Financial technology and decentralised finance: to embrace or forsake

By Dr Wenjuan Ruan, January 2024

Dr Wenjuan Ruan, Assistant Professor in Finance on what we can learn from China’s approach to a central bank digital currency. 

Financial technology (FinTech) and decentralised finance (DeFi) have penetrated all areas of the financial system across the globe. A spectrum of financial products and services such as digital banking, cryptocurrencies, real-time payments, and crowdfunding have seen striking growth. For some, they’re a source of panic, for others they’ve improved financial freedom and inclusion.  

China has been one of the few countries where FinTech has developed rapidly in the past decade. However, right in the exponential growth of DeFi, the Chinese government slammed the brakes and successively banned a series of FinTech products and activities. For example, the initial coin offerings (ICO), Bitcoin mining and all private cryptocurrency-related transactions were consecutively prohibited by the Chinese government in September 2017, May 2021, and September 2021. Concurrently, in the belief that a Central Bank Digital Currency (CBDC) would enhance financial efficiency and decrease paper-cash related costs, China’s central bank, the People’s Bank of China (PBOC) launched a CBDC, which is dominated by e-CNY, the digital version of the fiat currency that the PBOC issued.  

What is CBDC? 

CBDC is an electronic form of money that consumers and businesses hold with their country’s central bank, such as the Bank of England.  

Contrary to other legal tender issued by the central bank such as banknotes, CBDC is the digital form of a country’s fiat currency. CBDC is different to the deposits held with commercial banks, in that it could overcome the risk that the bank could collapse.  

While decentralised financial products such as cryptocurrency have no backup or stablecoins fully or partially backed by real assets, a CBDC is managed by a central authority and has the same security and government endorsement as cash. This means it can effectively protect customers and prevent them from being exposed to tremendous risks and price volatilities caused by DeFi products. 

Research has found that if banks have market power in the deposit market, a CBDC can enhance competition, raising the deposit rate, expanding intermediation, and increasing output. Therefore, it’s worth investigating if CBDC would be able to act as a role of supplementary for the tangible fiat currency.  

China’s CBDC pilot  

China’s e-CNY was initially tested in four cities (Shenzhen, Suzhou, Xiong’an, and Chengdu) in April 2020. A few more cities subsequently joined the pilot, including Shanghai, Hainan, and Changsha. During the Beijing 2022 Winter Olympics, China successfully verified the demand and convenience of the e-CNY by offering visitors mobile apps, payment cards and wristbands. The convenience stores in the Olympic Village and small merchants near the stadiums were all equipped with e-CNY machines. Visitors could also exchange foreign currency into e-CNY at self-service machines. 

Arguably, China’s CBDC will likely promote the internationalisation of the Chinese currency (RMB), foster international trades and investments, and even change the international economic order.  

CBDC in other countries  

Although China seems to be a pioneer in CBDC, the Bank of Finland, Finland’s central bank, launched a curious card called Avant in 1992. Avant cardholders were anonymous and didn’t need to have an account with the bank, but their money stored on the card was backed by the Bank of Finland and traceable through physical chips. The Avant cards discontinued after a few years of operation due to the disadvantages compared to credit cards. 

30 years later, with the emergence of technologies, declining cash usage, the rise of cryptocurrencies and stablecoins, as well as accordingly generated rampant speculative investment, gambling fraud and money laundering, the world’s central banks have realised they need to find a way to avoid losing control of their financial system or let the future of money pass them by. 

At time of writing, 20 June 2023, 11 countries have fully launched a digital currency and 114 countries, representing over 95% of global GDP, are exploring a CBDC. In 2023, over 20 countries will take significant steps towards piloting a CBDC. Australia, Thailand, Brazil, India, South Korea and Russia intend to continue or begin pilot testing in 2023. The European Central Bank is also likely to start a pilot next year. 

Together with the Treasury, the Bank of England launched a consultation on its assessment of the potential need for a digital pound and its design ideas in February 2023. The Economic Affairs Committee Report on CBDC debated on 2 February 2023 stated that “since bitcoin was called a coin instead of a token, lots of ordinary people lack understanding on the basic characteristics of this DeFi and its risks. As we saw from the FTX debacle, a lot of money can be swindled out of ordinary people. The sooner we get away from this digital nonsense, the better off we will be in terms of people’s welfare. We have enough problems with the unequal distribution of money and so on.” However, on 7 February 2023, Sir John Cunliffe, Deputy Governor of the Bank, made a speech that no firm decision can be made yet to implement a digital pound and it would take several years to plan and develop such an innovation.  

What we can learn from China 

Technology and innovation should be encouraged and monitored by the government to better serve the public. FinTech and financial innovation are particularly rooted in the monetary and financial spheres, inadequate regulation of the technologies and related innovations will cause greater harm to society since money is often the most sensitive interest of the public. The US subprime mortgage crisis is an example of social unrest caused by financial innovation. Perhaps China’s approach to DeFi can be used as a reference: when the government and regulatory authorities are still unable to fully monitor the underlying technologies and can’t grasp or predict their development, temporary suspension might be a way out. Instead, a state-backed monetary system rather than a DeFi can enhance public confidence, protect investors and boost financial inclusion. In the long run, such regulation or prohibition would in fact further drive innovations, rather than suppress them.