CBDC has become a hot issue of global concern. China’s DC/EP project is running faster than similar projects in other countries. Since April, the People’s Bank of China has been testing DC/EP in 4 pilot cities. In 2022, it will be tested in the Beijing Winter Olympics, being used to serve foreign users for the first time.
In the future when CBDC is well adopted in its own country, how will it go abroad, and what kind of impacts will it have on currency internationalization?
I will try to answer this question from the following 4 aspects:
First, I will briefly explain the cross-border movement of currencies from the perspective of international balance of payments.
Second, I will summarize some common features of mainstream CBDC plans.
Third, I will focus on the differences between the token model and the account model. It may seem to be very simple, but it is the key to understanding the cross-border movement of CBDC.
In the last part, I will talk about the cross-border movement of CBDC and its impact on currency internationalization.
Mechanisms of Cross-Border Money Movement
The cross-border movement of CBDC is quite different from that of physical goods. When you bring physical goods such gold from one country to another, it literally crosses country borders. However, that is not the case for money. From the perspective of real economy, why do we need to move money from one country to another? Serving as a means of payment, how can money be used in cross-border scenarios? The common use cases can be found in international trade and cross-border investment. For example, when one country exports goods and services to a foreign country, the foreign country will have to pay the home country, which triggers the cross-border movement of money.
Besides, the home country can also import goods and services from the foreign country. The home country then needs to pay the foreign country, which will also cause the cross-border movement of money. Import and export of goods and services are summarized in current account while cross-border investment is summarized in capital account. For example, when foreign residents and institutions buy domestic financial assets, they need to pay the home country. In this case, the home country can be viewed as exporting financial assets. Home country can also import financial assets by making outbound investment and receiving foreign financial assets where home country needs to pay the foreign country.
To sum up, cross-border money movement accompanies international trade of goods and services and cross-border investment. In current system of fiat money, how does money movement actually happen?
Image a Chinese company exporting to America. The Chinese company receives a certain amount of US dollar in turn. Does it keep US dollar in physical form and then bring it into China? That is not the case. Money movement is much more complicated than many people think. Except for cash, all other money exists in a digital form as entries in the accounts of central banks and commercial banks. Let’s assume the Chinese exporter has a deposit account in the Bank of Beijing. The American importer needs to pay the Chinese exporter, but its deposit account is in the Bank of Boston and there is no account connection between the two banks. It is impossible for money to move across banks when they have no account connection. To solve this problem, we need to resort to correspondent banks. The Bank of China and the Bank of America can play such a role. Then the money will firstly move from the Bank of Boston to the Bank of America, secondly from the Bank of America to the Bank of China and finally to the Bank of Beijing. How does money move between the Bank of America and the Bank of China? As correspondent banks, they need to maintain nostro and vostro accounts with each other. For example, the Bank of America keeps a Renminbi account with the Bank of China, while the Bank of China keeps a US dollar account with the Bank of America. When the two banks transact with each other, balances of those nostro and vostro accounts adjust accordingly.
How does banks communicate with each other? It is quite different from communication via emails and phone calls. Banks use special messaging systems, within which SWIFT plays a dominant role. To sum up, money moves cross border through bank accounts, especially the nostro and vostro accounts of correspondent banks and SWIFT messaging system. Let’s return to the example of the Chinese exporter and American importer. When the American importer pays US dollar to the Chinese exporter, the Chinese exporter will not bring physical cash into China. Rather, it will keep a US dollar deposit account in an American bank. When it receives US dollar, the balance of its deposit account increases accordingly. The account system has legal borders but not physical borders.
Common Features of Mainstream CBDC Plans
Let’s first look at China’s DC/EP. It follows a centralized management model, which simply means DC/EP is not built on a blockchain.
DC/EP is 100% backed by deposit reserves. Its circulation follows the traditional 2-tier system of the central bank and commercial banks. If we look at the Ubin project of the Monetary Authority of Singapore, it is easy to see that the design of Ubin is different from DC/EP. For example, Ubin clearly uses a consortium blockchain. Notwithstanding their differences, mainstream CBDC plans share some common features.
First, CBDC belongs to M0 or monetary base. CBDC is a digital form of central banks’ liabilities to the public. In this liability relationship between central banks and the public, there is no place for commercial banks or other financial institutions.
Second, there are two models of CBDC, i.e. the account model and the token model. Mainstream CBDC plans follow the token model. Different countries may have different names for the token model. For example, the People’s Bank of China says that DC/EP follows the Loose account coupling model. Some countries use the term “the value model”. But they all belongs to the token model. Ubin is a token inside a distributed leger, while DC/EP is a token inside a centralized ledger.
Thirdly, individuals and companies need CBDC wallets to own and use CBDC. There will be many types of CBDC wallet providers. For example, commercial banks, payment institutions, and fintech companies. But no matter what, CBDC wallet providers are custodians rather than debtors of wallet users. For example, Chinese commercial banks will provide DC/EP wallets. However, the DC/EP in those wallets won’t sit on the balance sheet of commercial banks.
Lastly, CBDC transactions are peer-to-peer by nature. Money moves from CBDC senders to receivers but not through the balance sheet of wallet providers.
Differences between the account system and the token system
The account system is hierarchical by nature. We have deposit accounts with commercial banks and accounts of payment institutions. At the highest tier, commercial banks have deposit reserve accounts with central banks. No matter at what tier, new accounts need pre-approval to be opened.
Different tiers of accounts correspond to different tiers of payment channels. The account system functions in a quite hierarchical way. For example, users with the same payment institutions use payment account balances to transact with each other. Users with the same commercial banks use deposit account balances.
Except for cash, all the other money exists and moves in the account system. Money movement is represented by debit and credit operations of bank accounts. For example, if I send you an amount of money, balance of my deposit account will decrease while that of your deposit account will increase. If we keep deposits in different commercial banks, transactions between us will lead to transfers between commercial banks, which are settled by commercial banks’ deposit reserve with the central banks.
Let’s then look at topology of the account system. It is hierarchical with lots of “hubs” but far from being fully connected. Not every two accounts can directly transact with each other. The correspondent bank model epitomes this phenomenon.
Let’s turn to the token system. There exists no hierarchy in the token system. All addresses in the token system are equal. In term of technology, there is no difference among addresses owned by individuals, commercial organizations, and public institutions such as central banks.
The token system is very open. Anyone who generates a pair of public and private keys through asymmetric encryption can participate in the token system. However, when we introduce the token system into the fields of money and payment, we must carefully balance openness with KYC requirements.
When tokens are transferred between addresses, the update of token state, which refers to the number of tokens associated with each address, and the confirmation of token transactions occur simultaneously. There is no settlement risk.
Token transactions are peer-to-peer. Any two addresses can directly transact with each other. Token transactions don’t rely on a third-party witness or bookkeeper.
If you look at the topology of the token system, it is fully connected.
In the last part, let’s first look at the cross-border movement of CBDC. We need to keep in mind that it is fundamentally different from the correspondent bank model. First, individuals and institutions only need CBDC wallets to conduct cross-border payment with CBDC. Although they need to meet certain requirements (e.g. KYC) and follow certain procedures to open CBDC wallets, wallets are much easier to open than bank accounts. Users can even open CBDC wallets without relying on commercial banks. If they want to meet the most stringent KYC requirements, they can visit commercial banks.
As I just mentioned, CBDC wallets are much easier to open than bank accounts, especially offshore ones. I have a perfect example to show this point. Many Chinese have visited America in the past four decades. But how many Chinese own US dollar bank accounts? Meanwhile, almost every Chinese trading cryptocurrencies own US dollar stable coins. It is easy to see that the openness of the token system far surpasses that of the account system.
Since all addresses in the token system are equal, there exists no difference between domestic and foreign wallets of CBDC. Any two CBDC wallets can transact with each other. There is no difference among on-share, cross-border, and off-shore transactions of CBDC.
Central banks need to carefully study two important problems before promoting CBDC abroad. First, the requirements and procedures for foreign individuals and institutions to open CBDC wallets.
Second, cooperation among monetary sovereignties. CBDC should go abroad in a cooperative approach rather than an intrusive one. For example, if there is a high demand for DC/EP in Singapore, People’s Bank of China should work with Monetary Authority of Singapore to make it easier for Singaporean people and institutions to own and use DC/EP while fully respecting Singapore’s monetary sovereignty.
CBDC’s Impacts on Currency Internationalization
It is fair to say that CBDC is a necessary condition for currency internationalization, but far from a sufficient one. Currency internationalization may play the following three roles. First, to settle international trade of goods and services. I have explained the differences between cross-border payment via CBDC and the correspondent bank model. Second, to serve as a tool for cross-border investment and financing activities. Third, to serve as international reserve for foreign central banks.
Cross-border payment via CBDC will help settle international trade but have limited impacts on the second and third roles of currency internationalization.
For those two roles, it is imperative for CBDC to be used to settle cross-border financial transactions.
This is a frontier issue that has drawn lots of attention from central banks. Prominent CBDC projects, such as Ubin of Monetary Authority of Singapore, Stella of European Central Bank and Bank of Japan, and Jasper of Bank of Canada, have put lots of emphasis on the use of CBDC in financial transactions.
In every financial transaction, there are a payment leg for money and a delivery leg for securities. And Delivery vs Payment (DvP) is an important goal as well as an industrial standard.
Is it possible to achieve DvP when CBDC is used in financial transactions? This is not only related to the payment system, but also to the security settlement system. Similar to money, securities can also exist as entries in the accounts of central securities depositories and as tokens. There have been several widely followed experiments with tokenized securities. For example, Ubin, Stella and Jasper all find that it is possible to achieve DvP when CBDC is traded against tokenized securities.
Of course there are other projects that use traditional wholesale payment system to work with tokenized securities. For example, World
When both money and securities are tokenized, there are two scenarios. First, CBDC and tokenized securities exist in the same ledger. Atomic settlement contract has been proved to achieve single-ledger DvP. Second, CBDC and tokenized securities exist in different ledgers. Cross-ledger DvP is more challenging than single-ledger DvP. Central banks have tested many cross-chain technologies. They find hash time lock contract (HTLC) is promising but not perfect. HTLC has the potential to achieve DvP and payment vs payment (PvP). But HTLC can also cause settlement failure. There is still lots of room for improvement.
To sum up, I talked about how CBDC will go abroad with the development of international trade of goods and services and cross-border investment, how CBDC can change cross-border payment and what are the differences between it and the correspondent model. I concluded that CBDC is a necessary condition for currency internationalization but far from a sufficient condition. For CBDC to facilitate cross-border investment and be adopted by foreign central banks, it must be able to settle cross-border financial transactions. This, in turn, has high requirements on cross-chain technologies. I’m looking forward to explore more unknown problems in CBDC.
*This is the speech delivered by Dr. Zou Chuanwei, Chief Economist of Wanxiang Blockchain at 2020 China-Singapore Blockchain Leaders Summit