Fan Yifei, Vice Governor of the People’s Bank of China

I. China’s central bank digital currency should adopt a two-tier placement system

Issuing a central bank digital currency in a large country is a complex system project. China is a vast country with a large population, and the economic development, resource endowment and education level of the population vary greatly from region to region. In the process of designing and placing (issuing) and circulating the central bank digital currency, the diversity and complexity faced by the system and system design should be fully considered. For example, it is necessary to consider the use of remote areas with insufficient network coverage. If single-tier is used, it will face a great test due to the above factors. In order to enhance the convenience and service availability of the central bank’s digital currency and strengthen the public’s willingness to use it, a two-tier (two-tier) placement can be considered to cope with the above difficulties.

“Two-tier placement” is conducive to making full use of the existing resources, talents and technologies of commercial institutions, and to promote innovation and competitive selection through market-driven. Commercial banks and other institutions have a relatively mature IT infrastructure application and service system, a strong processing capacity of the system, and have accumulated certain experience in financial technology applications and other aspects, with a more adequate talent pool. Therefore, it is a huge waste of social resources to start another stove and duplicate construction outside the existing infrastructure, human resources and mature application and service systems of commercial banks. Under the premise of safety and reliability, central banks and commercial banks and other institutions can work closely together without pre-determined technical routes, fully mobilize market forces, achieve system optimization through competition, and jointly develop and operate together. This is conducive to the integration of resources and synergies, as well as promoting innovation. Moreover, the public is already accustomed to handling financial services through commercial institutions such as banks, and the two-tier launch will also help to enhance public acceptance of the central bank’s digital currency.

“Two-tier placement” helps to diversify and resolve risks. During the development of the previous interbank payment clearing system, the central bank has accumulated a wealth of experience, but the interbank clearing payment system is a direct service to financial institutions, and the central bank digital currency is a direct service to the public, involving thousands of households. It is not easy to rely solely on the central bank’s own strength to conduct research and development to support such a huge system, which must meet the goals of security, efficiency and stability, as well as the needs of user experience. At the same time, the central bank is also constrained by objective constraints such as budget, resources, personnel and technology, which can avoid over-concentrating risks through a two-tier launch design.

“Two-tier placement” can avoid “financial disintermediation”. Under the “single-level placement”, the central bank will directly place the digital currency to the public, and the central bank’s digital currency will compete with the deposit money of commercial banks. Obviously, the credit rating of the central bank’s digital currency endorsed by the central bank is higher than that of commercial banks’ deposit money, which will have a crowding-out effect on commercial banks’ deposits and may lead to “deposit migration”, thus affecting commercial banks’ loan placement ability. In addition, the reduced ability of commercial banks to absorb deposits will increase their reliance on the interbank market, raising the price of funds, increasing the cost of social financing, harming the real economy and triggering “financial disintermediation”. In order to maintain their lending capacity and financial stability, the central bank will have to subsidize commercial banks. In extreme cases, the existing financial system will be overturned, and the central bank will have a “unified” situation.

In summary, the two-tier model of “central bank – commercial institutions acting as a placement agent” is a choice that is suitable for China’s national conditions and can make full use of existing resources and mobilize the enthusiasm of commercial banks. First of all, it does not change the creditor-debtor relationship of the currency in circulation. In order to ensure that there is no over-issuance of currency, the agency depository is required to pay 100% of the reserves to the central bank. Therefore, the central bank digital currency held by the public is still a central bank liability, guaranteed by the central bank credit, and has unlimited legal solvency. Secondly, it will not change the existing monetary delivery system and dual account structure, and will not compete with the deposit money of commercial banks, increase the reliance of commercial banks on the interbank lending market, or affect the lending ability of commercial banks, and will not lead to the phenomenon of “financial disintermediation”. Again, as it does not affect the existing monetary policy transmission mechanism, it will not reinforce the pro-cyclical effect in a stressful environment and therefore will not have a negative impact on the current way of running the real economy. Finally, the model is more conducive to the advantages of the central bank’s digital currency, saving costs, improving the speed of currency circulation, and enhancing the convenience and security of payments. In addition, with the credit advantage of central bank endorsement, it is conducive to curbing public demand for private cryptographic digital currencies and consolidating our monetary sovereignty.

Second, under the two-tier placement system arrangement, China’s central bank digital currency should be placed in a loosely coupled way with accounts and adhere to the centralized management model

In order to maintain the attributes of the central bank digital currency and achieve monetary policy and macro-prudential management objectives, China’s central bank digital currency two-tier placement system should be different from the decentralized mode of various tokens issuance model. First, because the central bank digital currency is still a liability of the central bank to the public, its debt relationship has not changed with the currency form, and thus the central bank’s central position in the placement process must still be ensured. Second, the macro-prudential and monetary policy regulation functions of the central bank need to be ensured and strengthened. Third, the binary account system is not changed and the original monetary policy transmission mode is maintained. Fourth, in order to avoid over-issuance of currency by proxy placement agencies, there needs to be corresponding arrangements to achieve central bank tracking and supervision of digital currency placement.

Therefore, the central bank digital currency should adhere to the centralized placement model. However, the centralized placement model described here is also different from that of traditional electronic payment instruments. The transfer of funds in electronic payment instruments must be done through accounts, using a tight coupling of accounts. The central bank digital currency, on the other hand, should be based on a loosely coupled form of account, so that the transaction link is dependent on the accountgreatly reduced. This makes it as easy to circulate as cash and enables controlled anonymity. Central bank digital currency holders can directly apply it to various scenarios, which is conducive to the circulation and internationalization of the RMB. In addition, if there is no third-party anonymity for transactions, personal information and privacy will be compromised; but if full third-party anonymity is allowed to be achieved, it will facilitate crimes, such as tax evasion, terrorist financing and money laundering. Therefore, in order to strike a balance, controlled anonymity must be achieved and transaction data must be disclosed only to the central bank, a third party. Under a loosely coupled account system, correspondent depositories could be required to transmit transaction data to the central bank on a daily basis asynchronously, both to facilitate the central bank having the necessary data to ensure that regulatory objectives such as prudential management and anti-money laundering are met, and to reduce the systemic burden on commercial institutions.

Third, the design of China’s central bank digital currency at this stage should focus on M0 substitution, not M1 and M2 substitution.

At this stage, M1 and M2 are based on commercial bank accounts, which have been electronically or digitized, and there is no need to digitize them again with digital currency. The inter-bank payment clearing system (such as large and small amount payment system and online payment inter-bank clearing system, etc.), the intra-bank system of commercial banks and various network payment means of non-bank payment institutions supporting the flow of M1 and M2 are functioning normally, and are constantly being improved and upgraded, becoming more and more efficient, and can meet the needs of China’s economic development. Replacing M1 and M2 with the central bank’s digital currency will not help improve payment efficiency, but will also cause a huge waste of the existing system and resources. In contrast, the existing banknotes and coins are more costly to issue, print, recycle and store, have more layers in the circulation system, and are inconvenient to carry, easy to be counterfeited, anonymous and uncontrollable, and have the risk of being used for money laundering and other illegal and criminal activities, so the need to realize digitalization is increasing day by day. In addition, non-cash payment instruments, such as traditional bank cards and Internet payments, are based on a tightly coupled model of accounts and cannot fully meet the public demand for easy-to-use and anonymous payment services, and cannot completely replace M0, especially in areas with poor account services and communication network coverage, where the population’s reliance on cash remains high. Central bank digital currencies maintain the attributes and key features of cash notes, satisfy the need for portability and anonymity, and will be the best tool to replace cash notes.

Because the central bank digital currency is an alternative to M0, it should not be subject to interest payments. This will not lead to “financial disintermediation”, nor will it lead to inflationary expectations. Accordingly, it will not have a major impact on the existing monetary system, financial system and real economic operation.

Similarly, since the central bank’s digital currency is an M0 alternative, it should also comply with all existing regulations on the management of cash and anti-money laundering and anti-terrorist financing. In order to cooperate with anti-money laundering and other related work, relevant institutions may be required to report to the central bank regarding large and suspicious transactions of the central bank digital currency. At the same time, in order to guide the application of central bank digital currency in small retail business scenarios, not to have a crowding-out effect on deposits, and to avoid arbitrage and pro-cyclical effects in a stressful environment, daily and annual cumulative transaction limits may be set for it, and large-amount exchange appointments may be required. If necessary, consideration could also be given to implementing tiered fees for the exchange of central bank digital currencies, with no fees for small, low-frequency exchanges and higher fees for large, high-frequency exchanges and transactions to increase exchange costs and institutional frictions. With a zero lower bound on interest rates, such an arrangement could also create conditions for the central bank to implement a negative interest rate policy.

Fourth, a cautious attitude should be maintained towards central bank digital currencies loaded with smart contracts

According to the definition given by Nick Szabo, a smart contract is a set of commitments defined in digital form, including an agreement on which the contract participants can execute these commitments. Smart contracts are written into computer-readable code. Once the trigger conditions are met, they are automatically executed by the computer. It can be loaded with preconditions such as time and credit, and can also be used in a variety of scenarios such as tax payment and counter-terrorism financing.

However, as mentioned earlier, the central bank digital currency is an alternative to M0 and has unlimited fiat, i.e., it assumes the functions of a measure of value, a means of circulation, a means of payment and a store of value. The original cash notes do not carry any other social and administrative functions. The Regulations of the People’s Republic of China on the Administration of RMB stipulate that intentional destruction of RMB is prohibited. Therefore, adding additional social or administrative functions to the cash notes actually smacks of damaging the RMB.

In order to maintain the legal status of unlimited legal tender, the central bank’s digital currency should also not assume other social and administrative functions in addition to the four functions proper to a currency. The loading of smart contracts other than the legal tender itself will affect its forensic function and even make it fade into a valuable instrument, reducing the degree of free use of our central bank’s digital currency and adversely affecting the internationalization of the RMB. It will also reduce the speed of currency circulation and affect the transmission of monetary policy and the central bank’s performance of macro-prudential functions. At the same time, it may also violate citizens’ right to privacy, which is not conducive to the protection of personal rights and interests.