By Bai Guo

“Cash is king!” That is a phrase that hasn’t aged well. In China, at least, cash is rapidly becoming obsolete. Just three years ago, in 2019, less than 10% of all China’s transactions used cash, demonstrating the supremacy of digital payment tools over timeworn coins and notes.

The next generation of money is now in its infancy, as emerging digital technologies create new and ever more efficient ways of moving, storing and spending capital. But what does this mean in practical terms for China, its economy, its consumers, and the wider international monetary system? With cryptocurrencies still experiencing extreme volatility, attention is turning to Central Bank Digital Currencies (CBDCs) and their potential to navigate a safe path between harnessing the power of digitalisation but with greater stability and predictability.

Defining the role of money in the digital age

1. Means of exchange
2. Storage of value
3. Unit of account

When combined, these three functions essentially allow everyone participating in the economy to keep track of ‘who owns what,’ while also allowing money to represent the final step in signifying when property rights of assets are transferred from one party to another. While the most popular digital payment platforms today allow for faster, more efficient and more convenient transactions than ever, they are still intrinsically linked to users’ bank accounts. Hence, they are tied directly to ‘real money,’ to cash that can be physically withdrawn.

If cash is to be phased out entirely, any would-be successor system must fulfil these three functions, even if they are spread over a range of digitised forms of money. For example, some new digital money forms might initially serve limited roles and evolve into the ‘full shape’ of money. Alternatively, people might pick and choose various currencies for different purposes.

Accordingly, while actual cash might be outmoded as a form of daily exchange (particularly in China) it remains a highly necessary unit of account and representation of stored value – at least until new digital currency formats can reliably take its place.

Cryptocurrencies – A mix too volatile to become next-gen money

Despite its headline-grabbing power, Bitcoin already appears to have failed as a viable currency, or even as a reliable vehicle for the storage of value. The price of Bitcoin and other prominent cryptocurrencies rose dramatically at the start of the pandemic, only to fall once the global vaccination response took hold. This is only one of the more recent examples of Bitcoin’s rollercoaster ride of peaks and troughs.

Even with growing cross-industry interest in blockchain technologies, it remains difficult to build confidence in Bitcoin or other cryptocurrencies as a means of regular exchange. There are no specific institutions (such as central banks) to back the value of cryptographic tokens. In Bitcoin’s case, there is also a set cap on the mining of further tokens, discouraging its routine spending or exchange. Lastly, the validation process of Bitcoin transactions is a relatively slow, and vastly expensive process in terms of the computing power and related electricity costs. Relying on Bitcoin as a medium for the world’s daily financial transactions would incur an environmental cost that would be simply ruinous.

This leaves cryptocurrencies roughly where they were five years ago; that is, they are an interesting, almost tantalising investment vehicle and a near ‘philosophical’ experiment in wealth creation. However, given that their value is based almost entirely on the collective perception of their investors, they remain among the most volatile, and least understood, elements of the current global financial system.

Enter Central Bank Digital Currencies (CBDCs) – A promising ‘middle way’

When imagining the architecture of the next generation of money, advocates of CBDCs see them as a way to “have your cake and eat it too.” A fully-fledged CBDC could embrace all the efficiency savings, ecological benefits and system simplifications enabled by digitalisation, while still maintaining sufficient control of the issuing, storing, exchange and redemption of the money itself. Unlike cryptocurrencies, CBDCs are backed by institutions (just like regular cash) who want to preserve the three principles of public policy that must be respected: financial integrity, financial stability and the effectiveness of monetary policy.

Decisions, decisions – How will CBDCs take shape?

Three key questions will determine the ultimate impact, and limitations, of CBDCs in the near future. First, what architectural form should CBDCs take to achieve these goals while maximising their utility and efficiency? Should they follow the ‘indirect model’ – similar to the currency monetary system – where households and businesses have claims against financial intermediaries, but the central bank only keeps account of the wholesale claims of each intermediary, and leaves the intermediaries to manage the individual payments themselves? Or is a more radical, ‘direct model’ preferable, where all CBDC claims are directly against the central bank?

If successful CBDCs choose the latter, the impact on financial systems will be fundamental. Central banks will wield even greater influence and muscle, while greatly weakening that of financial intermediaries. The ultimate consequences of this move may envisage the complete restructuring of the relationship between financial institutions, asset-holding businesses and individuals, and the money they hold.

Another key question is the management of CBDC payments. If they embrace blockchain, or any distributed ledger infrastructure using a peer-to-peer network, they could gain the benefits of greater transparency and security (potentially invaluable weapons against corruption and fraud). On the other hand, a centrally controlled infrastructure offers more predictability, but it may mean missing out one of the more radical and impactful digital innovations of our generation.

Finally, each CBDC must decide on whether to go account-based or token-based. This matters deeply, as it will determine the extent to which users will enjoy anonymity in their transactions. In a token-based system, users do not have to reveal their identity; they only provide proof that the money transferred is valid, much like a cash-based exchange. In an account-based CBDC system, transactions are conducted as transfers of claims between accounts held at the central bank. This system would give the central bank much stronger capabilities when trying to detect fraud or money laundering, and substantially greater oversight of exactly who is moving their money around. While this clearly benefits the central bank (and whoever it answers to), it may scare off users who value their anonymity, stymying adoption rates and confidence in the currency and the wider financial system itself.

Together, these three crucial elements will determine the purpose, usage and appeal of CBDCs. With more central banks ready to experiment with this monetary format, benchmarking and comparing the different combinations of approaches will become easier as more examples emerge.

Evaluating the e-CNY – China’s next-gen money experiment

The People’s Bank of China (PBoC), China’s central bank, is ahead of the CDBC game in several respects. It started studying digital currencies as early as 2014, leading to the creation of its CDBC – the e-CNY – in 2017 and a ‘soft launch’ in 2019.

Perhaps unsurprisingly, the e-CNY is a currency that is not designed to rock the boat, but rather to provide a convenient alternative to cash while testing the waters of digital finance innovation in a practical sense. It leverages some blockchain technology but is not a cryptographic token. It does not bear interest, limiting the risk of crowding out bank deposits based on regular CNY. It follows a two-tier model, where the PBoC issues the CBDC itself, but also credits participating institutions, such as major commercial banks, telecoms operators and, of course, WeChat and Alipay. Lastly, it operates on a policy of “controllable anonymity,” where the PBoC reserves the right to lift the anonymity of users if it suspects illicit activities or corruption.

Together, these design elements make the e-CNY an interesting but not radical CDBC. In almost every aspect, it has been designed to strike a delicate balance between leveraging the advantages of digitalisation and providing a stable, predictable new money format that complements the existing financial order, rather than overhauling it.

What does the introduction of the e-CNY mean for China, CDBCs and the international monetary system?

The introduction of a large-scale instant payment infrastructure, sponsored by the Chinese Government rather than private companies, is currently a domestically focused move. The e-CNY is about giving the Chinese population the option to slowly acclimatize towards a truly ‘cashless’ financial setup, while testing its effects on the domestic financial system as a whole. The design of the e-CNY means it doesn’t weaken central control or the visibility of money markets; on the contrary, it may well strengthen them.

In terms of immediate impact, the e-CNY may prove decisive in providing financial inclusion to China’s unbanked, who represent 20% of the adult population. If adoption rates grow swiftly, there may be a further benefit to the Chinese Government in the reduction of the total costs of printing, circulating and maintaining banknotes.

As for its limitations, the e-CNY is not going to strengthen the global presence of China’s currency, at least in its current iteration. Since the e-CNY does not bear interest, foreign investors will be less interested in it, even if it becomes easier to access internationally.

While the design of the e-CNY all but guarantees a slower, more incremental evolution, it also holds the potential (along with other CDBCs) to revolutionise the international monetary system. If deployed intelligently, CDBCs may provide the key to significantly improving cross-border payments. If the e-CNY can offer a better, cheaper and faster solution to international payments, then more companies – in and outside of China – will be encouraged to settle their transactions in Renminbi. Ultimately, this could be viewed as the ‘beginning of the end’ of the dominance of the US dollar as the go-to intermediary for foreign exchange operations.

If this does end up being the case, they we truly are in the beginning of a new generation of money, and its global reorganisation.

Bai Guo is an Assistant Professor of Strategy at CEIBS. For more on her teaching and research interests, please visit her faculty profile here.