China is taking the lead in moving to a central bank digital currency. It’s not altogether clear how much the US and other high-income countries should be worried about this. Sometimes it’s better to be the one who watches someone else go first, and then learns from their experience. For sorting out the benefits and risks, a useful starting point is Digital Currencies: The US, China, and the World at a Crossroads, edited by Darrell Duffie and Elizabeth Economy based on the discussions of a task force convened at the Hoover Institution.

I’ve described the central bank digital currency controversies before at this blog, but it’s probably useful to review. What we’re talking about here is how payments from one party to another are made behind the scenes–debit cards, credit cards, direct deposit, even old-fashioned paper checks. Duffie and Economy describe how the “bank-railed” systems of the past have worked :

For centuries, the world has relied on banks to handle the vast majority of payments via a straightforward and generally safe method. In the simplest common cases, a bank-railed payment system works like this: Alice pays Bob $100 by instructing her bank to deduct $100 from her bank account and to deposit $100 into Bob’s account at his bank. The instruction can take the form of the tap of a credit or debit card, a wire transfer, or a paper check, among other methods. In some countries, including the United States, the payment medium—bank deposits—is extremely safe, and banks take reasonable care to protect the privacy of their customers and monitor the legality of payments.

As shown in figure 1.1, many countries have been upgrading bankrailed payments by introducing “fast-payment systems,” which can make instant payments possible around the clock, largely eliminating costly delays and payment risks. The United States has a fast-payment system provided by a consortium of large banks. Not satisfied that the bank-provided solution will be sufficient, the US central bank, the Federal Reserve, will introduce its own fast-payment system, FedNow, by 2024.

With this and certain other improvements in traditional payment systems, why are most countries now considering radically disrupting their bank-railed payment systems by introducing CBDCs, or by accommodating other kinds of digital currencies? The answer is that most central banks have begun to question whether merely upgrading their bank-railed payment systems will be enough to meet the challenges of the future digital economy. They have also begun to consider whether to encourage, and how to regulate, private sector fintech innovations such as stablecoins. Moreover, some in the official sector are concerned about whether banks face sufficient competition for providing innovative and cost-efficient payment services.

How would a central bank digital currency work differently? Duffie and Economy explain:

Often in response to private fintech innovations or the declining use of paper money, some central banks are developing CBDCs. A CBDC is a deposit in the central bank that can be used to make payments. For example, Alice can pay Bob $100 by shifting $100 out of her central bank account and into Bob’s central bank account, whether on an internet website, a mobile phone app, or a payment smart card, among other methods. Depending on their designs, CBDCs can also be used for offline payments, meaning without access to the internet or a phone network. In many cases, Alice and Bob would obtain their CBDC and the necessary application software (“apps”) from private sector firms such as banks,
even though the CBDC itself is a claim against the central bank. A general purpose CBDC, often called a “retail” CBDC, would be available to anyone and accepted by anyone, much like paper currency but allowing for greater efficiencies and a wider range of uses. Special-purpose CBDCs can also improve the efficiency of wholesale financial transaction settlements and cross-border payments. …

Most CBDCs currently being developed adopt a hybrid model, according to which the central bank issues the CBDC to banks and other payment service providers, which in turn distribute the CBDC to users throughout the economy and provide them with account-related services.

In some ways, this doesn’t sound like much of a change. It sounds as if payments would still go through banks, but now, behind the scenes, the accounts would be settled with the CBDC. How does this approach provide any gains?

The short-term gain for US consumers is that payments could be faster and cheaper. Duffie and Economy write:

North Americans pay over 2 percent of their GDP for payment services, according to data from McKinsey, more than most of the rest of the world pays, particularly because of extremely high fees for credit cards. US payments are also processed and cleared slowly, often taking more than a day before they can be used by the recipient. And Americans’ primary payment instrument, bank deposits, is compensated with very low interest rates relative to wholesale money-market rates.

The longer-term benefit has to do with financial innovation and competition. Say that we shift away from a “bank-railed” system, where financial transactions take place between banks, and that other financial technology companies would also be able to have a CBDC account at the central bank. A number of US companies are among the innovators in payment systems. Duffie and Economy mention “Arbitrum, Avanti Bank, Betterfin, Celo, Chime, Circle (USD Coin), Coinbase, Diem, Electric Capital, Imperial PFS, Jiko, JP Morgan, Mobile Coin, Optimism, Paxos, Plaid, Polygon, R3, Ripple, SoFi, Stellar, Topl, Varo Bank, Venmo, Yodlee, and Zelle.” But whatever services these firms offer, in the US economy they are ultimately, behind the scenes, operating through banks. If they instead could have CBDC accounts at the central bank, new types of financial communication could be unlocked.

Duffie and Economy emphasize that when it comes to financial technology and payments technology, large Chinese firms have taken the lead: “In China, for example, 94 percent of mobile payments are now processed by Alipay and WeChat Pay, with 90 percent of residents
of China’s largest cities using these services as their primary method of payment … Building on Alipay, the Ant Group provides relatively low-cost and widely accessible small-business credit, wealth management, and insurance. Alipay now reaches small-tier cities and many
rural areas in China.” In addition, China has been experimenting in major cities with a new central bank digital currency, the e-CNY, and plans to launch it more broadly later this year.

China’s public posture is that the e-CNY is really just for domestic use. But one potential concern for the United States is that the system would, at least in concept, allow international payments as well in a way that would circumvent the SWIFT (Society for Worldwide Interbank Financial Telecommunications) system that is now the standard coordinator for international financial payments–and also a primary tool for imposing financial sanctions on other countries.

I’ve written about the risks of a CBDC in the past, and won’t repeat it all here. Might such a system pose risks to conventional banks? If conventional banks face standard financial regulation, with its costs and requirements, what regulations are appropriate for non-banks that would have a pipeline into their own account at the Fed? For example, banks face “know-your-customer” rules aimed at limiting money-laundering or financing other illegal activities. Would all the non-banks need to abide by similar rules? If not, do these nonbank financial firms create a risk of financial instability? A CBDC based on US dollars would be one of the preeminent targets for computer hackers all over the world. How would a CBDC be related to cryptocurrencies and blockchain-related innovations? What degree of privacy would a CBDC involve? In China, there doesn’t seem to be much of a problem with the idea that the central bank would oversee all the accounts in this system: in the US and other high-income countries, such a step might be more controversial.

Finally, remember that these non-bank financial firms aren’t necessarily just about payments. They might also offer loans, or assurances of kinds of contractual financial payments. They might offer insurance or investment options.

I’m underconfident that the Federal Reserve is ready to launch a central bank digital currency, and US financial markets and innovation are rather different from those in China. But China’s experiment with launching the e-CNY is worth watching.