The Cross-Border Use of Central Bank Digital Currencies (CBDCs): China’s Experiment and Regulatory Challenges

According to the Financial Stability Board (FSB), there is a consensus among major economies, such as the G20, to facilitate cross-border payments as a priority in their political agendas. Also, the Bank for International Settlements (BIS) suggested that the Covid-19 pandemic has made policymakers rethink about how to optimise global payment and settlement systems and consider the possibility of developing the cross-border use of central bank digital currencies (CBDCs).

In response, the People’s Bank of China (PBOC) has been speeding up a cross-border experiment of China’s CBDCs, widely known as ‘digital yuan’ or ‘digital renminbi (RMB)’, by joining the BIS’s ‘Multiple CBDC (m-CBDC) Bridge’ project together with the monetary authorities in Hong Kong SAR, Thailand, and the United Arab Emirates. Clearly, this plays a key role in furthering China’s long-term national strategy—the internationalisation of Chinese Yuan and its ability to compete with other major currencies, such as the US Dollar, Euro, British Pound, and Japanese Yen. The International Monetary Fund (IMF) also stressed that ‘CBDCs... could reinforce the incentives behind currency substitution and currency internationalisation’. Despite the advantages of the cross-border application of CBDCs, the potential financial risks and regulatory pitfalls should never be underestimated. When rolling out digital yuan on the global stage, China as the world’s second largest economy needs to take cautious steps.

In our recent paper presented at ‘The 4th International Forum on Computational Law: Data Governance and Legal Tech’ (25-26 September 2021, Tsinghua University, Beijing), we point out three areas of major regulatory concern over the cross-border use of digital yuan that merit attention from the PBOC and financial authorities in other countries:

(1) Reconciling regulatory conflicts between enforcing anti-money laundering (AML) regimes and data protection law

Failures to identify account ownership or to perform customer due diligence are the most common reasons accounting for AML fines imposed on financial institutions. Considering the anonymous design of CBDCs, how to balance the AML compliance task with the protection of personal data and privacy will be a major concern for Chinese financial regulators when dealing with the cross-border use of CBDCs. The solution lies in multi-party coordination as relevant transactions denominated in digital yuan will involve regulatory scrutiny and law enforcement across several jurisdictions. For example, Chinese law has not yet recognised personal data protection as a fundamental human right, but in contrast, the European Union has endorsed this in the EU Charter of Fundamental Rights. Thus, the permitted range of data collection and usage isn’t the same for regulators from China and the EU. Accordingly, controlled anonymity is likely to be a future mainstream design for China’s CBDCs, whilst anonymity vouchers have been newly introduced by the European Central Bank.

(2) Maintaining financial stability: liquidity spillovers, balance-sheet reorganisation, and floating interest rates

If and when retail-CBDCs become popular in foreign markets as the equivalent of publicly available cash, this will increase the circulation speed of RMB currencies in general and will lead to the rapid fluctuation of interest rates for RMB-denominated deposits and financial products, which might affect financial stability. Under the two-tier distribution model of Chinese retail-CBDCs (commonly referred to as DCEP), domestic commercial banks and offshore RMB business clearing banks are exposed to the liquidity risk caused by frequent fund movements between customers’ ordinary RMB deposit accounts (interest-bearing) and their DCEP accounts (non-interest bearing). In response, both onshore and offshore commercial banks are likely to reorganise their balance sheets by partly switching long-term RMB assets into short ones. Moreover, the cross-border payment convenience of Chinese CBDCs, coupled with the price stability of RMB, might expose certain developing countries with immature financial systems to the threat of currency substitution. Finally, in the event of an overheated domestic economy caused by a large inflow of foreign money via DCEP, the PBOC is likely to raise interest rates to curb the consequent inflation. In practice, however, the regular fluctuation of currency exchange rates and interest rates is determined by multiple factors that are either positively or negatively correlated with each other, which further complicates the problem. Such challenges require domestic commercial banks to closely watch the global inflow and outflow of Chinese CBDCs when they are setting interest rates for their savings products and rate-sensitive businesses.

(3) Revising settlement rules: weakening financial intermediaries or strengthening central counterparty clearing

Unlike retail-CBDCs, wholesale-CBDCs generally flow through financial intermediaries, which impacts the institutional settlement framework. The inter-bank bond market accounts for 80% of the bond trading volume in China, and its settlement and clearing scheme for qualified foreign investors is made up of multiple accounts and a tier structure. The PBOC, the Market Clearing House Co., Ltd. (Shanghai Clearing House), and commercial banks have collectively been granted statutory rights and duties to provide services of centralised registration, custody, clearing, and settlement. Technically speaking, if and when wholesale-CBDCs are used in financial markets in the future, this will allow foreign investors to complete the settlement process by bypassing third parties, as they will have direct claims on the PBOC. The peer-to-peer mechanism of CBDC settlement and clearing is likely to reduce transaction costs for foreign investors, but it may also weaken the status of financial intermediaries, especially traditional commercial banks. Considering the need to protect financial stability, the PBOC is expected to maintain the role of Shanghai Clearing House as the central counterparty and might even embed wholesale-CBDCs into the existing Clearing House system.

In a nutshell, the PBOC and other central banks, when issuing CBDCs for cross-border use, need to carefully evaluate the relevant impact on both domestic and international financial markets. Building a compatible transnational CBDC payment and settlement system could largely improve the efficiency of the international financial infrastructure which underpins the long-term growth of the global economy. However, this calls for joint efforts by global financial authorities and international organisations to address the discrepancies in technological standards and regulatory frameworks.

Lerong Lu is a senior lecturer in law and the director of LLM Law & Technology programme at the Dickson Poon School of Law, King’s College London.

Alice Lingsheng Zhang is a PhD candidate at the School of Law, Shanghai University of Finance and Economics.