FEBRUARY 6, 2020 Central Bank Digital Currency: Promises and Risks Digital currencies have advanced rapidly over the past decade, not without controversy. But the most important experiment of all may be taking place at the People’s Bank of China. By Paradorn Pasuthip and Steve Yang WorldQuant, LLC 1700 East Putnam Ave. Third Floor Old Greenwich, CT 06870 www.weareworldquant.com 02.06.20 CENTRAL BANK DIGITAL CURRENCY: PROMISES AND RISKS PERSPECTIVES THE INVENTION OF MOVABLE TYPE IN CHINA IN THE 11TH There is one major exception to this resistance: the People’s Bank of century revolutionized more than just the printing of books; China (PBoC), which under President Xi Jinping has embraced a CBDC. it also revolutionized money. The Song Dynasty was the first And that places Beijing at the forefront of public digital currencies. government to issue paper money. China’s currency had existed mostly in the form of copper coins, but coins were THE RISE OF PRIVATE DIGITAL CURRENCIES challenging to transport in large quantities and their supply Cryptocurrency was invented, perhaps coincidentally, in 2009, when was limited by the need to mine copper. When the economy the world’s banking system was in turmoil. Initially, it referred to a expanded and trade boomed, the strain on the money supply private currency that relied on a new technology called blockchain, led merchants and later the government to rethink coins which uses a distributed ledger technology (DLT) that validates as a medium of exchange. The Song government began to transactions by a consensus protocol and ensures the immutability print paper money, and the subsequent credit and economic of the data by cryptographic signature. Blockchain is maintained expansion lasted almost 100 years, until monetary misman- within a network of peer nodes and eliminates the need for a central agement sent inflation spiraling and helped bring down the authority to process and validate transactions, thus avoiding the regime. Even though successive Chinese dynasties retained danger of having a single point of failure. Blockchain gathers trans- paper currency, it took a long time to learn how to manage actions into blocks and binds them together with a cryptographic the new risks that came with it. Even to this day, hyperinfla- “hash,” an algorithm that verifies the authenticity of a piece of data. tion caused by “printing one’s debt away” still occurs. Such is both the promise and the risk of “new” money. Blockchain is an example of a Merkle tree, a data structure that’s particularly efficient at verifying data. The information can be quite We are now entering another innovative age of currencies with the general — say, a record of transactions between two entities, much development of virtual, or digital, currencies, popularly known as like how the first and best known of the cryptocurrencies, Bitcoin, cryptocurrencIes. Over the past decade, a broad range of currencies is structured. However, blockchain can also be a software program has appeared that exist only as data in digital form. These digital that runs without downtime, such as Ethereum, which employs currencies pose a theoretical challenge to central bank paper-cur- “smart contracts” (computer code) on a decentralized network of rency printing. Not surprisingly, central banks have reacted to the computers around the world to power its cryptocurrency, Ether. rise of digital currencies with a combination of deep skepticism, anxiety and curiosity.1 The relatively short history of this new technology has created true believers and profound skeptics. Cryptocurrencies offer an A number of central banks have begun studying the process and alternative way to settle payments and automate contracts, and implications of offering their own version of a digital currency — a they function in an open and decentralized manner independent central bank digital currency (CBDC). The Bank of England initiated of any controlling entity, while ensuring anonymity. The price of a series of studies on CBDCs’ potential in 2015. In Sweden, where Bitcoin has skyrocketed since 2009 — though it’s been extremely cash use has fallen to the lowest level in the world, the Riksbank, or volatile — and remains a benchmark for cryptocurrency prices. central bank, proposed to study two forms of CBDC, called e-krona, Ethereum has become a platform underlying many distributed in 2017.2 The next year, emerging economies including Uruguay, applications, and its concept of smart contracts has gained traction Lithuania, Tunisia and Venezuela implemented pilot programs to outside its own ecosystem.6 test CBDCs. However, central banks in major economies have been resistant to digital currencies. Some central banks believe current However, cryptocurrencies’ volatile prices and episodes of outright settlement systems are efficient enough without digital currencies.3 theft as a result of security loopholes have limited wider adop- Others raise concerns about the risk to the global banking system tion. Bitcoin’s option-implied volatility fluctuates between 50 and if CBDCs increase the risk of structural disintermediation of banks 150 percent, compared with a roughly stable 10 percent range for and the risk of facilitating systematic runs on banks in a crisis most U.S. dollar pairs for fiat currencies. The famous 2016 bug situation.4 Yet others worry that the effects of CBCDs on monetary in the DAO (decentralized autonomous organization) contract on policy are not well understood.5 the Ethereum network, which resulted in a $150 million theft of Ether, was exploited using callbacks — computer code automat- Central banks have reacted to the ically triggered when specific events occur, a key component of a rise of digital currencies with a “smart” contract.7 combination of deep skepticism, Cryptocurrencies are just one aspect of the rapid evolution of the payments infrastructure. Banks and technology companies have anxiety and curiosity. continued to seek new ways for consumers and businesses to Copyright © 2020 WorldQuant, LLC February 2020 2 02.06.20 CENTRAL BANK DIGITAL CURRENCY: PROMISES AND RISKS PERSPECTIVES settle payments, and new systems have proliferated. In China, medium-size enterprises (SMEs); it can now service the 900 mil- digital wallets such as Alipay and WeChat Pay now dominate most lion users in Alibaba’s ecosystem. MYbank uses its data on online retail transactions — including panhandling.8 In the U.S., Venmo shopping habits, bill payment patterns and digital wallet balances (backed by PayPal) and Zelle (owned by a banking consortium — among some 3,000 or so variables — to make credit decisions that includes JPMorgan Chase & Co. and Bank of America Corp.) in seconds.10 Over its four-year history, MYbank has loaned more allow instant transfers between bank account holders within the than $290 billion. country. There are four payment platforms in Singapore alone, with different bank partners that use various transfer modes, ranging Another example is the Geneva-based Libra Association, which from internet banking and instant messaging to QR code scanning, plans to launch a digital currency that it hopes to make finan- a kind of bar code with a matrix of dots. cial services and capital accessible to a wider population, thus facilitating international capital movement. Libra aims to create These services all compete with cash, and in a sense they are economic value and promote a digital global currency as a public winning. More people are becoming cashless. There is no single, good.11 Facebook, the driving force behind Libra — whose founding cross-country comparable statistic to measure the usage of cash in members also include Spotify, Uber Technologies and Vodafone an economy’s transactions. But in an International Monetary Fund Group — plans a crypto wallet service known as Calibra that will working paper, authors Tanai Khiaonarong and David Humphrey be built into current services such as WhatsApp and Facebook focused on the share of cash withdrawals in total cash and cash- Messenger. Facebook hopes that as more transactions are made like payments — their preferred measure of cash usage.9 They using the Libra currency, many of which will most likely be done estimated that from 2006 to 2016, cash use fell annually by an within its own ecosystem, more vendors and services will want to average of about 3 percent in the U.S. and 10 percent in China. participate in the Libra network.12 Using a regression model and survey results citing younger adults’ preference for cashless payments, the authors attributed this Regulators are on the alert about these private initiatives gestating decline to demographic changes. This hinted at the limitations outside the banking industry. The Chinese government has been of cash in settling payments versus other payment platforms: its fairly open to the idea of private technology companies compet- physical existence. ing with state-owned banks. However, under Chinese regulations MYbank and similar virtual banks cannot take deposits from cus- Cryptocurrencies offer an alternative tomers. Without deposits, 60 percent of MyBank’s liability structure is financed by the interbank market.13 Facebook, which already way to settle payments and automate is a lightning rod of contention over privacy issues, has received contracts, and they function in an considerable criticism since its introduction of Libra, including from traditional U.S. and European banks concerned that wide adoption open and decentralized manner of the new digital currency will draw deposits away from regulated independent of any controlling entity, banks and undermine central bank control over money.14 while ensuring anonymity. While one goal of these companies is to reward shareholders, gov- ernments may still play an important role. Demand for MYbank’s Commercial banks and technology companies are aware of the microfinancing exists in part because of the financial exclusion potential of digital currency and are eagerly pursuing it to achieve of smaller enterprises and consumers in rural or poorer areas. strategic objectives.