How China’s Digital Yuan (DCEP) Put It at the Forefront of Monetary Innovation

In 2020 many countries stepped up efforts to develop their own central bank digital currencies (CBDCs). According to the latest report by the Bank for International Settlements, to date 80% of central banks are studying the potential of national digital currencies, and half of them are already experimenting with new payment instruments.

Yet more progress has been made in this field by the People’s Republic of China, which has been developing the digital yuan (Digital Currency Electronic Payment, DCEP) since 2014.

ForkLog examines the history of China’s digital currency, its key characteristics and the reasons for heightened activity around the new payment instrument.

The People’s Bank of China (PBoC) was among the first among monetary regulators to undertake active research into the payment instrument, true to the spirit of the digital era.

Soon after work began on DCEP, the central bank joined forces with the Bank for International Settlements (BIS) and the International Monetary Fund (IMF). In 2017 the regulator established an institute that began pilot research into the digital currency.

From 2017 to mid-2019 mentions of the digital yuan rarely appeared in the media. CBDC-related questions were generally not much discussed in the cryptocurrency community.

The turning point came with information about Facebook’s Libra project and the release of the corresponding documentation. Almost immediately after, central-bank officials said that the sovereign digital currency was nearly ready to launch after five years of development. Deputy head of the payments division within the PBoC, Mu Changchun, stressed that the prototype was ready and the research group had fully worked out its architecture.

At that time, there were sparse details about the technical features of DCEP.

In December 2019 the central bank announced a partnership with seven major state-owned enterprises and banks to launch large-scale testing of the digital yuan.

In April 2020 the PBoC confirmed the start of testing of DCEP in four cities, including Shenzhen and Suzhou, and the Agricultural Bank of China unveiled a mobile app for the digital currency.

Around the same time, reports surfaced of transport subsidies paid in DCEP to government employees in the above-mentioned cities, as well as Chengdu and Xunyang. It was also announced that 19 stores and restaurants, including McDonald’s and Starbucks, would participate in testing the new payment system.

In May, Yi Gang, the governor of the PBoC, said that regulators had not yet decided on exact launch timelines, but allowed the possible use of the digital yuan at the 2022 Beijing Winter Olympics.

How is the digital yuan being tested?

In May 2020 the 8btc portal released a video showing the supposed conversion of yuan into the digital version.

A video of leaked on #WeChat showed how to use the system developed by Agricultural Bank of China to convert RMB into DC/EP, #China ‘s #CBDC . pic.twitter.com/RiJto2ExnK

— 8BTCnews (@btcinchina) May 28, 2020

One can see how a user transfers 50 yuan from a settlement account to a DCEP wallet, presumably developed by the Agricultural Bank of China.

Soon many similar videos appeared online.

In July the PBoC signed an agreement with more than 20 companies to test the real-world payment-system based on the digital yuan. This group includes one of China’s largest food-delivery services, Meituan Dianping, and the ride-hailing aggregator DiDi Chuxing.

The regulator also included in the program telecom operators China Telecom, China Mobile, China Unicom, technology giant Huawei, and state financial institutions Commercial Bank of China, China Construction Bank and Bank of China.

State banks converted part of their deposits at the PBoC into the digital currency and identified sectors of the economy for its promotion. Financial institutions also took on testing wallets for storing the digital currency. The development of the technical solution was undertaken in collaboration with payment-system operators Alipay and WeChat.

In August the Ministry of Commerce of China announced, that in addition to Beijing, testing of the digital yuan among the mass public would involve the Hebei province, the Yangtze River Delta, Guangdong and a number of cities in the central and western regions. The list includes cities that will host the 2022 Winter Games.

The Ministry announced the expansion of testing of DCEP to large commercial transactions across various sectors, including hotels and electronic commerce payments.

Su Zhou and Shenzhen were among the first to participate in testing. Local media report that commercial transactions with DCEP were undertaken by companies in retail, e-commerce and education. The top-up of digital yuan transit cards was also tested.

In August, China Construction Bank began registering wallets for the digital yuan, one of the country’s largest financial institutions. Users could obtain via a banking app a DCEP-wallet that supports topping up the balance, paying by QR code and transfers.

By early October the volume of pilot transactions with the digital currency amounted to 1.1 billion yuan (~$162 million). According to the deputy head of the PBoC, Fan Yi Fei, since the start of testing the digital yuan-based payment system had processed 3.13 million transactions. Regulators tested 6,700 different use cases, including bill payments, transport and government services. In the pilot transactions more than 113,300 personal wallets and 8,800 corporate wallets were created.

In October China held a lottery to distribute gifts in DCEP. Shenzhen authorities randomly distributed 10 million digital yuan among 50,000 residents of the Luohu district in the form of so‑called “red envelopes.”

Applications to participate in the lottery were submitted by 1,913,847 people. Winners were credited with 200 yuan each (~$29.5). It soon emerged that 47,573 of the 50,000 winners received and spent their prize.

The lucky participants made 62,788 transactions totalling 8.8 million yuan (~$1.3 million), spending 88% of the funds allocated by the authorities. Some topped up their wallets, purchasing an additional 901,000 yuan (~$134,000).

The Guangdong Petroleum network of gas stations also added DCEP as a payment option. Initially, the pilot involved 11 gas stations in Shenzhen. The company plans to extend DCEP support to 110 stations in the near future.

Local media say the PBoC will complete the drafting of the necessary norms and rules by the end of 2020. The regulator has already proposed amendments to the law that would legalise the digital yuan and prohibit issuing tokens pegged to it.

Why does China need the digital yuan?

Why is Beijing so keen to develop and deploy the digital yuan? There are many plausible explanations.

Connor Dempsy from the analytical firm Messari believes that the DCEP will allow the authorities to tighten control over monetary policy, making it more precise, targeted and comprehensive.

“Suppose certain regions need help during a pandemic. The authorities could simply press a button and provide funds as efficiently as in the case of a lottery payout,” the researcher believes.

It is also possible that the digital currency is designed to reduce the dominance of WeChat Pay and Alipay. Access to these popular payment systems can be severely constrained if a user has no bank account in China. DCEP, by contrast, would be usable by anyone who downloads a digital wallet.

“This should make the yuan more accessible to foreigners, which largely serves China’s interests,” Dempsie said.

Beijing does not hide its aim to become a dominant superpower. To achieve this, the yuan must prevail in all forms of commercial activity.

“The authorities believe that by creating a better product they can break the global dollar monopoly. If the old USD runs on legacy infrastructure, DCEP is built for the digital era.”

Representatives at the People’s Bank of China believe that issuing digital assets will be a “new battleground” between states. A victory in the race would strengthen the yuan’s position on the world stage and undermine the dollar’s supremacy.

“China has advantages and opportunities in issuing a national digital currency. We need to accelerate to win the lead,” says a September statement from the bank.

Sino Global Capital founder Matthew Graham expressed the view that a digital yuan-based payment system could replace the dollar-dominated SWIFT system.

According to a veteran of the bitcoin industry, Chinese authorities will enter competition with the dollar, not with the first cryptocurrency, once DCEP launches.

“It’s a big opportunity for China.”

Beyond collecting data on monetary flows and real-time economic conditions, the digital yuan, in Graham’s view, will enhance the People’s Bank of China’s capacity to conduct monetary policy.

“DCEP will be useful for implementing negative interest rates. Moreover, it opens up many AI- and machine-learning-powered avenues for fraud detection,” explained Graham.

Representatives of the PBoC emphasised that the digital yuan is a lawful means of payment, accepted by any company or individual.

Other reasons for issuing the DCEP by China’s central bank:

• Lower operating costs. The issuance and maintenance of cash in existing systems entails substantial costs.
• Improved effectiveness in anti-money-laundering (AML). Cash is heavily used in illicit activity, while digital-money movements are easier to track.
• Better countering capital outflows from the country—a problem that became more acute amid the US-China trade tensions, slower growth and yuan depreciation.

The United States, the main geopolitical rival, has been far more sceptical about the prospects for a national digital currency. Recently Fed Chair Jerome Powell ” target=”_blank” rel=”noopener noreferrer”>stated that it is important not to rush into a CBDC, but to do so with the right approach.

The right approach, he argued, involves examining not only potential benefits but also possible risks.

Powell identified several political and operational questions that need to be thoroughly analysed before issuing a CBDC:

• How to protect the digital currency from cyberattacks, counterfeiting and fraud?
• What effect will CBDC have on monetary policy and financial stability?
• How to prevent illicit activity using the digital currency while ensuring user privacy and security?

Powell added that the Fed is studying CBDC questions, both independently and in partnership with other central banks and the BIS.

One Belt, One Road

In October, Deputy Governor Chen Yulu stated that China must accelerate its efforts to launch a sovereign digital currency. In his view, DCEP supports the implementation of the previously announced new growth strategy anchored in domestic demand. The policy aims to insulate the economy from rising geopolitical tensions with the United States and other countries.

“We must create an independent and robust financial infrastructure … accelerate the pace of research and development of the digital currency, and during pilots ensure that it is controllable and secures payments,” stressed a central-bank representative.

According to Connor Dempsy, the One Belt One Road initiative is intended to deepen Asia’s links with Africa and Europe through economic cooperation without reliance on the US dollar.

“Electronic yuan, together with One Belt One Road, could give China a chance to raise the profile of its currency. That could imply changes to the global reserve system,” said Deutsche Bank’s chief investment strategist.

He also expressed confidence that DCEP has enough potential to shake the dominance of the American currency.

“The Belt and Road Initiative and DCEP will remove the need for SWIFT and give the yuan a chance to become an international reserve currency,” says a report by Germany’s largest financial conglomerate.

Wanxiang Blockchain economist and PBoC researcher David Zou, in an interview with The Block, said that the Chinese regulator takes the DCEP project very seriously, viewing it as strategic.

“As far as I know, important players in China, including banks and payment companies, are keen to join the digital yuan ecosystem. DCEP is a substantial upgrade for Chinese payment infrastructures. It opens up many business opportunities and requires substantial investment,” emphasized Zou.

According to him, in the next 12 months the project will remain in a pilot phase with DCEP mainly used in domestic retail payments. But over time the scope will widen.

“Beyond domestic use cases, the pilot will also cover foreign guests during the 2022 Winter Olympics. Thus, when foreigners travel to China, they won’t need a local bank account. They can open a DCEP wallet and use the digital yuan. On returning home they can take DCEP with them. This is one example of how the digital yuan could cross borders.”

In conclusion Zou stressed that internationalisation of the yuan is a strategic objective of the PBoC, and DCEP will offer a new pathway for cross-border use of the national currency.

What lies under the hood of the digital yuan?

There is not much detail on the technical aspects of DCEP — much of the information is based on remarks by Chinese officials.

It is known that the digital currency will represent the monetary aggregate M0, backed by fiat yuan reserves on a 1:1 basis.

The PBoC put forward for public comment amendments to the laws that would legalize DCEP and ban issuing tokens pegged to it. The regulator proposes punishing violators with a fine of up to five times the income earned, cessation of activity and confiscation of profits from issuing and selling yuan-backed digital tokens.

The digital yuan will differ markedly from traditional cryptocurrencies. In particular, it will not have a publicly verifiable ledger or a decentralised network supported by rational agents.

There is planned a two-tier database system, overseen by the central regulator and commercial banks. The latter, according to The Block, will act as providers of digital wallets and ensure user interaction with the central bank in the context of payment requests.

DCEP will boast substantial throughput for handling the volumes required for retail operations. A centralised ledger will handle issuing the currency, clearing and settlement. Distributed ledger technology may be used to register the digital currency, and to ensure data security and integrity.

“The central bank bears macroprudential and monetary policy responsibilities to the public. Commercial banks will serve as the interface for retail users, offering the ability to deposit and withdraw the digital currency. In cooperation with the central bank they will also help ensure the stability of the money supply,” say The Block researchers.

As Fan Yi Fei explained, offline transactions are to be understood in the context of counterparty transactions. The central bank will have access to information about all operations for counter-terrorism and anti-money-laundering purposes. Whether commercial banks will enjoy the same level of access as the central bank remains to be seen.

There are reports that the digital yuan will support offline transactions. The feature would allow transfers between mobile devices when there is no internet access. The existing Chinese payment apps require at least an online connection to operate.

The offline-payment function is not yet available in the DCEP app; details of the mechanism remain scarce. Participants will test this capability in the next pilot phase.

“According to some reports, the DCEP will indeed feature some Bitcoin-like traits. For example, asymmetric cryptography (public and private keys) and to some extent a transaction model [UTXO]. These elements would allow DCEP to mimic a peer-to-peer nature while maintaining full traceability and avoiding bothersome pseudo-anonymity,” emphasised Connor Dempsy.

Technical details will emerge over time. But it is already clear that China’s DCEP is a “totally different beast” compared with traditional fiat currencies, added Dempsy.

A fly in the ointment

The Shenzhen authorities’ distribution of 10 million digital yuan among 50,000 residents is no more than a change of payment channel. The public does not realise what lies ahead, when monetary policy will be under even greater control of the Chinese central bank, — confidant Primitive Ventures’ managing partner Dovey Wan says.

The expert argues that with the transition to DCEP, the People’s Bank of China will be better able to deliver direct financial assistance to the public in the form of so-called “helicopter money.”

Wan says that for confiscating wealth, the authorities would only need to change “a couple of lines of code.”

In a digitising payments landscape now housed in the digital yuan, the public could easily lose autonomy, to be replaced by the central DCEP servers.

Some Twitter users see China’s developments as years ahead of Orwell’s 1984 dystopia.

1984 is coming?

— unite Lian连 (@unite49212139) October 12, 2020

The other side is that the regime may gain a powerful instrument to monitor citizens. The ability to easily manipulate interest rates and wield other monetary tools also risks encroaching on people’s savings and distorting market signals.

According to experts at the Atlantic Council, the release of a highly centralized DCEP carries the risk of reducing the role of financial intermediaries and pushing resources into an unregulated loan market. That could threaten financial stability and undermine the effectiveness of monetary policy.

***

China’s progress in digital currency has spurred similar research in other large economies. The European Central Bank, the Bank of England, the U.S. Federal Reserve, the Bank of Canada, the Bank of Japan, as well as the Sveriges Riksbank and the Swiss National Bank, have already defined core CBDC requirements.

The Bank of Korea will begin the final stage of testing a digital currency in 2021. The Bank of France carried out the first successful CBDC test in May, and Societe Generale entered into a partnership with ConsenSys. The possibility of issuing a digital ruble was allowed by the Bank of Russia.

CBDCs could fundamentally alter the traditional financial system, impacting a wide range of aspects of society.

Many questions remain, including the potential impact of DCEP and CBDCs on capital markets, the crypto industry, and in the long term the geopolitical landscape and the role of the U.S. dollar as the world’s primary reserve currency.

Whether China can deliver its ambitious plans and become the leader in monetary innovation remains to be seen.

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