security and strengthens the protection of data and privacy; decentralized operations can allow banks and other private sectors to fully participate and continue to innovate. The open design of the second layer of China’s DCEP is also the best embodiment of the “selfless spirit” because DCEP or CBDC should not be the digital version of the original currency system and payment system, that is, it is not intended to squeeze the existing “third party” “Payment” does not mean to nationalize the payment industry in a disguised form. CBDC and the existing digital payment system can fully compete. The first layer of DCEP is infrastructure, and the second layer is “Wuye Qianli”. Financial institutions and other private sector enterprises can completely compete with the Central Plains. Merry”. With China’s DCEP running trials in Shenzhen and Suzhou, more than 6,000 private sector companies have participated, including some American companies such as Wal-Mart, Starbucks, and McDonald’s. At the same time, China is also actively building a global Blockchain-based Service Network (BSN) and launching an interoperable blockchain alliance network.

Recently, there have been more and more discussions about DCEP going overseas. As early as the design of DCEP was launched, the author believed that as a new payment system, it would cooperate with the RMB internationalization policy in the traditional financial system, and proceed in a two-pronged way. The construction of the “Belt and Road” economic belt and the “21st Century Maritime Silk Road” connects BSN. Singapore’s system advantages in the field of public chains and alliance chains are particularly obvious. The Singapore industry’s understanding of DCEP and RMB internationalization is “One Belt, One Road, One Initiative” and “One Network, One Finance, One Token”. Singapore looks forward to building the “21st Century Global Economic Digital Silk Road” with China and believes that the digital Singapore dollar will play an active role in cooperation.

The new crown pneumonia epidemic since 2020 may trigger further financial crises and large-scale corporate bankruptcies. The public will suffer losses as a result, and payment and settlement of some financial institutions may be interrupted. As we saw in the 2008 global financial crisis, due to the massive bank failures and the collapse of the international letter of the credit system, the global trade and supply chains have shrunk in the past three months. The lessons are profound.

In the final analysis, the central bank’s digital currency is the unity of legitimacy and convenience, innovation and supervision, cost and security. The central bank’s digital currency will also improve the efficiency of the international payment system, but at the same time, supervision must also keep pace with the times. Decentralization and inclusiveness will be the main directions of future development.

In the next 10 years, we will open the door to the fourth industrial revolution. The digital currency and payment system will be the infrastructure of the future digital economy, which will bring us changes in the financial and economic paradigm. This is the first time in history that Asia has had the opportunity to fully participate in an industrial revolution, and it is still in a favorable position. Asian countries should cooperate more closely in the field of the digital economy and digital finance to further consolidate their leading position in this field.