What is it and how does it work?

GUANGZHOU, China – China is arguably the world 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 led the way in working with the digital yuan, a so-called central bank digital currency (CBDC) that aims to replace part of the money in circulation.

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

It is effectively a way for the central bank to digitize banknotes and coins in circulation. The Chinese market is already well advanced in cashless payments. The digital yuan would be a way to speed up this process.

It will be legal tender in China and there will be no interest payments.

“The use of money is decreasing. Eventually, the money will be replaced by something in digital format. This is one of the big drivers behind this,” Yan Xiao, project leader for digital commerce at the World Economic Forum, told CNBC.

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

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

In a separate article, Fan described how a CBDC could make payments more efficient and improve the transmission of monetary policy. Fan also argues that a digital yuan could help financial stability through a “controllable anonymity” system. It is here that payments would be somewhat anonymous, but data analysis tools could help the central bank detect illegal activity.

Another reason behind PBOC’s efforts could be to increase competition in the payment space and reduce systemic risk. China’s digital payments arena is dominated by Alipay, which is managed by the affiliate of Alibaba Ant Group, as well as WeChat Pay, managed by internet giant Tencent.

“The existing system is owned by private companies. If Alipay or WeChat goes bankrupt, which is extremely unlikely, it creates a systematic risk,” Linghao Bao, an analyst at Trivium China, told CNBC. “The biggest reason for them (the PBOC) to do that is to level the playing field. Another reason, perhaps, is the creation of a new payment system platform that will increase efficiency.”

The issue has two aspects: distribution and, eventually, how it will be spent.

The distribution will be conducted through the so-called two-layer system. This means that the PBOC will distribute the digital yuan to commercial banks. Commercial banks will be responsible for placing the coin in the hands of consumers. This could include services that allow consumers to exchange their currencies and money for digital yuan.

China has already donated millions of dollars in digital currency in real-world tests in several cities, including Shenzhen, Chengdu and Suzhou. This involves the local government distributing a certain amount of yuan through a lottery. Users generally need to download a separate application to receive the currency. JD.com, one of China’s largest e-commerce companies, was involved in the test and allowed customers to purchase items with the digital yuan.

At this point, it is not clear how users can actually maintain and spend the digital yuan when it is launched across the country. The most popular form of mobile payment in China depends on so-called quick response codes (QR). Users can display this barcode on their Alipay or WeChat app in a store and the merchant will scan it.

WEF’s Xiao says commercial banks are likely to be able to integrate similar functionality into their applications. And that Alipay and WeChat Pay could have a section of their apps dedicated to the digital yuan. Meanwhile, smartphone makers can also create digital yuan wallets for their devices.

“It will be interesting to see how telephone companies will take advantage of the opportunity to become a payment player in the market,” said Xiao.

PBOC’s fan also said that commercial banks already have the infrastructure to distribute the digital yuan and they better do that than the central bank.

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

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

“In my view, the digital yuan is not a direct competitor to Alipay or WeChat Pay, but a new platform that allows other players to enter and compete with WeChat and Alipay,” said Bao of Trivium China. “They can be commercial banks or other payment companies.”

PBOC’s fan also said that the proposed two-tier model can help “avoid disintermediation in the financial sector” because the central bank will not be competing with commercial banks.

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

Bitcoin is also based on a technology known as blockchain. It is not clear at this point what kind of technical composition the digital yuan would have.

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

PBOC’s fan said the digital yuan would have “controllable anonymity”. This would involve those who operate digital yuan wallets to disclose transactions to the PBOC as the “only third party”. Users would have a “loose account coupling”, which means that their current bank account may not necessarily be linked to their digital yuan account.

It can be based on a phone number, according to Xiao of WEF.

The PBOC says that agencies operating digital yuan services should “send transaction data to the central bank via asynchronous transmission in a timely manner”. This would allow the PBOC to “keep track of the necessary data” to suppress money laundering and crimes.

Some commentators have raised concerns, however, that the digital yuan could be used to increase surveillance of citizens.

China has been pushing for the internationalization of the yuan and some commentators see the digital yuan as a way to do this.

But today, digital currency has a domestic focus and international use “is not an immediate priority,” according to Bao of Trivium China.

But the PBOC has started to pave the way for digital currency to be used in international transactions. Last month, the PBOC joined central banks in Thailand, the United Arab Emirates and Hong Kong to jointly explore a cross-border digital currency payment project.