By Gordon Clarke and Emir Hrnjic
The Wirecard scandal has revealed that even major companies involved in online payments may be disastrously unreliable and even enable illegal transactions such as money laundering.
In fact, Visa and MasterCard allegedly had their suspicions about Wirecard since 2015 after they realised that the company had high levels of stolen card purchases and reversed transactions.
The internal file from 2017 shows that Wirecard processed payments for a variety of controversial and potentially illegal businesses.
In fact, sceptics are warning that there might be more scandals ahead due to unscrupulous accounting practices, poor auditing controls, and technical security failures.
While online payments have been exponentially growing for decades, the global pandemic has given it an unexpected boost. According to 2019 e-Conomy Southeast Asia report, the six largest Southeast Asian markets recorded S$600 billion in online payments last year, while they were projected to exceed S$1 trillion by 2025. Moreover, in the last few years we have also witnessed rapid growth of instant payments using e-wallets and account–to–account transfers initiated on the mobile handset.
The COVID-19 pandemic has accelerated this trend. Online purchasing soared due to worldwide lockdowns whereby people remained confined to their homes for months. Moreover, Bain & Company now expects digital payments to account for 67 per cent of total transaction values in 2025 – 10 percentage points above their pre-pandemic prediction.
With online shopping regarded as a norm, we have become desensitised to allowing the storage of our payment details by merchants and processors, whose security is likely inferior to that of financial institutions. While our credit card details are deposited all over the web, companies we trust have failed to keep our data safe.
According to Statista, over 164 million sensitive records were exposed in 1,473 data breaches in the United States alone last year, while fraud cost the world economy over US$5 trillion overall, according to Crowe.
The question arises on how safe our online shopping experience is and how service providers can protect us.
In the card payment business, fraud defences include on-line authentication, chip card security using the international EMV standard, the CVV figure on the back of the card, the “3-D secure” approach, as well as encrypted messages and databases at banks.
For instance, in Singapore, where the limits on instant payments and contactless card payments are increasingly high, the main defence against fraud is the instant SMS warning to the cardholder when an unusual transaction occurs. However, this does not work as well for overseas issued cards which must rely on notoriously unreliable cross-border SMSes.
Card payment transactions are relatively well protected, but instant account–to–account payments have very few of these facilities. There is clearly a need for heightened vigilance on the part of service providers, merchants, as well as others who accept digital payments.
Most merchants, payment service providers (PSPs) and payment system operators use machine learning algorithms to detect suspicious transactions. Two other actions that would certainly minimise fraud risk are security monitoring systems and tokenisation.
MONITORING SYSTEM AND TOKENISATION
The first step in securing data and systems is to control the technology perimeter of the organisation for both processing services and PSPs. This includes setting up a monitoring system, often called a security operations centre (SOC), which is often a physical box containing the necessary software. The SOC contains machine learning algorithms that learn the normal patterns of data and system behaviour in a company or network and instantly flag deviations from historical patterns.
The SOC also requires IT staff to be well–trained to act appropriately upon the monitoring alerts.
The monitoring system should detect attempts by external agents to log in to the company’s system, which are surprisingly frequent. Some intrusions result in the planting of malware which can sit quietly in a system for months, gradually learning how valid payment messages are authenticated while informing its controllers. Then, it suddenly sends massive payments abroad as in the well-known attack on Bangladesh Bank a few years ago.
The monitoring software, however, should spot the communications made by the malware, identify it using an extensive library of malware signatures, isolate the problem, and, finally, alert the IT team to remove it.
But all this is to no avail if someone on the inside is colluding with criminals or being coerced to manipulate the systems and substitute false destination accounts – also known as mule accounts – when payments are being sent. According to US publication Digital-First Banking, up to one in five account openings at present could be fraudulent.
The best solution to this is tokenisation (not to be confused with the “tokenisation” in the crypto industry), where all databases and messages contain a token that looks like a real account number instead of the actual account numbers. Widely used in the cards industry, for example in the ApplePay and Google Pay schemes, the token also carries instructions (“domain controls”) which allow transactions to be executed only under a very specific set of circumstances. These may include a specific day of the month, or only once, or only for bill payments, or countless other specifics. Using tokens makes mule account substitution frauds extremely hard, even from the inside.
In an ideal world, payment companies and merchants would make it so difficult for fraudsters that the benefits from a lucrative sting – which may take months of time and effort as well as lot of investment – would simply not be worth the risk of being caught.
However, we are far from that utopia, and the risks to customers and their service providers are real and large. The exponential growth of online purchasing and a further dramatic increase during the COVID-19 crisis are making the protection even more urgent.
Commentary: E-commerce is set to boom driven by COVID-19
Brief: COVID–19 crisis may provide the impetus to creative destruction as seen during the dotcom bubble burst, says Emir Hrnjic.
SINGAPORE: A fear of the uncontrollable spread of the COVID-19 virus compelled governments around the world to lock down cities and close national borders.
Ever–diminishing consumer demand led to a near collapse of industrial production and a complete shutdown of service industries. As the crisis triggered massive layoffs, unemployment reached double digits.
At the early signs of trouble, stock markets plummeted. Major indices such as S&P500, Japan’s Nikkei Index, and Singapore’s Straits Times Index started dropping on Feb 19 and lost approximately 30 per cent of their value in a month.
As the pandemic spread, most major economies faced unprecedented recessions. According to the OECD Economic Outlook, the world is headed for an almost 13 per cent decline in global gross domestic product (GDP) in the first half of 2020.
Closer to home, Singapore’s GDP fell by 41.2 per cent in the second quarter of 2020, while the government projected as much as a 7 per cent decline of annual GDP.
As the global situation looks extremely bleak, observers wonder if there is a silver lining.
Austrian Economist Joseph Schumpeter argued that economic growth relies on daring entrepreneurs, evolving institutions and innovative technologies. Without daring entrepreneurship and innovation almost all businesses fail.
Moreover, major crises reveal true survivors – businesses resilient enough to weather the most challenging conditions. It is often in such extreme circumstances and the excessive volatilities, that we witness creative destruction.
Creative destruction is based on the principle that the existing system needs to be challenged so that innovative products or services can replace the outdated ones. Effectively, the existing equilibrium gets disrupted, market dynamic changes, and routine practices get transformed.
Typically, innovative solutions spring to life. As innovative technologies replace existing technologies, the resources are more efficiently reallocated by the market, thus allowing economies to grow. This economic progress is chaotic and often unpleasant and thus the moniker “creative destruction.”
Indeed, we witnessed creative destructions in action many times before.
When the dotcom bubble burst 20 years ago, the Nasdaq index plummeted by almost 80 per cent. Moreover, a majority of dotcom companies quickly ran out of cash and went bankrupt. Unsurprisingly, doomsayers predicted the end of the internet era.
Even though the dotcom era witnessed a glut of bankrupt companies, massive layoffs, and a wipe-outs of market values, some of the capital was invested in a very high throughput backbone for the internet. That initial infrastructure has enabled the development of companies that have changed the business models of modern era.
Moreover, the existing equilibrium got disrupted, market dynamic changed, and routine practices got transformed.
Finally, crisis revealed true survivors. Indeed, companies that had survived the dotcom bubble and had a spectacular growth include Amazon and Google – some of the largest companies in the world.
Similarly, the global COVID–19 pandemic triggered plunges in market indices, widespread bankruptcies, and worldwide recession. Yet, the destruction often creates space for innovative players and thus this COVID–19 crisis may provide the impetus to creative destruction.
The question becomes, “What will be destroyed and what will replace it?” Some industries such as airlines and tourism are very difficult to forecast. Yet, the theory of creative destruction implies a complete shake-up and major innovations in these industries.
It is easier to predict industries such as e-commerce.
Since the invention of the internet, the online sector has been consistently chipping away the market share from brick-and-mortar stores.
According to the US Commerce Department, online sales beat general merchandise stores for the first time in February last year.
According to eMarketer, US e-commerce sales are estimated at approximately US$700 billion in 2020 - 14.5 per cent of total US retail sales - compared to slightly above US$600 billion in 2019. The e-commerce share of total retail sales is estimated to reach 15.5 per cent in 2022.
Unsurprisingly, Amazon’s stock price soared by 66 per cent and eBay rose by 55 per cent since the beginning of the year.
Closer to home, the internet economy in six largest Southeast Asian markets with a population of 570 million surpassed US$100 billion last year, according to the 2019 e-Conomy Southeast Asia report.
While internet economy in most countries was growing at 20 per cent to 30 per cent, Indonesia and Vietnam grew over 40 per cent a year.
By mobile internet usage, four Southeast Asian countries rank in the top 10 in the world. Driven by a high mobile internet penetration rate, young consumers, and an increase in disposable income, Southeast Asia’s online sector is expected to hit US$300 billion by 2025, while e-commerce sector was projected to be worth US$150 billion by 2025.
The study reported US$600 billion in online payments last year, while gross transactions were projected to exceed US$1 trillion by 2025.
Indeed, online purchasing soared due to worldwide lockdowns and people’s inability to do the shopping in brick-and-mortar shops. In fact, according to Accenture, the COVID-19 crisis caused a shift in Singapore consumers behaviour and thus spurred Singapore’s digital economy to earn additional US$500 million annually, while some businesses saw up to three times their normal growth.
The COVID-19 pandemic will provide further impetus for the growth in digital payments. Bain & Company projected digital payments to account for 67 per cent of total transaction values in 2025 – up 10 percentage points from their pre-COVID-19 prediction.
The COVID–19 pandemic has caused loss of human lives and destroyed jobs, but there is a silver lining to the crisis.
The ensuing creative destruction will likely spur innovation, as innovative technologies will replace existing technologies and thus resources will be more efficiently reallocated by the market.
Emir Hrnjic is an adjunct assistant professor at National University of Singapore (NUS) Business School and a co-founder of Block’N’White Consulting. The opinions expressed are those of the writer and do not represent the views and opinions of NUS.
Should government bailouts restrict stock buybacks? (as published on Channel NewsAsia on July 27, 2020)
Should government bailouts restrict stock buybacks?
By Emir Hrnjic
Much depends on governments’ specific objectives for the bailouts and whether supporting the stock market is a key goal, says NUS Business School Emir Hrnjic.
SINGAPORE: Amid the COVID-19 pandemic, governments have allocated trillions of dollars to businesses and financial institutions to boost the economy and prop up share prices.
In this, regulators are calling for emergency assistance to companies to come with strings attached, particularly with respect to potential stock buybacks. Most notably, influential US Senator Elizabeth Warren proposed a permanent ban on stock buybacks for all companies that accept emergency federal funding.
A recent article in the Harvard Business Review argued stock buybacks made companies vulnerable in an inevitable economic downturn when their cash flows dry up. The article reported that S&P 500 companies spent US$4.3 trillion on buybacks over the last decade, roughly half of their net income.
Notably, the six major US airlines spent about US$47 billion buying back their own stock in the last decade. Cynics noted the money spent on buybacks might have been put to better use in the current crisis when the same six firms asked for a combined US$58 billion in federal assistance.
MORE BUYBACKS IN ASIA
While stock buybacks have traditionally been concentrated in the US, they are increasingly popular in Europe and Asia. Japan reported US$52.5 billion of buybacks in 2018.
Softbank announced doubling its buyback plan to 2.5 trillion yen (US$23.5 billion) in April, sending its stock soaring by almost 40 per cent, despite posting an annual operating loss of 1.35 trillion yen.
Closer to home, while the Straits Times Index lost almost a fifth of its value in a month of March, SGX reported that total share buybacks for Singapore–listed stocks in just that month – roughly half a billion Singapore dollars – almost matched the total amount of buybacks for the entire last year.
While buybacks in Singapore were dominated by DBS, UOB and OCBC, the US Federal Reserve ordered the country’s largest banks to suspend their stock buyback programs.
BUT MANAGERS’ AND SHAREHOLDERS’ INCENTIVES ARE ALIGNED
As lawmakers weigh whether emergency assistance should come with stock buybacks restrictions, observers wonder whether this stand is restrictive or justified.
The answer depends on whether we believe in laissez-faire capitalism. The phrase laissez-faire capitalism simply means that governments stay away from the workings of the free market.
In laissez-faire capitalism companies should be investing in projects expected to provide a rate of return higher than their cost of capital. If firms run out of such projects, they should return cash to shareholders in the form of dividends or stock buybacks. So stock buybacks are in the best interest of the shareholders.
From the perspective of the overall economy, firms with no profitable opportunities return cash to shareholders so they can invest in other profitable opportunities.
In principle, buybacks could help the economy by reallocating the resources to the best possible use. However, the problem may arise in a crisis if investors who sell their shares during a buyback choose to hoard the cash and do not reinvest in the economy.
Furthermore, since buybacks reduce the number of outstanding shares, they automatically improve many valuation ratios such as earnings-per-share. While economists argue the effect of artificially inflated valuation ratios should have no effect on valuation, an increase in share price is a well-documented consequence of stock buybacks.
Critics point out managers conduct stock buybacks for selfish reasons such as to boost the value of their own stock holdings and stock options. Nevertheless, stock buybacks should be seen favourably as managers’ and shareholders’ incentives are aligned.
On the other hand, when governments are involved in markets, the key question becomes why they help companies. If governments’ main objective is to help improve shareholder wealth by propping up share prices, supporting stock buybacks using federal money may be justified.
However, if their objectives include supporting investments in the real world, boosting the economy, or slowing down rising unemployment, stock buybacks help very little.
Stock buybacks do not invest in the real world, do not create positive externalities, nor do they slow down rising unemployment. Stock buybacks only help augment shareholders wealth and they may boost positive market sentiment that could spill over to the real world.
Theoretically, rising shareholder wealth may have a positive impact on consumption and thus the real economy (also known as wealth effect). However, the research study by Karl Case, John Quigley and Nobel Laureate Robert Shiller found “at best weak evidence” of a stock market wealth effect.
Given the above, if companies are calling for emergency assistance, then governments around the world need to carefully consider their objectives for acceding to these requests for bailouts. If the reason is to prop up the stock market, the stock buybacks are a useful way of investing the bailout money.
On the other hand, if the reason is to prop up the economy and stop skyrocketing unemployment, lawmakers should be calling for conditions attached to buybacks.
Stock buybacks using shareholders’ money may be the right thing to do, but stock buybacks using taxpayers’ money is probably not.
The curious case of Wirecard
By Paul Condylis and Emir Hrnjic
On June 18, global fintech company Wirecard admitted that large parts of its Asia business were misrepresented and that €1.9 billion (S$3 billion) in cash reported on their financial statements did not exist.
Five days later, the company filed for bankruptcy protection from creditors, and Wirecard’s share price collapsed from more than €100 to less than €3.
In the largest auditing scandal since Enron, Wirecard’s auditing firm of more than ten years did not carry out even basic auditing procedures such as checking directly with banks to confirm that Wirecard held large amounts of cash in these banks.
While most experts will focus on deciphering dubious accounting practices and puzzling auditing failures, this article will focus on three non–auditing issues.
None of these issues were indicators of potential fraud, but combined, they start to look suspicious. Admittedly, however, everything looks obvious in hindsight.
Before the earth-shattering scandal last month, Wirecard was a global fintech company with its headquarters in Germany. It started in 1999 by helping websites collect payments from customers.
More specifically, it operated on the fringes of electronic payment processing business servicing online gambling companies and pornographic websites.
While traditional payment processing companies stayed away from these sectors due to high risk and small margins, Wirecard filled the gap.
As the past two decades witnessed a plethora of businesses moving online and away from traditional cash payments, this darling of the fintech industry experienced spectacular growth. In 2018, Wirecard became a payment processing giant worth almost €25 billion and was included in the prestigious German blue-chip index – the DAX.
After Wirecard acquired XCOM in 2006, the renamed subsidiary was licensed to issue credit cards and handle money on behalf of merchants.
Thus Wirecard became a fintech hybrid with banking and non-banking operations.
These hybrid fintech firms are not subject to the same regulations as banks and financial firms. If a company does not meet the typical threshold of 50 per cent of its business in lending and taking deposits, it is not scrutinised like the banks.
Hence, while Germany’s financial regulator BaFin regulated Wirecard’s banking arm, it did not regulate its payments processing business, which fell through regulatory cracks.
Founded in 1999, the company was listed in 2005 via a reverse takeover of a defunct call centre group which was publicly listed.
A reverse takeover or a reverse merger is the process of going public via a back-door listing. In short, the private company buys shares of a public company and takes control. So, effectively, the private company becomes a publicly traded one.
This allows the private company to transfer its business operations into the public entity and bypass the complex process of going public via initial public offering (IPO) – a much more common method for going public.
Compared with IPO, reverse mergers happen at much lower costs, in much shorter time and with few regulatory requirements and little overseeing. Also known as back-door listing, this unusual method avoids the intense scrutiny and regulatory procedure of a typical listing via IPO.
Several academic studies documented that reverse merger firms are typically smaller, less profitable, and riskier than IPO firms, consistent with the notion that reverse merger is a way for smaller and less developed firms to become publicly listed.
Notoriously, a boom in reverse mergers of China–based firms in the United States ended due to a series of financial scandals in 2011, when more than 20 of such companies were delisted and as many as 42 out of 150 were accused of fraud.
PRICE MANIPULATION VERSUS PRICE DISCOVERY
Short sellers expressed concerns about the company as early as July 2014, but every time they were met with accusations of price manipulation.
For example, when the Financial Times reported claims of forged documents in Wirecard’s Asia headquarters in January last year, oddly, BaFin launched a probe into the FT reporting and an alleged attempt at share price manipulation.
In an unprecedented move, BaFin imposed a ban on short selling of Wirecard’s shares a month later. Even though BaFin banned the short selling of banks during the global financial crisis in 2008 due to concerns of price manipulation, this was the first time that Germany’s watchdog banned a short selling of a single company.
In 2016, short sellers under the pseudonym Zatarra published money-laundering allegations against Wirecard. Again, BaFin started investigating accusers for alleged price manipulation.
Soon after, critics of Wirecard started receiving “spear-phishing” emails in an online bullying attempt.
Finally, Wirecard hired KPMG to conduct a special audit, but the auditors were not able to clear the company.
Despite short sellers’ allegations of Wirecard’s transgressions since 2014, it was not until June 2020 that EY, its auditor of more than ten years, refused to sign its financial statements due to fraud concerns.
It was only in June that BaFin stopped blaming whistleblowers, journalists, investors, and short–sellers and started probing Wirecard.
The example of Wirecard shows the value of short selling when viewed from the perspective of price discovery and not price manipulation.
The non–auditing issues should have given rise to suspicion among investors and, especially, Germany’s financial watchdog.
While investors and BaFin may not go back in time for a do-over, at minimum, they can pay more attention to similar concerns in future.
Fraud Detection Using Machine Learning Amid Covid-19 crisis (as published in Business Times on July 21, 2020)
Fraud Detection Using Machine Learning Amid Covid-19 crisis
By Paul Condylis and Emir Hrnjic
Online shopping and the quest for ever-increasing convenience resulted in the scattering of our credit card details across various websites. Over time, we have become desensitised to providing our payment details and, effectively, passed the responsibilities of storing and protecting our personal and transaction details to e-commerce companies.
Unfortunately, many companies have failed to keep our data safe and secure. According to Statista, over 164 million sensitive records were exposed in 1,473 data breaches in the United States last year.
The exponential growth in e-commerce attracted even more aggressive growth in illicit activities. Southeast Asia’s e-commerce market will likely exceed Google’s prediction of US$200 billion, driven by a high mobile internet penetration rate, young consumers, and an increase in disposable income.
At the same time, fraud cost the world economy over US$5 trillion in 2019. According to AppsFlyer, APAC’s fraud is 60 per cent higher than the average global rate, while South East Asia is the heaviest hit region, especially Indonesia, Malaysia, Thailand, and Vietnam.
Recently, the international law enforcement agencies warned of a spike in fraud related to the COVID-19 pandemic, and The Straits Times reported that victims in Singapore have lost S$41.3 million in the first quarter of this year, nearly a 30 percent increase. Unfortunately, it seems that 2020 will turn out to be a bumper year for fraudsters around the world.
Fraud Detection and Machine Learning
In order to protect the customers, banks and retailers have deployed large-scale fraud detection pipelines that scan transactions in real-time. For a long time, fraud detection has relied upon rule-based expert systems to detect illicit activities. Traditional experts analysed transaction logs, identified fraudulent patterns, and implemented hand-coded rules to flag those activities. The rules were as simple as blocking the transactions from a compromised credit card number to more sophisticated rules such as flagging transactions that deviate from the credit card’s historical patterns.
Over time, as transaction volumes have exponentially grown, thousands of increasingly complicated fraud–detection rules emerged and this approach became intractable. Fortunately, machine learning can easily scan millions of transactions to enable real-time fraud detection. Machine learning is a procedure that enables a computer to learn from data how to perform a certain task. Once a computer learns the task to a sufficient level, human experts are no longer needed.
Indeed, fraud detection algorithms based on past purchase behaviour have matched accuracy of human performance at identifying anomalous transactions. Meanwhile, the experts’ role evolved to analyse and understand larger issues such as new global fraud trends.
But what happens when purchase behaviour suddenly changes? And therein lies the rub. If machine learning algorithms rely on learning from historical data, a rapidly changing environment and fast-evolving patterns will wreak havoc on the predictions and forecasts.
The world has drastically changed since COVID-19 wrecked the global economy. Predictably, fraudsters have taken advantage of the uncertainty in the rapidly evolving environment and changed the patterns and targets of attack. For instance, traditional strategies of ticket fraud (i.e. reselling tickets purchased with stolen card information) have migrated, and fraudsters are increasingly turning to well-orchestrated scams directly defrauding unwitting consumers.
In such an environment, machine learning algorithms must be retrained on new data and quickly redeployed. However, as changes are unfolding in real-time, algorithms have far less data to learn from and adapt to changing fraud attack vectors. Slow moving trends underpinning increasingly irrelevant historical data must be unlearnt and machine learning engines must accurately predict newly evolved tendencies using limited data. Moreover, the impact is compounded by having less validation data to judge the effectiveness of machine learning algorithms.
As fraudsters changed the patterns and targets of attack forcing experts to retrain and quickly redeploy machine learning algorithms in a rapidly evolving environment, automatic retraining of machine learning algorithms on new data and thwarting fraud attacks become paramount.
Only companies that have significantly invested in talent and robust big-data pipelines are well placed to cope with the current situation. Have the companies you have trusted with your data been so diligent? Maybe it is time to check your bank statement.
The future is digital
Digital currencies may one day challenge US dollar supremacy
Interest in digital currencies has been boosted by recent developments such as China’s pilot rollout of the digital yuan and a shift in Facebook’s plan for its Libra cryptocurrency.
While consumers may still associate blockchain technology closely with the speculative and volatile nature of bitcoin, significant advances in the use of distributed ledger point to a more promising outlook for digital currencies.
Dr. Emir Hrnjic, an adjunct assistant professor of finance at the National University of Singapore and a co-founder of Block’N’White Consulting, provides insight into central bank digital currencies and private cryptocurrencies and the potential impact on financial markets and investors in this question and answer with Asia Asset Management (AAM).
AAM: What do you see as the benefits and costs of central bank digital currency (CBDC)?
Hrnjic: The actual CBDC has yet to be properly launched. The People’s Bank of China (PBOC) achieved the first milestone by rolling out a pilot test of CBDC in four cities. We still do not know all the details.
Nevertheless, a CBDC needs to be properly designed and enable scalability, accessibility and privacy. The challenge is to design a CBDC with the convenience typically provided by financial intermediaries, not by central banks. PBOC tried to combine these by designing a two-tier system: the central bank will create the digital currency and then large financial institutions and the four largest state-owned banks will distribute it.
A properly designed CBDC will help target money supply and enable central banks’ access to money demand data. However, a CBDC will also enable central banks to trace individuals’ transactions. While this may help the battle against illicit transactions, it will also permit encroachment on consumers’ privacy.
The PBOC will probably institute limits on the frequency and amounts of anonymous transactions to try to strike a balance between preserving privacy and halting illicit transactions.
AAM: How do you see distributed ledger technologies being utilised by central banks in the next five to ten years, and what would the implications be for financial markets and investors?
Hrnjic: This is a million-dollar question. The future of blockchain technologies depends on many unknown variables and everyone is really making at best an educated guess at this point. A recent study by the Cambridge Centre for Alternative Finance prophesised that a third of central banks will have active applications within a decade.
Moreover, a study by the Bank of England in 2016 concluded that a properly designed CBDC may strengthen the transmission of monetary policy changes. However, the study also warned that any mismanagement of transition from physical to digital cash could pose a major threat to financial stability.
Despite many potential challenges, the Bank of England’s study concluded that CBDC issuance “could permanently raise GDP [gross domestic product] by as much as three percent and could substantially improve the central bank’s ability to stabilise the business cycle”.
AAM: Do you think the coronavirus pandemic may have helped push digital currency developments forward?
Hrnjic: Many changes across the world happened simultaneously as a consequence of Covid-19 [the disease caused by the coronavirus] and it is very hard to disentangle the impact of the pandemic versus numerous other seemingly related contemporaneous events.
Nevertheless, during the Covid-19 pandemic, communities socially distanced and observed strict hygiene measures. Since earlier research suggested that physical money carry up to 3,000 types of bacteria, money in a physical form became less desirable than digital money. Even the World Health Organisation warned that bank notes may carry the coronavirus for several days and advised the use of contactless payments.
While contactless payments and digital currencies are not the same, this is consistent with the notion that Covid-19 helped push digital currency developments forward.
Even the early versions of the US stimulus bill unexpectedly included the development of the digital US dollar to disburse stimulus payments. Eventually, the digital dollar did not make it to the stimulus bill, but the mere attempt seemed very intriguing. While a proposed digital dollar would have not used blockchain, it would have bypassed intermediaries by creating government-run digital wallets for all Americans.
AAM: Do you believe the digital yuan will have a significant impact on the dollar in coming years?
Hrnjic: One can argue that the launch of the digital yuan may pose a distant threat to the US dollar’s supremacy. Indeed, a recent Foreign Affairs article argued that the failure to “develop a competitive American alternative could significantly hinder the United States’ global influence” despite the fact that nearly 90% of international transactions were settled in US dollars, whereas RMB controlled only 2% of the market.
Nevertheless, China has worked on its CBDC since 2014 and its next emphasis will likely be on improving the domestic banking and payment system. While rolling out a pilot test of the digital yuan represents a major milestone, and China may have the ambition to unsettle the global monetary system in the distant future, it seems that this process will likely be slow and deliberate.
AAM: What can you tell us about Facebook’s recent pivot away from launching its Libra currency?
Hrnjic: Libra was initially designed as a stablecoin fully backed by a basket of bank deposits and treasuries denominated in five major international currencies. After strong pushback from regulators around the world, Libra was recently revamped.
Revamped Libra will comprise several stablecoins – each backed by a single currency such as the US dollar or British pound – separate from the Libra coin. Libra coin will simply be a digital composite of some of these coins.
In another major change, the Libra Association will vet any wallet launched on the network. While the first Libra White Paper vowed to transition Libra to a permissionless system, revamped Libra backed out of this promise.
Although Libra’s initial idea was to become a global digital currency with permissionless network and censorship resistance, revamped Libra significantly scaled back. While attempting to satisfy regulators, it seems that Libra has lost its soul.
AAM: What is your opinion about Libra’s potential to act as an alternative for currencies of countries with high inflation such as South Africa?
Hrnjic: Libra should have a stable exchange rate due to its backing by five major international currencies and thus it could be very useful in certain countries as well as in cross-border transactions. For example, populations in many developing nations have access to mobile networks and high mobile phone ownership rates, which offer potential for Libra to improve financial inclusion.
This could be especially useful in countries with high inflation or unstable banking systems as well as for cross-country remittances. Hence, Libra can expand access to capital and help people in developing countries get involved in the global economy.
This may be of great importance to countries such as India, Philippines and Indonesia with large remittances from their diaspora and a high fraction of underbanked people.
AAM: Do you believe private cryptocurrencies may pose a big risk to CBDCs?
Hrnjic: Despite the fact that private cryptocurrencies are facing intense regulatory scrutiny, especially in the US, Libra may eventually challenge the digital yuan’s global dominance.
Indeed, Libra could partially replace some sovereign currencies, especially in countries with high inflation, an unstable banking system and a large underbanked population.
Moreover, the potential dominance of any private cryptocurrency in a specific country would undermine the monetary policy of that country. If private cryptocurrency started replacing local currency, it would cause the local currency’s depreciation and thus higher inflation.
In this respect, the effect of cryptocurrencies would be analogous to dollarisation – the impact of the US dollar on local currencies in some developing countries. For example, the population in countries such as Zimbabwe or Cambodia use the US dollar due to a lack of trust in local currency.
AAM: What are the main takeaways regarding CBDCs and private cryptocurrencies.
Hrnjic: CBDCs and private cryptocurrencies may partially replace fiat currencies relatively soon, but not in the near future. If that happens, the impact on financial inclusion would likely be positive for both private and government-backed cryptocurrencies. That should be of enormous interest to policymakers in countries such as India, Philippines and Indonesia with large diaspora and tens, if not hundreds, of millions of underbanked people.
However, the impact of private and government-backed cryptocurrencies on monetary policy diametrically differs. CBDCs are likely to strengthen the transmission of monetary policy and help in targeting money supply.
On the other hand, dominant private cryptocurrencies would severely undermine the effect of monetary policy. Furthermore, they could also lead to diminishing the relevance of some fiat currencies, the loss of their value, and high inflation.
Did Islamic equity funds outperform?
By BEN CHAROENWONG and EMIR HRNJIC
decade long performance
AS the Covid-19 virus reached pandemic proportions, national borders closures and country lockdowns led to diminished consumer demand and a collapse of industrial production and service industries. The crisis led to financial distress among small and medium enterprises (SMEs) and sparked massive layoffs. In matter of weeks, unemployment rose to double digits.
Large companies were not immune to the pandemic either (no pun intended). While Boeing and major US airlines pleaded for more than US$100bil in federal funding to stay afloat, several well-known companies including Hertz, Thai Airways, and JCPenney filed for bankruptcy.
As the Covid-19 pandemic ground international trade almost to a halt and wreaked havoc on national economies, stock markets plummeted.
The S&P500 started dropping on February 19 and lost almost a third of its value in a month. Only after the Fed committed to lend trillions of dollars and US Congress allocated more than US$2 trillion in federal emergency assistance to American companies and financial institutions did the American stock market reverse the free fall and partially recover.
Almost simultaneously, dominos started falling in Asian markets. Along with the collapse in the US stock market, the Japanese Nikkei Index and Singapore’s Straits Times Index lost roughly 30% of their values, while Hong Kong’s Hang Seng Index dropped by almost 20%.
As the global economy reached the brink of total collapse, Morningstar Research reported that in March 2020 investors withdrew US$326bil from mutual funds across the world.
Islamic equity funds
In the midst of the unprecedented mayhem, an often-overlooked area of niche investing stands out – Islamic equity funds.
Islamic equity funds avoid non–halal activities such as conventional finance, alcohol, gambling, pork related products, and adult entertainment, as well as tobacco, weapons, arms, and defence manufacturing. Additionally, the screening criteria requires investing in companies with low debt ratio, low cash and interest-bearing items, low accounts receivable and cash, as well as low revenue from non-halal activities.
Originally targeted to Islamic investors, these funds appeal to non-religious investors as well. Notably, shunning sectors associated with weapons production would appeal to the broader investors’ base, especially with the general trend towards environmental, social, and governance (ESG) investing. Furthermore, their conservative nature may be attractive to long-term investors as well.
During the Covid-19-induced market panic through March, the MSCI World Index lost over 30%, while the MSCI World Islamic Index lost 20%, thus resulting in a relative outperformance of 10%. As the Islamic index fared better than the rest of the market during the crisis, one might argue that Islamic equity funds offered some protection from downside risk to investors.
Remarkably, while the pandemic triggered massive declines of assets under management (AUM) across the world, in-flow into Islamic funds in certain countries picked up. According to the Fitch ratings agency, Islamic funds in Saudi Arabia experienced an increase in AUM by 3%, thus surpassing Malaysia as the largest market for Islamic funds in the world.
Nevertheless, it is still too early for a victory lap since the Covid-19 crisis has been around for a relatively short time and thus corresponding outperformance of Islamic finance index provides relatively few data points to support meaningful conclusions.
Global financial crisis
Even though some analysts were quick to attribute the outperformance during Covid-19 to luck, we find a consistent pattern during another major market downturn – the Global Financial Crisis (GFC) from 2008 to 2009.
While outperformance of Islamic indices during the Covid-19 crisis could have been due to short-term fluctuations, longer data surrounding the GFC provides the ground for more robust experimentation to examine the relative performances of the Islamic versus conventional global indices.
In the six months around the failure of Lehman Brothers, the MSCI World Index lost 42.6%, while the MSCI World Islamic index lost only 12.4%, resulting in an outperformance of over 30%.
Another prominent measure of performance over a decade–long horizon around the GFC – from the Dow Jones Global index’s inception in October 2006 through December 2016 – indicates that a US$100 investment in the Dow Jones Global index would yield US$123.96 while an equivalent investment in the Dow Jones Global Islamic index would yield US$144.99, roughly a 20% improvement.
Part of the difference in the performance in the period surrounding the GFC stems from Islamic funds’ avoidance of conventional financial institutions and the embrace of Islamic financial institutions, making them inherently more defensive and better able to withstand adverse economic conditions.
Notoriously, Bear Stearns, Lehman Brothers, Merrill Lynch, and other behemoths of financial world either filed for bankruptcy or were acquired to escape insolvency.
Their shareholders lost hundreds of billions of dollars. None of these conventional financial institutions were syariah-compliant and thus were not included in Islamic funds.
An IMF study by Jemma Dridi and Maher Hasan suggests that Islamic banks outperformed conventional banks during GFC due to smaller investment portfolios, lower leverage, and avoidance of financing or investing in the innovative (and risky) instruments that wrecked conventional banks.
Surprisingly, Islamic AUM was only US$15bil in 2008. While it grew almost five-fold to US$70.8bil in 2017 according to the Malaysia International Islamic Financial Center, projections are even more optimistic going forward – to approximately US$216bil by 2024.
Islamic equity funds can provide some protection from downside risk as evidenced by their outperformance in two high-profile crises. This is partially due to a limited exposure to highly volatile stocks such as conventional financial institutions. These return characteristics should appeal not only to Islamic investors, but to the broader public as well.
Moreover, Moody’s 2020 Investors Service’s report predicted expansion of Islamic assets by 3% to 4% per annum in the short to medium term. The report states that the demand for Islamic asset management is rising due to “large Muslim populations, supportive legislation and growing investor demand for syariah-compliant products.”
We expect this wake-up call to further boost the development of the Islamic asset management industry and thus expand the existing investable universe.
Development of Facebook’s Libra expedited amid Covid-19
By Emir Hrnjic
Amid the COVID-19 pandemic, experts warned that the virus could spread via physical money as the monetary notes and coins may carry viruses and up to 3,000 types of bacteria. In March, the World Health Organisation confirmed that banknotes may carry the coronavirus for several days and recommended the use of e-payments to mitigate the risk of contagion.
Moreover, the widespread national lockdowns highlighted the need for people to transact from the comfort of their own home. Thus, a heightened virus awareness and a more urgent need for contactless payments might have expedited the development the digital currency of Facebook, Libra.
Libra’s development was further highlighted by the pilot launch of digital yuan in four cities across China. Even though digital yuan may not be a direct competitor to private digital currencies such as Libra, its upcoming rollout threatens to affect Libra’s potential market.
More recently, Libra made the headlines again as Singapore’s sovereign wealth fund Temasek joined Libra Association and became its first Asia-based member as well as the first member with state backing. After the departure of several prominent members such as Visa, MasterCard and PayPal, Temasek’s backing breathed new life into the digital currency.
On May 7, the Libra Association appointed Stuart Levey, former chief legal officer of HSBC, as its first CEO. The hiring of a legal expert to run the digital currency clearly signalled Libra’s priorities after intense regulatory scrutiny from US lawmakers triggered massive exodus from the Association last year.
While cryptocurrencies have great potential, they are notorious for widespread scams, frauds and hacks. Thus, scepticism towards Libra has been expected. US Congresswoman Maxine Waters went as far as to request a moratorium on the development of Libra, comparing it to “starting a bank without going through any [regulatory] steps”.
Regulatory response around the world will differ due to diverse regulatory philosophies. While China is expected to ban Libra, Singapore will likely have a much more accommodating approach. Even though Ravi Menon, Managing Director of Monetary Authority of Singapore, expressed concern that Libra raises global financial risk, Temasek’s involvement signals that the Singapore government has decided to focus on potential benefits.
Libra has the potential to be a game–changer in digital payments thanks to Facebook’s 2.5 billion active users. While one of the major problems with existing cryptocurrencies is slow and insufficient adoption, Libra wallets will likely ease and accelerate Libra’s adoption, thus creating an immediate advantage over existing cryptocurrencies.
One could argue that a single digital currency – or perhaps very few of them – will dominate the global market, while the overwhelming majority will fail. In this “winner-takes-all” market, contenders are incentivised to move early and aggressively, and Libra’s start seems like the step in the right direction.
Libra was initially designed as a stablecoin fully backed by a basket of bank deposits and treasuries denominated in stable international currencies, comprising the US dollar, euro, Japanese yen, pound sterling and Singapore dollar. This backing would ensure a stable exchange rate in contrast to the overwhelming majority of existing cryptocurrencies with extremely volatile prices.
After the strong pushback from the regulators around the world, Libra was recently revamped in the initiative allegedly aimed at minimising disruption to the global monetary system.
Libra 2.0 will comprise several stablecoins – each backed by a single currency such as the US dollar or Singapore dollar – separate from the Libra coin. The Libra White Paper added that “each single-currency stablecoin will be fully backed by… cash or cash equivalents and very short-term government securities denominated in that currency.”
Libra coin will be a “digital composite” of some of those coins – most likely the initial five currencies – and could potentially operate as a settlement coin in cross-border transactions as well as in countries without a single-currency stablecoin on the Libra network.
In a further attempt to satisfy regulators, Libra reemphasised its commitment to financial compliance, including strict enforcement of measures against money laundering, terrorism financing, sanctions compliance, and the prevention of illicit activities.
In the first stage of Libra rollout, Unhosted Wallets will not be allowed on the Libra network and their eventual inclusion will have limited balance and number of transactions. As Unhosted Wallets are, loosely speaking non-institutional developments and thus crucial for financial inclusion, crypto enthusiasts criticised this deferral.
In another major change, the Libra Association will vet any wallet launched on the network. While the first Libra White Paper vowed to transition Libra to a permissionless system, Libra 2.0 backed out of this promise. Hence, Libra 2.0 will lack censorship resistance, disappointing cryptocurrency devotees who consider the absence of censorship a very important feature of cryptocurrency.
While Libra’s initial idea was to become a global digital currency with permissionless network and censorship resistance that would have an easy adoption by Facebook’s massive user base, Libra 2.0 has significantly scaled back from its initial promise and made uneasy compromises to satisfy regulators. In an attempt to please both crypto enthusiasts and regulators, it seems that Libra 2.0 has not satisfied either side. Time will tell.
As China's digital currency moves ahead, can Facebook's Libra match up? (as published on ThinkChina.sg on June 2, 2020)
As China's digital currency moves ahead, can Facebook's Libra match up?
By Emir Hrnjic
The People’s Bank of China recently started pilot-testing a digital RMB in Shenzhen, Suzhou, Chengdu and Xiong’an New Area. Will this development threaten the US dollar’s role as the world’s reserve currency in the future? Meanwhile, Facebook and the non-profit Libra Association headquartered in Switzerland have been working towards launching a revolutionary cryptocurrency since June 2019. Although the shape of the project has changed, what will Libra be adding to the mix?
In late April, the People’s Bank of China (PBOC) started a pilot test of the digital RMB in Shenzhen, Suzhou, Chengdu and Xiong’an New Area, and thus China became the first major economy to roll out a central bank digital currency (CBDC).
Digital currency is money that exists in electronic form. While deposits in commercial banks are also digital, they are a liability of the bank. In contrast, China’s CBDC is a liability of the state.
China had already become a global leader in e-payments with its market surpassing those of the US, the UK, Japan, and Germany combined. Notably, the world’s largest FinTech company Ant Financial — the China-based company behind mobile payment app Alipay — is valued at US$150 billion. Remarkably, the capitalisation of this private company is roughly equal to those of Citigroup and Goldman Sachs combined. Additionally, the launch of the digital RMB aims to further cement China’s leadership in e-payments.
A recent report from the Bank for International Settlements mentioned “scalability, accessibility, convenience, resilience, and privacy” as desirable features that a CBDC needs. The challenge, the report argued, is to “design a CBDC that combines the virtues of a direct claim on the central bank with the convenience offered by intermediaries”.
Even though this may facilitate the fight against money laundering and terrorist financing, tracing may also enable the close surveillance of cash flow movements in the economy and invade people’s privacy.
Notably, the PBOC created a two-tier system whereby it creates the digital currency and passes it on to China’s large financial institutions and largest state-owned banks which are supposed to further distribute it to the retail population. As the digital RMB will be used for settlement of transactions, it may increase the transparency of the Chinese banking system and create more stability.
On the other hand, CBDC enables the PBOC to trace transactions. Even though this may facilitate the fight against money laundering and terrorist financing, tracing may also enable the close surveillance of cash flow movements in the economy and invade people’s privacy. While the PBOC has promised to balance concerns about privacy against the objective of halting illicit transactions, it remains unclear how it can achieve balance between these opposing objectives.
The launch of the digital RMB may signal China’s ambition to unsettle the global monetary system. China is already ahead of the US in the digital payments market and one can argue that digital RMB may pose a distant threat to the dollar’s supremacy as an international means of payment.
Even though nearly 90% of international transactions were settled in US dollars in 2019, whereas RMB controlled only 2% of the market, a Foreign Affairs article by the executive director and co-director of the Belfer Center, Harvard Kennedy School notes that “the failure to check the influence of China’s digital RMB and develop a competitive American alternative could significantly hinder the United States’ global influence in the information age”.
Current sentiment in China may give credence to this theory. Recently, a former Bank of China president, Li Lihui, delivered a talk, opining how China’s digital currency may restructure the global monetary system. Furthermore, a recent opinion piece in China Daily by Daryl Guppy, an equities and derivatives trader and columnist, said: “A sovereign digital currency provides a functional alternative to the dollar settlement system and blunts the impact of any sanctions or threats of exclusion both at a country and company level.”
Finally, most cross-border payments are facilitated by the Society for Worldwide Interbank Financial Telecommunication (S.W.I.F.T.) while a large fraction is routed through US banks. Even though S.W.I.F.T. is headquartered in Belgium, many argue that the US yields a disproportionate influence including the ability to exclude countries under sanctions from cross-border transactions. This implies that the digital RMB may weaken the power of US sanctions and its ability to track illicit financial flows.
How will the world react?
Intuitively, the best response to the digital RMB would be the digital dollar. In that spirit, the early versions of the US stimulus bill included the development of a digital US dollar to provide payments to people and businesses hit by the economic downturn. According to the reports, the Fed was supposed to offer bank accounts to all Americans — FedAccounts — which would bypass commercial banks.
The digital dollar would likely combine the economic strength of the US dollar with the convenience of digital technology. It was unlikely that a new digital dollar would use blockchain, but, nevertheless, the idea was scrapped and did not make it to the final version of the stimulus bill. Moreover, while more than 50 central banks around the globe have been experimenting and researching digital currency space for years, the US Fed is lagging behind the rest.
While Libra, the digital currency proposed by Facebook, is facing a regulatory pushback and scrutiny in the US and is being reconfigured, ironically, it may be America’s second-best response to potential challenge to its global monetary dominance. In his testimony to US Congress, Mark Zuckerberg, the Facebook CEO noted that increased regulatory scrutiny over Libra impedes its development, which would benefit China that was working on a similar project. While being grilled in Congress, Zuckerberg tried to convince US lawmakers that the choice is not Libra versus no Libra, but rather Libra versus digital RMB.
In fact, Li Lihui spent half of his talk discussing Libra and described it as a “supranational digital currency”. Even though the two currencies widely differ, Libra and CBDC may yet compete on the international scene.
Moreover, Mark Carney noted in a speech in August 2019 when he was still governor of the Bank of England that the US dollar has played a dominant role in the world order for much of the past century and discussed the need for a new international monetary and financial system.
While he opined that neither RMB nor Libra were in a position to take over from the dollar yet, Carney suggested several possible replacements to the dollar, including a digital currency supported by an international coalition of central banks co-insuring each other.
Carney added that a “SHC [synthetic hegemonic currency] could dampen the domineering influence of the US dollar on global trade. If the share of trade invoiced in SHC were to rise, shocks in the US would have less potent spillovers through exchange rates...”
Notwithstanding all of the above, we should keep in mind that the deliberate process of developing China’s CBDC lasted six years and its early focus will likely be on ironing out the wrinkles in the domestic banking system before it makes a leap on the international scene.
While digital RMB represents a major milestone and China may have the ambition to unsettle the global monetary system in the distant future, it seems that this process will be slow and deliberate. However, if digital RMB takes off sooner than expected, ironically, the best defence in preserving the dominance of the US dollar may be a dominant private cryptocurrency such as Libra as it was earlier envisioned or a multinational digital currency issued by a coalition of central banks.
Did Covid-19 spur digital currency development?
By Emir Hrnjic
With people observing social distancing measures during the COVID-19 pandemic, a serious concern has emerged. Can the virus spread via physical money? One research seems to suggest so – tests conducted found that some notes and coins may carry as much bacteria as those present on the soles of shoes or even toilet seats.
In March, the World Health Organization confirmed that banknotes may carry the coronavirus for several days and advised the use of contactless payments instead. Amid the heightened hygiene awareness, digital currencies came to focus Improbably, the Covid-19 crisis might have prompted central banks to expedite this development.
Recently, the head of the Bank of International Settlements (BIS) Innovation Hub Benoît Cœuré said “the [COVID-19] crisis has exposed the value of technologies which enable the economy to operate at arm’s length and partially overcome social distancing… The current discussion on central bank digital currency also comes into sharper focus.”
China leading the way
While the rest of the world has been discussing and analysing the benefits and costs of digital currency, China’s central bank—the People’s Bank of China (PBOC)— had seized the moment and started a pilot test of the digital yuan, the electronic form of the renminbi with value equivalent to the paper notes and coins in circulation. It has since become the first major economy to introduce a central bank digital currency (CBDC), rolling out the pilot test in three cities, including Shenzhen, Suzhou, and Chengdu, as well as in the Xiong’an New Area.
Also known as “DC/EP (Digital Currency/Electronic Payments),” the digital yuan transactions can be made through smartphone–based NFC technology (Near Field Communication). The technology enables the phones to interact with each other when in close proximity and, thus, allows the digital currency to be exchanged without the internet.
Mobile cashless payments – like Alipay or WeChat pay – have become a part of daily life in China. But the launch of digital yuan – coupled with a recent President Xi Jinping’s call for China to focus more on blockchain – exemplifies China’s continuous push to become the world’s leader in digital currency space. Moreover, digital yuan may even pose a threat to the dollar’s supremacy as an international means of payment. Mainland based English newspaper China Daily went as far as to claim that “[China’s] digital currency provides a functional alternative to the dollar settlement system and blunts the impact of any sanctions or threats of exclusion both at a country and company level… It may also facilitate integration into globally traded currency markets with a reduced risk of politically inspired disruption.”
Pros and cons
While it may be too early to evaluate China’s experiment, central banks around the world are paying great attention to this development while carefully observing pros and cons of digital currency.
The truth is, central banks have been studying the use of blockchain technologies for years. The Bank for International Settlements (BIS) views potential CBDCs favourably as they would be backed by the government, and the money supply would be controlled by the central bank. Furthermore, the early versions of the US stimulus bill flirted with the development of a digital US dollar to disburse economic stimulus payments, while The European Central Bank recently released a working paper analysing merits of its potential digital currency.
The pros are there. A Bank of England’s study in 2016 on the feasibility of digital currency pointed out that it could increase Growth Domestic Product (GDP) “by as much as three percent.” The usage could also “improve the central bank’s ability to stabilise the business cycle.”
Following the rise of cryptocurrencies such as bitcoin, the secure digital transfer of money has become paramount. While Bitcoin’s extreme volatility and low transaction processing capacity hinder its ambition to become a global medium of exchange, digital currency issued by a central bank has a far greater potential to become a trusted medium due to inherent low volatility as well as potential for greater efficiency, lower transaction costs, and large scale.
CBDCs would likely help monetary policy targeting money supply and enable access to real-time data regarding money demand. At the same time, blockchain could support faster, auditable, and in general more transparent interbank settlement systems at decreased settlement costs, while avoiding issues like single point of failure.
As societies become immersed in digital payment, central banks which roll out digital currency could gain the first-mover advantage. Any central bank ignoring the role of digital currency could risk losing relevance in the global economy.
Challenges to overcome
However, the transition to digital currency adoption needs to be carefully managed. One challenge to overcome is the potential shortfall in credit. As the head of Germany’s Bundesbank, Jens Weidmann once argued, in uncertain economic times, people may choose to put their money as digital currency in central banks, instead of deposits in commercial banks as the former is more secure and holds lesser risk. With reduced deposits also comes a severe contraction of consumer credit which would clearly harm the real economy. As central banks’ digital currency looks set to take on a bigger role in future, commercial banks would have to find alternative sources to replace the deposits.
The PBOC are aware of this shortcoming: They did not want digital yuan to become a threat to the retail banking system. For this reason they did not make it available directly to the public. Instead, the digital yuan will be used by the PBOC and commercial banks for settlement of transactions which may increase transparency of the Chinese banking system and create more stability.
PBOC’s playbook calls for implementation of a two-tier system – the central bank will create the digital currency and issue it only to large financial institutions and four largest state-owned banks that will further distribute it to China’s 1.4 billion citizens, just like the issuance of cash.
Another major challenge is privacy. Digital currency enables digital tracing of all digital cash in circulation and, thus, a person’s use of finances. While this considerably helps authorities to fight money laundering, terrorist financing, and even tax evasion, it also facilitates close surveillance and control of individuals’ transactions. In countries where privacy is a great concern, this may lead to serious public opposition.
Even though PBOC promised to keep the balance between privacy and supressing criminal transactions, it remains unclear how it can achieve balance between these diametrically opposite objectives. Early reports hint at limits in the frequency and amounts involved in anonymous transactions.
As an improbable consequence of COVID-19 crisis, CBDCs were brought in focus and governments might have been prompted to expedite their development. Seizing the moment, China’s central bank made major steps toward becoming the first major economy to issue a CBDC. How other central banks follow suit will be something that markets will play close attention to.