What is it and how does it work?

GUANGZHOU, China – China is arguably a leader in the development of a national digital currency, a project it has been working on since 2014.

The People’s Bank of China (PBOC) has been at the forefront of work on the digital yuan, a so-called central bank digital currency (CBDC) that aims to replace some of the money in circulation.

Field trials are already underway in the world’s second largest economy. Here’s what we know about the digital yuan or its official name so far: the Digital Currency Electronic Payment (DCEP).

In fact, it is a way for the central bank to digitize notes and coins in circulation. The Chinese market is well advanced in the field of cashless payments. The digital yuan would be a way to speed up that process.

It becomes legal tender in China and no interest is paid on it.

“The use of cash is declining. Eventually, cash will be replaced by something in digital format. That’s one of the big drivers behind this,” said Yan Xiao, project leader for digital trade at the World Economic Forum.

Fan Yifei, deputy governor of the PBOC, said last year that there is “an urgent need to digitize cash and coins” as producing and storing them is currently expensive. In an article in state-sponsored publication Yicai Global, Fan said that cash and coins are not easy to use, are easy to counterfeit and can be used for illegal purposes due to their anonymity.

The PBOC sees a number of other benefits for the digital yuan.

In a separate article, Fan outlined how a CBDC could make payments more efficient and improve the transmission of monetary policy. Fan also argues that a digital yuan can help with financial stability through a system of “verifiable anonymity”. This is where the payments would be anonymous to some extent, but data analysis tools could help the central bank detect illegal activity.

Another reason behind the PBOC’s efforts could be to increase payment competition and reduce systemic risk. China’s digital payments arena is dominated by Alipay, run by Alibaba-affiliated Ant Group, and WeChat Pay, run by internet giant Tencent.

“The existing system is owned by private companies. Should the payment from Alipay or WeChat go bankrupt, which is highly unlikely, it creates a systematic risk,” Linghao Bao, an analyst at Trivium China, told CNBC. “The main reason for them (the PBOC) to do this is to level the playing field. Another reason may be to create a new platform payment system that will increase efficiency.”

The question has two aspects: distribution and ultimately how it will be spent.

Distribution takes place via a so-called two-tier system. That means the PBOC will distribute the digital yuan among commercial banks. The commercial banks will ensure that the currency gets into the hands of consumers. This may include services that allow consumers to exchange their coins and cash for digital yuan.

China has already given away millions of dollars in digital currency in field trials in a number of cities, including Shenzhen, Chengdu and Suzhou. This involves the local government handing out a certain amount of yuan through a lottery. Users usually have to download a separate app to receive the currency. JD.com, one of China’s largest e-commerce players, was involved in the trial and allowed customers to purchase items using the digital yuan.

At this point, it is unclear how users would actually be able to hold and spend digital yuan when it is rolled out nationwide. The most popular form of mobile payment in China is based on so-called quick response (QR) codes. Users can display this barcode in their Alipay or WeChat app in a store and the merchant will scan it.

WEF’s Xiao says it is likely that commercial banks will be able to integrate similar functionality into their apps. And that Alipay and WeChat Pay could have devoted some of their apps to digital yuan. Meanwhile, smartphone makers can also create digital yuan wallets for their devices.

“It will be interesting to see how phone companies are seizing the opportunity to become a payment player in the market,” said Xiao.

The PBOC fan also said that commercial banks already have the infrastructure to distribute the digital yuan and it is better that they do that instead of the central bank.

“Building a separate system would be a huge waste of such existing resources,” he said.

In some ways, it is designed to increase competition with Alipay and WeChat Pay, but not completely replace them.

“The way I see it is that digital yuan is not a direct competitor to Alipay or WeChat Pay, but a new platform that allows other players to compete with WeChat and Alipay,” said Trivium China’s Bao. “They could be commercial banks or other payment companies.”

The PBOC Fan also said the proposed two-pronged model could help “stave off disintermediation in the financial sector” because the central bank will not compete with commercial banks.

No. Bitcoin is a so-called decentralized cryptocurrency. That means it will not be controlled by a central authority such as a central bank, unlike the digital yuan that will be issued by the PBOC.

Bitcoin is also built on a technology known as blockchain. It is unclear at this point what kind of technical makeup the digital yuan would have.

Proponents of bitcoin also praise the anonymity of the digital currency.

The PBOC fan said the digital yuan would have “verifiable anonymity.” This would mean that those who operate digital yuan wallets would disclose transactions to the PBOC as the “only third party”. Users would have a “loose account link” meaning their current bank account is not necessarily closely linked to their digital yuan account.

According to WEF’s Xiao, it could be based on a phone number.

The PBOC says agencies operating yuan digital services “must send transaction data to the central bank in a timely manner via asynchronous transmission.” That would enable the PBOC to “keep the necessary records” to tackle money laundering and criminal offenses.

However, some commentators have expressed concern that the digital yuan could be used to increase surveillance of citizens.

China is pushing for the internationalization of the yuan, and some commentators see the digital yuan as a way to do that.

But currently, the digital currency has a domestic focus and international use is “not the immediate priority,” Trivium China’s Bao said.

But the PBOC has begun to lay the foundation for digital currencies that can be used in cross-border transactions. Last month, the PBOC joined central banks from Thailand, the United Arab Emirates and Hong Kong to jointly investigate a project for cross-border payments in digital currency.