Global reset – Monetary decoupling (Part 8: Sovereign digital currencies and networks in the currency war)
Phuah Eng Chye (25 September 2021)
Information disruption will be a major factor affecting outcomes in the currency war. Changes in the information properties of currencies through digitalisation opens up new possibilities and will affect the competitive positioning of countries and intermediaries.
Digital currencies: Momentum for faster adoption
Digital currencies started as a private sector initiative. Crypto currencies, such as Bitcoin, was created on the ideal of a decentralized digital currency operating on peer-to-peer networks independent from governments. This philosophy attracted a following, which as the number of adherents grew, so did the number of digital currencies. Stephanie Segal and Pearl Risberg notes “there are an estimated 7,000 distinct cryptocurrencies, with a combined market value in the hundreds of billions of dollars”. Momentum is building for faster adoption of both private and sovereign digital currencies. The pandemic, fiscal stimulus and low interest rates have stirred consumer and corporate interest. The exponential rise (and fall) of cryptocurrency prices have enlarged the investor base.
Kim Andreasson sees these developments as “a move towards cashless societies…incorporating a variety of approaches ranging from credit cards and payment apps to cryptocurrencies and central bank digital currencies (CBDCs)”. His survey[1] shows “more than one-half (56%) of consumer respondents believe that CBDCs are likely to replace physical or fiat national currencies in their country. And eight in ten institutional survey takers agree that consumer demand for all digital currencies (CBDC, open-source or corporate issued) has increased in their country over the past three years, while a similar number (76%) say covid-19 has accelerated demand and adoption. For corporate organisations, digital currencies are on the radar – both as a transactional unit and a store of value or appreciation; there is likely a reinforcing correlation between consumer and corporate use and acceptance”.
Survey respondents ranked “market trust or understanding of digital currencies and assets (47%), and financial market structures (43%)” as the “primary obstacles to greater adoption” and regulations (32%) ranked fourth. Kim Andreasson notes most respondents felt “a cryptocurrency with no intermediary or sovereign organisation controlling the supply presents relatively greater risk as an asset in a portfolio or treasury account”. Regulatory clarity may go a long way to easing such concerns. “Wider adoption and acceptance of CBDCs (31%) and availability of an institutional-only digital-currency exchange platform and (29%) appear to be the main triggers from the institutional and corporate survey for greater portfolio and treasury activity in cryptocurrencies, with respondents in North America most interested in an institutional-only exchange platform”.
Private digital currencies have so far blossomed in a regulatory vacuum. Cryptocurrencies “are privately issued and neither regulated nor backstopped by a monetary authority, raising questions about how their adoption might impact monetary policy transmission, visibility into economic and financial activity, and financial stability”. There are also concerns that private digital currencies and payment platforms could result in the disintermediation of traditional banks, undermine government oversight and financial sector stability.
After watching from the sidelines, governments have started to intervene. The interventions include an extensive crackdown on activities such as crypto mining and exchanges (in China), restricting the use of crypto for payments or issuing warnings on using or investing in cryptocurrencies. Formal regulatory frameworks on cryptocurrencies remain work in progress. Nonetheless, El Salvador bucked the trend by becoming the first country to recognise bitcoin as legal tender and other developing countries have signalled interest in following suit.
Ironically, what started as a movement advocating currency decentralisation independent of governments is being eclipsed by governments further extending their control through issuing their own digital currency. Central banks are coming on board[2]. Six countries – Bahamas, Saint Kitts and Nevis, Antigua and Barbuda, Saint Lucia, Grenada with Nigeria the latest – have launched central bank digital currencies (CBDCs) while 14 are in the pilot stages.
Issues on CBDC internationalisation
Raphael Auer, Codruta Boar, Giulio Cornelli, Jon Frost, Henry Holden and Andreas Wehrli highlights BIS survey findings that central banks view CBDCs as mainly catering to domestic use. Central banks appear cautious about “allowing usage of their CBDC by non-residents abroad, given the risks this may entail for the issuing and recipient economies”.
The European Central Bank (ECB) states “a digital euro could be issued (i) to support the digitalisation of the European economy and the strategic independence of the European Union; (ii) in response to a significant decline in the role of cash as a means of payment, (iii) if there is significant potential for foreign CBDCs or private digital payments to become widely used in the euro area, (iii) as a new monetary policy transmission channel, (iv) to mitigate risks to the normal provision of payment services, (v) to foster the international role of the euro, and (vi) to support improvements in the overall costs and ecological footprint of the monetary and payment systems”.
The ECB is mindful of “several risks related to the cross-border use of a digital euro. In general, wide circulation of a digital euro outside the euro area could have implications for capital flows and the exchange rate of the euro, with potential knock-on effects on the Eurosystem’s monetary policy stance and transmission. Such effects would depend on the characteristics of the digital euro, including its interfacing with non-euro payment systems, its remuneration and the limits on holdings (especially for transactions by non-euro area residents). If non-euro area residents were to rebalance their portfolios significantly towards digital euro, the size of and risks to the Eurosystem’s balance sheet would increase…strengthen the euro exchange rate and harm the competitiveness of euro area firms…amplify the real and financial cross-border spillovers of domestic monetary policy shocks by creating a new channel for their propagation…might facilitate…terrorist financing, money laundering and other cross-border criminal activities…Finally, the availability of a digital euro could lead to currency substitution in third countries, in particular those with weak currencies and fragile economic fundamentals. It might facilitate digital euroisation…In general, the threat that a digital euro poses to monetary sovereignty in non-euro area countries entails political risks”.
Raphael Auer, Codruta Boar, Giulio Cornelli, Jon Frost, Henry Holden and Andreas Wehrli note concerns “CBDCs could facilitate tax avoidance or a loss of domestic oversight capabilities. This could occur if domestic authorities had only a limited overview of holdings or transactions by residents in a foreign CBDC. A further potential concern is undesired volatility in exchange rates, for instance if flows between domestic currency and a foreign CBDC were to be disorderly. Finally, there could be complications in macroeconomic management, and in foreign economic cooperation, from the perspective of the issuing central bank”. They highlighted emerging economies are vulnerable to “digital dollarisation, or the risk that use of a foreign currency CBDC may become widespread in a recipient economy, displacing the domestic currency in payments and financial transactions…Specifically, households facing domestic economic instability or high inflation in their home currencies may look to a global stablecoin or foreign CBDC as a convenient means of payment and a safe store of value. Yet this trend may have destabilising effects on the economy as a whole, and might be difficult to reverse”.
From international payment system to digital currency areas
Despite these reservations, it is unimaginable that digital currencies will be limited to domestic use. Growing cross-border flows of CBDCs and cryptocurrencies will certainly disrupt the existing international payment networks. In this regard, the legacy cross-border payment networks are vulnerable as they riddled with inefficiencies. Raphael Auer, Philipp Haene and Henry Holden note “cross-border payments are settled through correspondent banking arrangements…currency conversion typically involves several parties, ie smaller payments will be netted and hedged in wholesale markets by banks…message standards…opening hours…compliance and regulatory standards can differ, adding frictions and risks”.
Markus K. Brunnermeier, Harold James, Jean-Pierre Landau predict “the ongoing digital revolution may lead to a radical departure from the traditional model of monetary exchange. We may see an unbundling of the separate roles of money, creating fiercer competition among specialized currencies. On the other hand, digital currencies associated with large platform ecosystems may lead to a re-bundling of money in which payment services are packaged with an array of data services, encouraging differentiation but discouraging interoperability between platforms. Digital currencies may also cause an upheaval of the international monetary system: countries that are socially or digitally integrated with their neighbors may face digital dollarization, and the prevalence of systemically important platforms could lead to the emergence of digital currency areas that transcend national borders”.
Raphael Auer, Codruta Boar, Giulio Cornelli, Jon Frost, Henry Holden and Andreas Wehrli point out “CBDC design can protect monetary sovereignty by making legitimate crossborder and cross-currency payments easier, thereby obviating the need to hold other currencies and helping a central bank to monitor transactions. For account-based CBDCs, tied to identity, central banks would retain greater control and oversight of cross-border use. Seamless integration of CBDCs could help make currency substitution less pervasive…by facilitating convenient crossborder and cross-currency payments. Smoothly functioning multi-CBDC arrangements could allow cheap and fast conversion to reduce the need to hold foreign currency”.
The BIS notes “the potential for a foreign CBDC to make deep inroads into the domestic market, or to take off as a dominant global currency, is likely to be limited. For example, for China’s account-based e-CNY to circulate widely in another jurisdiction, both the issuing central bank (the People’s Bank of China), and to a large extent also the central bank of the receiving jurisdiction would need to accept this situation. The issuing central bank would need to recognise a foreign user’s digital ID as that of a bona fide member of the CBDC network. The idea of paper currency circulating in the black market is thus an inaccurate analogy to how a CBDC would operate. In this sense, CBDCs have attributes that are very different to those of cash, even though both are direct claims on the central bank”. “For instance, a tourist from China who is shopping at a department store in a foreign holiday destination. Since issuing central banks would retain control over cross-border usage, they could restrict non-residents’ access to their currency to certain permitted transactions only. This might reduce the risk of volatile flows and currency substitution in recipient economies. Such restrictions would resemble existing rules governing how non-residents can open a bank account outside their home country…recipient economies have policy tools to address the concerns of digital currency substitution. In particular, robust legal tender provisions can ensure that the use of the national currency is favoured in domestic payments”.
BIS highlights “the cross-border use of account-based CBDCs will require international cooperation. One challenge relates to the use of digital ID information outside the originating country. The issuing authority or user may not be willing to provide this information to countries that may have different data protection regulations. ID systems may be not fully interoperable. Indeed, even within a jurisdiction, ID documents may be issued by several different public authorities, sometimes with limited coordination between them. As a supranational digital ID would require unprecedented concentration of an individual’s information, it would be politically fraught…Instead, international efforts towards mutually recognising national ID credentials are a more promising approach. A G20 roadmap for cross-border payments has given impetus to cooperative efforts in several directions, complementing the standard-setting efforts among central banks in the BIS Committee for Payments and Market Infrastructures. One building block involves fostering KYC and sharing information on identity across borders. Another involves reviewing the interaction between data frameworks and cross-border payments, and yet another involves factoring an international dimension into CBDC design”.
Stephanie Segal and Pearl Risberg notes “action on the part of national authorities will be required to align regulatory, supervisory, and oversight frameworks and provide the regulatory clarity required by private sector participants”; otherwise, “the efficiency gains of digital currency and digital payments may be lost on cross-border flows”. “At the same time, individual central banks with interest in CBDC cannot wait until all policy questions are answered to make progress. In the U.S. context, national legislation on data privacy and digital identity – the implications of which extend well beyond the scope of CBDC – may well be complementary to efforts at developing a digital dollar”.
Raphael Auer, Philipp Haene and Henry Holden note “payment system design is a domestic choice, but it has important international implications. Wherever there are macroeconomic or institutional reasons for dollarisation today, foreign CBDC issuance may aggravate this threat, by making it even easier for users to adopt a foreign (digital) alternative. A CBDC cannot, in itself, make a currency more stable. Yet CBDCs that form well-functioning multi-CBDC arrangements can then allow cheap and fast conversion to discourage holding of foreign currency”. They suggest multi-CBDC arrangements are preferable as it fosters “a diversity of convertible national currencies and strengthen monetary sovereignty in the digital age”. The adoption of “common technical standards, such as message formats, cryptographic techniques, data requirements and user interfaces can reduce the operational burden of participating in multiple systems. Aligned legal, regulatory and supervisory standards can simplify know-your-customer and transaction monitoring processes. However, without coordinated policy action, compatibility takes time. Experience has shown it takes years to coordinate participants in complex markets to move to common message standards or align legal frameworks”.
Markus K Brunnermeier, Harold James and Jean-Pierre Landau predicts “in the future, the international monetary system could possibly be structured around digital currency areas (DCAs)[3]. Even if this does not happen, digitalisation could reshape international monetary relations through increased currency competition and new ways to internationalise existing currencies…In a digital world, it becomes easier for (new or existing) currencies to compete with each other for two reasons. First, a currency supported by a digital network may be able to quickly achieve broad domestic and international acceptance. Second, switching costs – a traditional obstacle to currency competition – are lower. There are programs available on mobile devices that can be used to manage currency transformations…easy and instant computation of relative prices and conversion of monetary balances from one currency to another as well as automatic arbitrage. Digital currency competition will be starkly different from traditional currency competition”.
They add “digital networks are large, in fact larger than many national economies. They are not bounded by national borders”. DCAs “will compete across many dimensions. Some networks may offer different types of automated conditional payments (smart contracts) or interoperability with other financial services. Competition among digital currencies will effectively be a competition among bundles of information services provided by each network. One dimension of particular importance is privacy. DCAs’ currencies could differentiate themselves by how the networks manage users’ data. Some networks could intensely exploit or sell users’ data, whereas others may prioritise absolute privacy. Digital currency areas may lead to a less stable monetary architecture. If switching costs are low, people may be part of several different DCAs simultaneously…While it is easy to switch away from a digital currency, though, the additional informational and social connectivity provided by digital networks promotes greater cohesion of DCAs, above and beyond the cohesion of traditional currency areas”.
Markus K Brunnermeier, Harold James and Jean-Pierre Landau argue digitalisation is unlikely to lead to world global currencies. “Because digitalised money is inseparable from other essential features of digital networks, it will be subject to specific frictions. Digital currencies encompass a wide range of payment and data services. The provision of those services will face unequally stringent types of regulation in different countries. One key issue is privacy. Approaches to regulation in Europe, the US, and China are very different. Differing regulatory frameworks may make it difficult for network operators to fully exploit economies of scale and scope provided by big data. It may be impossible to use the same digital currency in different jurisdictions. This could be the ultimate paradox of digitalisation. Technically, digitalisation will break barriers and cross borders. But, because of its many inseparable dimensions, it may ultimately lead to an increased fragmentation of the international financial system”.
Digital yuan in the currency war
Stephen Cecchetti and Kim Schoenholtz argue CBDCs represent “an epic battle for the soul of the financial system…Central banks are thinking about whether they should substitute publicly issued digital currency for the bank-issued digital money that people use every day. How this plays out can profoundly reshape the financial system and make it less stable…The forces driving government decisions are unusual because there is a widespread fear of losing an emerging arms race. No one wants to face plunging demand for their currency or surging outflows from their financial institutions should another central bank introduce an attractive new means of exchange. But that pressure to prepare for the financial version of military mobilisation can lead to a very unstable global system that thwarts monetary control”.
Stephen Cecchetti and Kim Schoenholtz summarise “the problem, as we see it, is that central banks fear being left behind in a way that damages the interests of their jurisdiction. Their solution is to create a form of shovel-ready CBDC programmes. But, the resulting framework is unstable. The situation is analogous to the one prior to WWI, when countries prepared to mobilise rapidly for fear that delay meant losing a war. In the early 20th century, in the absence of trust, an obscure event in a far-off land tipped this fragile balance into war. In the current financial circumstances, the bad equilibrium is a world of multiple CBDCs in advanced economies that threaten financial stability domestically and pose a severe threat to monetary control in developing economies. We see no easy steps to prevent this poor outcome. As in a classic prisoner’s dilemma, there is little way to enforce the cooperative equilibrium in which no one introduces CBDC. First, central banks cannot credibly commit to never issue CBDC. Second, with China already headed down the CBDC road, others now view it as too late to resist – even with full knowledge of the risks, they feel compelled to prepare. Perhaps the best hope is that central banks will all proceed very slowly and…try to get the design right”.
Former central bank governor Zhou Xiaochuan[4] explains the digital yuan is part of China’s initiatives to modernize its payment system, to enhance retail usage, and to monitor illicit cross-border flows and capital flight. Observers note China is also concerned with risks posed by digitalisation such as the dominance of Alipay and WeChat Pay in the domestic payments system, Facebook’s proposed Libra[5], and crypto currencies and exchanges. These domestic considerations tend to be overshadowed by the potential role of the digital yuan in spearheading its internationalisation and the emergence of a yuan-based international payments network. The digital yuan will have the following effects on accelerating currency internationalisation.
- Strengthen international competitiveness of yuan. The existing payments system is skewed in favour of the USD and it is costly to transact in non-USD cross-currency pairs. With information disruption, new business models will emerge to arbitrage the non-USD cross-currency frictions. Digital currencies with their enhanced information bundles will facilitate new ways[6] of using currency, increase efficiencies and conveniences, and drastically reduce verification costs, settlement time and risks. The digital yuan will improve the currency’s international competitiveness.
- Facilitate liberalisation of capital controls. China has been reluctant to liberalise because it was concerned by leveraged speculative attacks on its currency from offshore markets. The digital yuan will alleviate these concerns as it operates in a China-controlled network and its regulators will be able to trace flows and settle only “authenticated” transactions (the equivalent of physical delivery and cash payments). This will allow regulators to monitor and stem the practice of round-tripping and multiple rehypothecation which are used to leverage speculative attacks on currencies in offshore markets. In this regard, the emergence of a digital yuan network will reduce the influence of offshore financial centers.
- Accelerate capital market development. The digital yuan and its network will greatly strengthen connectivity (and efficiencies) between the currency and yuan-denominated assets. This will facilitate greater use of sophisticated products, calibrated portfolio strategies and the development of information support services such as settlement, indices and ratings. This depends on whether they are also able to build the intermediation capacity and market liquidity to support capital market activities within the digital yuan network.
- Intensify geopolitical technology competition. Digital currencies are underpinned by patented technologies. Most countries are unlikely to develop their own systems and would likely license technologies and purchase products to support their digital currencies. Hence, a major battle to define the technology and interoperability standards in payment systems will ensue as part of the broader technology war.
One major objective of the digital yuan is to undermine the power of US financial sanctions. Robert Greene points out “the reliance of RMB cross-border infrastructure on SWIFT still has profound implications on China’s monetary sovereignty…The e-CNY network certainly fulfills this vision, as the PBOC will have near-complete control over its design and structure. The network’s use in large-value international transactions would hinder the United States’ ability to apply pressure on intermediaries to prevent such transactions between Chinese firms and entities in China, Iran, North Korea, and Russia subject to U.S. sanctions. In other words, the e-CNY could offer US-sanctioned Chinese companies, as well as Chinese firms seeking to carry out transactions with US-sanctioned entities at home and abroad, a way to do so without relying upon intermediaries that need access to U.S. dollars, including large banks. And importantly, this can happen without meaningful changes to capital controls policy; the e-CNY network would simply be used instead of other existing payment rails…Beijing seems to have the political will to facilitate such sanctions avoidance. A few months ago, the Ministry of Commerce enacted a blocking statute that could ultimately force any business operating in China to not comply with U.S. sanctions if compliance harms Chinese consumers and businesses. More recently, the National People’s Congress Standing Committee passed a sanctions law that seemingly gives the Chinese government power to seize the assets of or prohibit the business activities of any company that, by complying with U.S. sanctions, harms Chinese persons”. “The growth trajectory, financial stability implications, and geopolitical consequences of the e-CNY will depend on how the PBOC and other state organs resolve important structural details regarding its underlying network”.
Yaya J. Fanusie and Emily Jin argue that strategically, “China is seeking a stronger foothold in the global financial system of the future. Beijing aims to counter the U.S. role as standards setter, cultivate Chinese government leadership in international engagement on digital currency technology, and potentially offer technological know-how to other interested nations”. They warn that “since using (Digital Currency Electronic Payment) DCEP means directly providing personal data to the (Chinese Communist Party) CCP, U.S. officials should be as concerned about DCEP’s collecting data in the United States…An outright ban on Americans’ use of DCEP is probably not feasible, because many Americans with relatives in China may need to rely on the platform…U.S. policymakers should assess…to institute measures to restrict DCEP usage or broader, general restrictions on how financial data from U.S. persons can be collected by foreign entities…ensure that the U.S. National Security Strategy clearly defines the risks arising from CBDC deployments and lays out the U.S. direction for assisting, influencing, or responding to such efforts. In considering CBDCs as a security issue, the U.S. should articulate how it will continue to help maintain the integrity of the global financial system should they become more common…National Illicit Finance Strategy treats CBDCs as an emerging component of the international finance system and evaluates their illicit finance risks. Many U.S. companies are intertwined with China’s technology industry as investors, partners, subsidiaries, or recipients of Chinese private investment…identify and track the Chinese tech firms significantly involved with DCEP design and implementation. They should assess whether it is appropriate to introduce actions to require disclosure or licensing of U.S. firms involved with fintech tools, such as DCEP, that directly strengthen the CCP’s authoritarian activities and restriction of human rights, or otherwise to limit or unwind those firms’ involvement. And while assessing U.S. private sector ties to China’s digital financial system, the U.S. government should also listen to U.S. firms’ perspectives about any push factors drawing U.S. investors and talent to Chinese financial technology ventures over domestic ones – and consider ways to foster more local fintech innovation. Also, U.S. financial regulators should solicit and incorporate expertise from the private sector in responding to CBDC developments from China”.
Yaya J. Fanusie and Emily Jin suggests the US work with other “market” economies “to articulate a framework around CBDC design that goes beyond technical standards. The framework should prioritize protection of personal privacy and safeguard against government abuse of user data…This framework should be promoted as an alternative to the digital authoritarianism in the CCP’s DCEP model”. The US should “evaluate whether and how the United States can apply sanctions tools to CBDCs…study how trade-related enforcement actions against foreign CBDCs would affect the U.S. fintech sector…study the ways international shifts to CBDCs might affect existing trade regulations and bilateral investment agreements…assess how foreign nations’ CBDC accounts would affect U.S. tax evasion overseas and hinder or enhance foreign financial institutions’ adherence to the Foreign Account Compliance Act”.
Karen Yeung notes “China was not included in recent talks among central bankers from developed nations on potential collaboration involving CBDCs…A working group was formed by the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, Sweden’s Riksbank, the Swiss National Bank and the US Federal Reserve, along with the Bank for International Settlements (BIS), all of which are said to share a common motivation – avoiding unintended barriers for transferring sovereign currencies in their electronic forms”.
Undaunted, China is pushing ahead. Stephen Cecchetti and Kim Schoenholtz explain “it is easy to see why the People’s Bank of China is moving ahead of other central banks in creating a digital renminbi. Its large banks are typically state owned, so there is little risk of disintermediation – even in a financial crisis. With stringent capital controls in place, there currently are effective limits on inflows into the currency. There already is little expectation of personal privacy. Finally, if the government wishes, state-owned banks can easily subsidize access”. In contrast, other developed countries (US, Europe, Japan and Korea) appear to be treading cautiously. They are burdened by legacy intermediation and privacy issues and concerns about the potential damage from abrupt information disruption.
Conclusions
The list of countries issuing sovereign digital currencies or adopting private digital currencies is likely to grow rapidly. In particular, China’s economic size and the ubiquity of its mobile payments systems means the digital yuan will have an outsized effect; particularly in the context of decoupling. Digital currencies could tilt the balance against USD dominance as they will disrupt the US-centric payments system, weaken US oversight over international financial flows and ultimately even reduce the need for a dominant international reserve currency. Digital currencies thus will have massive implications on the international monetary system; particularly in relation to the cross-border sharing of information, patterns of capital flow and intermediation.
References
Atlantic Council (7 August 2021) “Central Bank Digital Currency (CBDC) tracker”.
Bank of International Settlement (BIS) (23 June 2021) “Annual economic report 2021: Chapter III. CBDCs: An opportunity for the monetary system”. https://www.bis.org/publ/arpdf/ar2021e3.htm
Barry Eichengreen, Ganesh Viswanath-Natraj (25 April 2020) “Libra still needs more baking”. Voxeu. https://voxeu.org/article/libra-still-needs-more-baking
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[1] The survey based on 3,053 consumers and 200 institutional investor and corporate treasury management respondents was conducted in early 2021.
[2] See Atlantic Council; Bank for International Settlements (BIS); and James Pang for reviews on central bank progress on CBDCs.
[3] They define DCA as a network where payments and transactions are made digitally by using a currency that is specific to this network.
[4] See Global Times.
[5] See Douglas Arner, Raphael Auer and Jon Frost; by Barry Eichengreen and Ganesh Viswanath-Natraj; and by Julia Anderson and Francesco Papadia for critiques on the regulatory shortcomings of Libra.
[6] See International Monetary Fund for an overview on digital currencies.