Two big questions ahead of China's central bank digital currency launch

China’s central bank digital currency appears to be advancing quickly through its real-world testing phase and just received the highest-level endorsement from the country’s top political power.

Still, significant questions continue to linger ahead of the system’s full rollout.

This week, the central committee of the Chinese Communist Party published a lengthy proposal to China’s upcoming 14th five-year economic and social development plan. In the proposal, the powerful central committee advises that the five-year plan should push to establish “a modern central banking system” and keep “steadily moving forward the research and development for digital currency.”

It’s the first time that the work related to China’s central bank digital currency, known as DC/EP (digital currency electronic payment) has been elevated to formal discussions of its five-year plan, a document that forms an integral part of China’s macroeconomic and social development blueprint.

The proposal follows last month’s large DC/EP trial in Shenzhen, which involved nearly 50,000 people. The People’s Bank of China (PBoC) is also seeking a revision to the current central banking law, part of which would legalize DC/EP’s status. 

At this point, however, there are still more questions than answers about the role that DC/EP will play in China’s mobile payments market, which today is dominated by Ant Group’s AliPay and Tencent’s WeChat Pay.

We see two of those questions as particularly pertinent. 

1.) Will DC/EP compete with AliPay and WeChat Pay?

Mu Changchun, head of PBoC’s Digital Currency Research Institute, said during the second Bund Summit in Shanghai on October 25 that the issuance of digital yuan will “proceed in a market driven way.” 

“For instance, we’ll issue whatever the amount of DC/EP that people actually need,” he said, adding that the bank will issue DC/EP alongside physical cash, at least for the foreseeable future. “As long as people have the demand for banknotes, the PBoC will not stop the supply for physical cash.”

In fact, the monthly ratio of China’s circulating physical cash (M0) over M2 (a measure which includes bank deposits, money market deposits, and small certificates of deposit) has been on a downward trend for several years amid the rise of digital payment platforms led by AliPay and WeChat Pay.

Source: https://data.eastmoney.com/cjsj/hbgyl.html

According to government data, Chinese commercial banks processed 223 billion electronic payment transactions totaling 2,607 trillion yuan ($400 trillion) in 2019. Among those, there were 78 billion online payment transactions worth $322 trillion and 101 billion mobile payment transactions worth $52 trillion.

For the same year, non-banking payment institutions like AliPay and WeChat Pay made 720 billion transactions worth $37 trillion. The role that these commercial platforms play in China’s economy has raised an obvious question about DC/EP: might the new central bank digital currency be a threat to their business? 

Keep in mind that the digital money that AliPay and WeChat Pay users transfer around is already backed by reserves at the PBoC. That's been required by the central bank since last year.

According to Mu, DC/EP will by its nature not be in competition with AliPay or WeChat Pay. “DC/EP is not on the same dimension as AliPay or WeChat Pay, who are both financial infrastructures and wallets," he said at the Bund Summit. DC/EP, he said, is “the content of a wallet. 

Mu added: “After the issuance of DC/EP, consumers can still pay with WeChat or AliPay. It’s just their wallets will then additionally support DC/EP.”

At least the big four state-owned commercial banks will also offer DC/EP wallets, either as standalone mobile apps or as features within their existing online banking mobile apps. Chinese technology giant Huawei recently announced that its latest M40 smartphone series will feature a built-in DC/EP hardware wallet as well.

So perhaps the real competition that DC/EP creates will be between the wallet providers — AliPay, WeChat, commercial banks, and others like Huawei. Can they build up enough network effects around DC/EP to gain a slice of the potential $1.3 trillion M0 market that DC/EP aims to replace? 

The network effects that AliPay and WeChat have built around their respective mobile apps are a core factor that has made them popular. The apps enable all sorts of services from a centralized hub, such as credit score development, bill payments, social security accounts, ride-hailing, logistics — basically anything one would need for urban life.

Users can also deposit funds into their AliPay or WeChat wallets to invest in currency funds that offer a relatively higher yield than what commercial banks could offer. “AliPay/Wechat have enormous network effects. It makes it really hard for anyone to compete with them,” said Leo Weese, co-founder of Bitcoin Hong Kong Association.

Ultimately, however, the full impact that DC/EP will have on AliPay and WeChat Pay is far from settled. Just ask Ant Group, the payment affiliate to Alibaba that operates AliPay, which hopes to raise $37 billion via IPO listings in Shanghai and Hong Kong. 

In its IPO prospectus, the company confirmed it has been a participant in the research and development of DC/EP. It also said that it is "not clear how the DC/EP will fit into or change the current digital payment industry landscape,” and acknowledged that “our business may be adversely affected by new initiatives in the payment industry in China.” 

Meanwhile, on November 3, Chinese authorities postponed Ant Group’s massive IPO, citing regulatory concerns. 

2.) How will the PBoC utilize DC/EP's 'smart contract' capabilities?

Whether and how people use DC/EP might depend on whether and how the PBoC programs it to do certain things. For instance, as part of a trial in April, the bank used the system to issue transportation allowances to civil servants in Suzhou. In theory, it could also program such allowances to be spendable only on transportation services.

In September 2019, Mu confirmed that “DC/EP is capable of adding smart contracts.” He added: “We will enforce smart contracts [on DC/EP] that can strengthen its roles as a sovereign currency and maintain a cautious attitude towards smart contracts that go beyond the roles of a currency.” 

Mu did not elaborate. But a pending patent application from the PBoC entitled “A method and device for directional usage of digital currency,” which was submitted in June 2017, hints at the system’s technological potential. It describes how a digital currency issuer can encode smart contracts so that, for instance, only certain people can spend the issued funds for certain things at certain times.

According to the patent application, such technology might be useful for things like issuing government subsidies or commercial bank mortgages — essentially, funds issued for specific purposes to targeted people or industries.

Another patent application filed by the PBoC that was authorized on October 9 details how wallet providers could take advantage of DC/EP’s smart contract capabilities. 

The patent, entitled “a method and system for bundling a digital currency wallet with a bank wallet,” describes the base layer of a digital currency wallet system that includes a number of basic properties including user ID and available balances. It also describes a smart contract index, which includes a set of smart contract scripts designed to interact with bank wallets. 

In the application, the central bank adds that the technology would present all sorts of possibilities for smart contract applications, and that the wallet providers can compete to build the best ones.

It also includes an example that involves a government ministry issuing a specific financial budget across several layers of administration to companies or individuals. Traditionally, as the document describes, tracking the money flow relies on each administration reporting the usage of the funds to their superiors.

The DC/EP’s traceability combined with its “smart contract management” means “the ministry doesn’t need to rely on any other participant,” the document reads. “It will have a direct visibility to all the issuance and usage of the funds across multiple administrative layers to ensure a fund is spent on what it’s meant for.”