JUNE 2021

Central Bank Digital Currency:

A boon to the global trading system?
BY STEWART PATERSON
RESEARCH FELLOW, HINRICH FOUNDATION
 Introduction
The debate over Central Bank Digital Currencies, or CBDC, has become more
prominent among policy makers and in the media since the publication of the
Hinrich Foundation’s primer report on the subject. According to the Bank of
International Settlement (BIS), more than 80% of central banks around the world
are now studying the feasibility of this new form of digital central bank money.

Developments in China are gaining particular attention. China’s CBDC, known as

Electronic Payment / Digital Currency (EPDC), has undergone significant trials.
Local governments in Chengdu, Shenzhen, and Suzhou have issued millions of
dollars’ worth of the digital currency through a lottery. E-commerce giant JD.com
also participated in the trial by allowing some purchases to be paid with the digital
yuan. The trial has added private bank Zhejiang E-Commerce Bank in Zhejiang
province to its roster of seven banks to test the digital yuan.

The People’s Bank of China has For cross-border transactions, the People’s Bank of China (PBoC) has combined
combined with the Hong Kong with the Hong Kong Monetary Authority, the central bank of the United Arab
Monetary Authority, the central Emirates, and the Bank of Thailand to explore the potential for making CBDC inter-
bank of the United Arab Emirates, operable between platforms. The goal: to facilitate cross-border payments using
and the Bank of Thailand to explore multiple digital currencies.1
the potential for making CBDC inter-
operable between platforms. These recent developments prompt the question: Will central bank digital
currencies help to advance or hinder future global trade?

China’s digital yuan

China’s EPDC is not the first CBDC. In late 2020, the Bahamas launched the Sand
Dollar, the world’s first digital currency, after years of development.

The digital yuan is different from Bitcoin. The CBDC will be legal tender in the
same way as physical cash and holders will be able to meet tax liabilities using
digital yuan. For now, the currency will operate on a “two-tier system”, with the
PBoC distributing the currency to domestic commercial banks who pass it on to
customers. Users hold a digital wallet on their phones or electronic devices and
transact for goods and services by passing the electronic currency to one another.

The EPDC takes on considerable China’s EPDC is the first to be trialed in a major global economy. More accurately,
significance as a potential currency for the EPDC takes on considerable significance as a potential currency for the world’s
the world’s second largest economy second largest economy, largest trading nation, and manufacturing powerhouse.
and largest trading nation. For more than 120 nations, China is their most important economic partner in
terms of trade. China is also arguably the global leader in financial technology.
China has been a rapid adopter of electronic payments. As of December 2020,
about 852 million people in China used mobile payment methods for hundreds of
billions of transactions.

Authorities are keen to stress that the motivation behind its development is
primarily domestic. These objectives can be broken down into three parts. The first
objective may be to provide competition to the oligopolistic e-payment systems
that currently dominate retail payments in China – Alipay and Wechat pay. These
private payment systems have about a 90% market share of China’s e-payments
market and are perceived as posing a threat to the State-run financial system.
Their monopolistic behavior has also been criticized as potentially damaging to
consumer interests.

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 The second objective may be to harvest information pertaining to the macro
economy that in turn can be used to better fine tune macroeconomic stabilization
policy. This may well include, but is not limited to, information pertaining to the
credit worthiness of both individuals and companies. This would be useful to
banks, the majority of which are state-owned, in managing their loan portfolios.
This will, to some extent, level the playing field between the private e-pay
companies and the state-owned banks.

Thirdly, one goal may be to increase financial inclusion, by making a state-

sponsored means of electronic payment widely available at zero (or near zero)
cost to users.

A configuration approximating to There are two international dimensions of China’s CBDC. The first relates to
a renminbi bloc might emerge in relatively small payments associated with, for example, tourism or e-commerce.
countries with deep economic and The success of Alipay and UnionPay in internationalizing their systems in the wake
investment relationships with the of increased overseas travel from China is perhaps indicative of the digital yuan’s
People’s Republic of China. prospects. The currency might gain acceptance abroad to facilitate payments
by Chinese visitors or workers employed overseas by China’s Belt and Road
infrastructure projects. A configuration approximating to a renminbi (RMB) bloc
might emerge in countries with deep economic and investment relationships with
the People’s Republic of China.

The second international dimension is potentially more significant for trade as well
as geopolitics. China’s CBDC may be used wholesale for the settlement of large
trade or investment related transactions. Underlying the desire to internationalize
the RMB – that is, the expansion of its role in international transactions and
potentially as a reserve currency – is the possible aim to supplant the US dollar as
the global reserve currency. Although Chinese money stock is now larger than that
of the United States – in 2019, China’s M2 stood at the equivalent of USD28 trillion
versus USD16 trillion in the United States – foreign exchange reserves remain
the overwhelming asset on the PBOC’s balance sheet and these continue to be
dominated by US dollars despite some diversification.

If China succeeds in supplanting the US dollar, it would increase the seigniorage

that accrues to the Party-State and challenge what is often referred to as
America’s ‘exorbitant privilege’. Linked to this is, presumably, the goal of
immunizing the Chinese economy and important trading partners and political
allies such as Iran and North Korea from the possibility of economic sanctions.

What is wrong with current arrangements for cross-border payments?

Following the start of advancing globalization in the 1980s, the world witnessed
the rapid growth of trade, foreign direct investment, international portfolio
investment, and remittances. The international e-commerce sector can now be
added to this list of drivers of growth of cross-border transactions. E-commerce
has led to an explosion in the size of the cross-border movement of money.

According to the Bank of England, According to the Bank of England, the size of the cross-border payment market is
the size of the cross-border payment about USD150 trillion, or about 1.8 times of global GDP.2 Furthermore, the size will
market is about USD150 trillion, or increase to about USD250 trillion over the coming five or six years. Given the size
about 1.8 times of global GDP. of flows involved, modest improvements in efficiency could have a large impact,
be they involve lower costs, greater security, or speed. This is why the G20 has
prioritized cross-border payments as an area for investigation and improvement.

The current system is based on a network of correspondent banks, the SWIFT

messaging system, and a variety of payment and settlement systems such as

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 CHIPS. The multi-layered system has evolved over the decades. Currency does
not cross borders. Instead, accounts are debited and credited in each jurisdiction
upon receipt of instructions. Transfers between large economies and in liquid
freely traded currencies can be very quick and efficient. A USD and Euro transfer,
for example, will be cheap and fast. Problems arise and costs escalate as the chain
of intermediaries lengthens. Transferring money between Brazil and Thailand may
involve several correspondent banking relationships.

In the aftermath of the 9/11 attacks on the United States and again after the
global financial crisis of 2009, regulations that impact international money flows
have been tightened. Efforts to monitor global payments related to counter
terrorism financing initiatives and anti-money laundering policy, together with
tough punishments for banks found in breach of the rules, have resulted in greater
friction and a reduction in the number of correspondent banks.

The risks of the cross-border payments industry have increased. Consequently, the
rewards of the industry need to be greater to compensate for the risks, or banks
withdraw from the market. In 2020, Westpac Bank in Australia was fined AUD1.3
billion for breaches of Anti-Money Laundering rules. In 2014, BNP Paribas was fined
nearly USD9 billion for processing cross-border payments on behalf of clients that
were in breach of US economic sanctions against Iran, Sudan, and Cuba.

Following the bail-out of various The global financial crisis has also impacted trade financing and cross-border
banking systems, regulators were keen payments. Following the bail-out of various banking systems, regulators were
to ring-fence banks to limit the costs to keen to ring-fence banks to limit the costs to taxpayers of future crisis. This has
taxpayers of future crisis. increased the capital intensity of international operations and influenced the
reduction in the correspondent bank network.

The cost of cross-border financial transactions is high, relative to domestic

transfers. According to McKinsey, cross-border transactions account for about
16% of total transactions by value. However, the revenue from such transactions
accounts for 27% of the total revenue of the payments industry.

International transactions are on Therefore, international transactions are on average 70% more expensive than
average 70% more expensive than domestic transfers. At the extreme, the IMF estimates the average cost of a
domestic transfers. remittance payment to be 7% of the transfer value – and can be as high as 15% to
20% in some corridors. Remittance payments tend to be small, which makes the
costs relatively high. For economies such as the Philippines or Bangladesh, where
remittances are large relative to the size of the economy, these payments impose
a serious cost.

In contrast, business to business transfers, which constitute about 80% of cross-

border payments by value, cost about 0.1% of the transfer value. For the banks,
this amounts to approximately USD125 billion in revenue stream.

It can be argued that, broadly speaking, the main outstanding issues with high
value cross-border payments between developed markets is their potential to
be cheaper and faster. It has long been the case that small and medium-sized
enterprises, or SMEs, account for a smaller share of cross border payments than
they do of overall economic activity. This may be indicative of barriers that smaller
scale presents to international trade. The most costly and lengthy transfers tend to
be of small value and along under-serviced corridors to emerging economies. This
is where potentially the greatest gains lie.

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There is little point in reducing trade A more sustainable global trading system requires greater participation from
barriers on a multilateral basis through developing countries. Costly, slow, and risky international payments present a
the WTO or plurilaterally through barrier to trade and subsequent integration into the global economy. There is
regional trade deals if the financial little point in reducing trade barriers on a multilateral basis through the WTO or
infrastructure to facilitate associated plurilaterally through regional trade deals if the financial infrastructure to facilitate
payments is not in place or is too associated payments is not in place or is too costly to be effectively utilized.
costly.
Sources of friction in international payments
The international payments system has several sources of friction. Understanding
these frictions is a prerequisite in determining to what extent new technology
might reduce them and whether CBDC will be a part of the solution. The major
sources of friction and subsequent high costs and slow delivery, as identified by
the BIS, are:

– Fragmented data standards that lead to a lack of interoperability between

participants
– Oversight regulations pertaining to anti-money laundering and countering the
financing of terrorism
– Complexities revolving around data protection standards in different
jurisdictions
– Different operating hours across different time zones
– Outdated legacy technology platforms
– Barrier to entry
– Funding costs / capital intensity

The G20 has challenged the Committee for Payments and Market Infrastructure
(CPMI) of the BIS and the Financial Stability Board (FSB) to prepare a plan to
overcome the frictions in the cross-border payments system and increase its
utility. Their reporting has three sections: the first identifies the problems; the
second identifies 19 building blocks for an updated eco-system, and the third
outlines a road map for achieving the goals.3

There are five focus areas in the building blocks:

– The public and private sector’s joint commitment to enhance cross-border

payments
– The coordination of regulatory, supervisory and oversight frameworks
– Improvement of existing payment infrastructures and arrangements to support
the requirements of the cross-border payments market
– Strengthening of data quality and straight through processing by enhancing
data and market practices
– Exploration of the potential role of new payment infrastructures and
arrangements

According to the CPMI and FSB reports, incremental changes to the existing
infrastructure and design could be expedited over the next one or two years.
However, a fundamental change in the technology used, such as distributed ledger
technology (DLT) and therefore possibly CBDC, is some way off.

China’s distinction as the only major China’s distinction as the only major economy to pursue a CBDC on a trial basis is
economy to pursue a CBDC on a trial no surprise. It is not impossible to have a new multilateral cross-border payment
basis is no surprise. It is not impossible system, or indeed more than one. The current system operates on several “rails”
to have a new multilateral cross-border and the future is likely to be the same with competing technologies. The question
payment system, or indeed more than is: If in ten years the CBDC is widely used in multiple jurisdictions, will it help
one. overcome the frictions in the system?

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 Distributed ledger technology & CBDC
As is already well understood, digital central bank money already exists – almost
everywhere – in the form of bank reserves at the central bank. What is commonly
thought of as CBDC is perhaps less of a break with the past than is often thought.
In addition, commercial bank money is also digitalized.

What is driving retail CBDC, as being trialed in China, is a combination of the

growth in e-commerce, the proliferation of private electronic payment vehicles,
and the advances in ledger technology (distributed or centralized) for record
keeping. This is taking place against a backdrop of wide adoption of smartphones
by the population.

It is worth noting that China’s two-tier CBDC does not use blockchain as its
ledger technology. Advances in ledger technology have the potential to improve
the efficiency of the cross-border payments systems. However, there is a good
argument for saying that incorporating the benefits of ledger technology does
not in itself require a retail CBDC. Banks already have access to central bank digital
money, while consumers have access to digital commercial bank money. One
consideration would be to widen access to central bank digital money to a variety
of non-banks involved in payments such as money transfer operators.

The number of private companies deploying DLT or other technologies to make

cross-border payments more efficient is multiplying. Fintech company Ripple has
been operating in the Mexico-US corridor using DLT, with considerable cost and
time savings. Circle pay is deploying DLT for peer-to-peer payments. SWIFT is
exploring DLT to overhaul B2B payments.

If financial inclusion is the sole goal of The design of retail CBDC involves making choices; for example, account based
the CBDC, a tokenized form that avoids versus tokenized. The design choices impact directly on the utility and character
the need for financial intermediaries of the end product. If financial inclusion is the sole goal of the CBDC, a tokenized
altogether would be the best choice. form that avoids the need for financial intermediaries altogether would be the
best choice. From a security and law enforcement perspective, however, cash-like
anonymity without the bulk of physical cash or the risk of destruction by fire or
water poses a serious problem.

If reducing frictions in cross-border payments is the goal, the FSB and CPMI reports
call for paying closer attention during the design stage of a CBDC for its potential
interoperability. Yet hard design choices are made with tradeoffs. Different
societies with different priorities and values may well opt for very different
designs. The degree to which this reduces the use of CBDC in cross-border
payments is, at present, unknown.

Interoperability and the geo-economics of cross border payments

The recent reports into the frictions of cross-border payments continuously refer
to the problems of interoperability between systems. There are multiple references
to a “common vision”; “common standards”, “standardized protocols”, and so forth.
When value is being transferred between one domestic system to another, clearly
interoperability is key. Indeed, the BIS Innovation Hub has modeled three scenarios
for interoperability. The first makes multiple CBDC systems compatible. The second
links different systems. The third creates one system for multiple CBDCs.

The potential “elephant in the room” here is that there is no common vision of
what the world should look like from a cross-border payments perspective. The
rise of geo-economics – the use of economic tools to pursue geopolitical ends –

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 means that cross-border payments and the international financial architecture are
potentially being fought over for geo-strategic reasons.

The PRC, Russia, and even the EU have made no secret of their concern over the
perceived control of SWIFT and the rails along which international payments flow
by the United States, in addition to the country’s frequent willingness to impose
economic sanctions. This perceived power imbalance has served as motivating
factors in attempts to build an alternative infrastructure.

If the digital yuan and its payments system were to provide increased efficiency,
faster settlement, and lower transaction costs with clearing through a central bank
potentially with payment guarantees, it could be the case that it outcompetes
the incumbent system of international payments and its associated instruction
network. Hence, geo-political rivalries and a clash of ideologies are bifurcating
the global economy. It would be naive to assume that the international payments
infrastructure will prove to be an exception.

China, Russia and other nations may On the contrary, China, Russia and other nations may prefer for the international
prefer for the international payments payments system to evolve beyond the control of any one country and for its
system to evolve beyond the control of operation to allow anonymous use with access to the US dollar. Conversely, the
any one country and for its operation United States likely prefers an architecture that cedes control and visibility to
to allow anonymous use with access to them and allows the continued use of economic and monetary sanctions. This
the US dollar. clash of interests suggests that several ecosystems will continue to exist, possibly
in complete isolation from one another.

Such a development has broad implications for the way cross-border payments
evolve and well-meaning attempts to reduce frictional costs. Geopolitical
considerations will no doubt be a feature when it comes to data sharing and
the enforcement of different jurisdictions regulations and law. Efforts to simplify
regulations related to Know-Your-Customer guidelines, Anti-Money Laundering,
and Counter-Terrorism Financing enforcement might depend on cooperation and
trust that are simply not existent.

That said, in the absence of comparable competitors in the digital currency space,
China is stepping forward to propose rules and standards. Mu Changchun, Director
General of PBoC’s Digital Currency Institute, proposed at a BIS seminar in March
2021 for interoperability and ‘synchronized’ information flows between CBDC
systems of different jurisdictions and exchange.

Those countries that currently find Competition might prove to be a boon to third countries. In any payments
themselves excluded from cheap system, network effects are crucially important. Those countries that currently find
and fast cross-border payments may themselves excluded from cheap and fast cross-border payments may well find
well find super-powers falling over super-powers falling over themselves to improve their access as multiple networks
themselves to improve their access compete for dominance or at least market share in the global payments market.
as multiple networks compete for
dominance. Conclusions
The G20 have prioritized making the cross-border payment system more efficient,
especially for emerging economies that have found themselves disadvantaged by
high costs and slow delivery times. International payments that are faster, cheaper,
and more secure, and broader and more inclusive access should bring substantial
benefits to those countries where payment costs represent a big barrier to
international trade.

As the private sector is demonstrating, distributed ledger technology can reduce

frictions associated with information flows and potentially reduces costs. It is not

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 yet clear whether retail CBDC will act as a major enabler of better international
payments for large scale business to business transfers. It is more likely that CBDC,
in a similar format to that developed by China, will become a means of payments
in industries such as travel and retail e-commerce.

Such networks, however, may find their New payments platforms and networks are likely to develop in the coming years
efficiency compromised by geopolitical and, to some extent, replace some of the multilayer system that has evolved in
considerations and the battle for past decades. Such networks, however, may find their efficiency compromised by
control over cross-border payments. geopolitical considerations and the battle for control over cross-border payments.

***

About the author

Stewart Paterson is a Research Fellow at the Hinrich

Foundation and the author of China, Trade and Power:
Why the West’s Economic Engagement Has Failed.
He spent 25 years in capital markets as an equity
researcher, strategist and fund manager. Paterson
has worked in London, Mumbai, Hong Kong and
Singapore in senior roles with Credit Suisse, Credit
Suisse First Boston, CLSA and more recently, as a
Partner and Portfolio Manager of Tiburon Partners LLP.

Notes

1. BIS innovation hub report, https://www.bis.org/about/bisih/topics/cbdc/

mcbdc_bridge.htm

2. Bank of England report, https://www.bankofengland.co.uk/payment-and-settlement/

cross-border-payments

3. The FSB and CMIP reports, https://www.fsb.org/2020/04/enhancing-cross-border-

payments-stage-1-report-to-the-g20/; https://www.bis.org/cpmi/publ/d193.htm;
https://www.fsb.org/2020/10/fsb-delivers-a-roadmap-to-enhance-cross-border-
payments/

Disclaimer:

The Hinrich Foundation is a philanthropic organization that works to advance mutually beneficial and
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