What to Expect When Central Bank Digital Currencies Cross Borders—the Spillover Effects and Corresponding Policy Responses

By | August 20, 2021

Central bank digital currencies (CBDCs) impact a sovereign state’s monetary policy and financial markets, and necessitate a rethink of the roles of modern states and central banks. The current literature around CBDCs focuses on two dimensions: (1) the impact of CBDC on monetary and macroprudential policies, and (2) the institutional infrastructure, legal mandates, and technical design necessary for CBDC issuance.

Missing from early debates around CBDCs is an analysis of their cross-border impacts. In our recent paper, we explore three spillover effects when general purpose CBDCs circulate beyond borders. We find that the unique characteristics of CBDC will make it difficult for the issuing jurisdiction to prevent cross-border transactions, even when such transactions are currently prohibited, and that receiving jurisdictions will have an even harder time when it comes to monitoring and regulating the flow of the foreign CBDC.

It is commonly agreed that China is the leading jurisdiction in CBDC development.  The total amount of e-CNY (China’s CBDC) issued has reached 34.5 billion (5.3 billion USD). The e-CNY is likely to be the first operational general-purpose CBDC and the People’s Bank of China (PBOC) is purportedly prepared to launch the e-CNY during the 2022 Winter Olympics. 

The institutional design of e-CNY bodes well for cross-border financial transactions, as the e-CNY follows a standard double-layered design. The PBOC distributes the e-CNY through end-user interfaces provided by financial intermediaries and electronic payment platforms. It supports offline transactions, and it will not generate any interest.

In terms of privacy protection, the e-CNY would have “controlled anonymity.” The central bank will be able to review all transactions, but the identities of transacting parties will remain unknown to it. Users will be able to establish different e-CNY wallets according to their needs: low-value and low-quantity transactions can be entirely anonymous, with more Know Your Customer (KYC) safeguards for higher-value or more frequent transactions.

If other major economies start issuing CBDC similar to e-CNY, we expect three spillover effects that will impact the receiving jurisdictions, while the issuing jurisdictions may also face some challenges. These spillover effects are: (1) a crowding out effect on local currency, (2) evasion of local capital controls, and (3) infringements on privacy of foreign users.

First, the crowding out effect involves a gradual process of replacing a less popular local currency with a popular foreign CBDC. If the technological design allows for it, people can use foreign CBDC to conduct transactions with other holders of the local CBDC. Thus, local currency is at risk of being replaced by the foreign CBDC if the foreign CBDC is considered more trustworthy or convenient in daily transactions. This effect will hamper the local government’s monetary policies even if the issuing jurisdiction denies transactions outside its jurisdiction. This is especially true if the foreign CBDC permits offline transactions—in such cases, users will be able to use foreign CBDC even outside of the issuing country’s borders.

Second, with the advent of CBDC, capital controls will cast a heavy burden on the receiving jurisdiction, as detecting and monitoring the inflow and outflow of CBDC becomes very difficult. This is because capital can move faster via digital wallets, rendering traditional monitoring measures no longer effective. What is more, the customs officials may not have the required expertise and training to properly oversee digital wallets.

Third, one of the main criticisms of CBDC is that its design can potentially allow the issuing government (or the central bank) to oversee the details of users’ daily transactions. Although some literature has proposed designs that can limit or avoid privacy issues, the threat to privacy remains real. This is especially true in countries where surveillance of citizens is a common practice. Since foreigners can also hold local CBDC, they might be subjected to the issuing government’s surveillance. Such a privacy infringement is likely to give the foreigners certain legal claims under the existing privacy protection laws, such as the European Union’s General Data Protection Regulation (GDPR).

The e-CNY will most likely have the largest impact in countries that are geographically close to China, or in countries with close economic or political relations with China. This is particularly true for countries that are the main participants of the Belt and Road Initiative (BRI). In addition to concession loans made by Chinese banks which will foster financial transactions, the inflow of Chinese workers and businesses to the BRI countries will also facilitate the e-CNY flow. What is more, the e-CNY is likely to be popular in BRI countries because the PBOC is known for building good payment platforms, while main BRI countries consider RMB a stable international currency.

We argue that these spillover effects can be tackled by the receiving jurisdictions or through cooperation between receiving and issuing jurisdictions. The policy responses we endorse can be broadly put into three categories: unilateral, bilateral, and multilateral (see Table 1).

Table 1. Strategies for tackling the spillover effects of cross-border use of CBDC

Crowding out effectaccess control use-banfavoring local currencyforeign offline transaction prohibitionborder control and wallet monitoringforeign offline transaction prohibitionborder control and wallet monitoringregulatory coordination
Capital control evasionborder control and wallet monitoringsingle clearing institutionmultilateral capital control monitoring
Privacy infringementprivacy-by-design*coordinated digital ID scheme**coordinated digital ID scheme

* Only the issuing jurisdiction can exercise this strategy 

** Even though bilateral effort will work, multilateral cooperation will be more effective.

Several policies are available to issuing and receiving jurisdictions to tackle the crowding out effect. First, the issuing jurisdiction may use an “access control strategy,” which involves binding CBDC to a digital ID and developing CBDC on an account-based system. Second, the receiving jurisdiction may prohibit its own citizens from using foreign CBDCs domestically. We refer to this method as the “use-ban strategy.” Third, the receiving jurisdiction can ensure robust legal tender provisions, making the use of the legal tender more attractive in the domestic market. We call this method the “local currency favoring strategy.”

The crowding out effect may occur when the receiving jurisdiction hosts a significant population of the issuing jurisdiction’s citizens. In this case, the issuing jurisdiction can utilize technological design to make offline transactions outside its jurisdiction impossible. We call this method the “foreign offline transaction prohibition strategy.” The receiving jurisdiction, on the other hand, can enforce the border control and wallet monitoring strategy to prevent the spillover effect. For example, when foreign citizens enter the receiving country, border customs can monitor travelers’ CBDC wallet IDs and balances.

For countries dealing with CBDC, an effective capital control should involve more sophisticated border controls and careful monitoring of financial flows, which we refer to as the “border control and wallet monitoring strategy.” The effectiveness of this strategy is premised on the coordination of the receiving country’s technological readiness, the professionalism of custom officials, and the cooperative efforts of telecommunications companies.

While use of CBDC can potentially lead to the surveillance of citizens’ transactions by the issuing government, it also allows for effective monitoring of illicit activities. However, the account-based CBDC will not necessarily infringe on privacy, as the issuing country can design a proper payment authentication process. To this end, the issuing jurisdiction can protect users’ privacy by providing adequate architecture and access designs. This approach is unilateral in nature and can be referred to as the “privacy-by-design strategy.” Unfortunately, the receiving country cannot deal with this problem unilaterally. Bilateral efforts are required to address infringements of privacy of citizens of the receiving country.

In a bilateral context, the crowding out effect can be addressed by the foreign offline transaction prohibition strategy and the “border control and wallet monitoring strategy.” The nature of these two strategies is essentially the same. They require both issuing and receiving jurisdictions to prevent unwanted transactions in a foreign jurisdiction. To further dissuade the use of CBDC in a receiving jurisdiction, technology limiting the number and value of transactions in foreign countries can be paired with effective border controls. We argue that both the issuing and receiving jurisdictions should follow the approach of FinTech MoUs or FinTech Cooperation Agreements – arrangements between regulatory authorities to provide a framework for cooperation, information sharing, and referrals – to enhance bilateral collaboration. These strategies are also effective in addressing capital control evasion.

With the cooperation of the issuing jurisdiction, the receiving jurisdiction can better address privacy concerns. The issuing jurisdiction can provide technological solutions enabled by sensibly designed Digital ID and KYC schemes.

The need for interoperability is another urgent issue. Bilateral coordination may yield limited results as the receiving jurisdictions often lack the leverage to urge the issuing jurisdiction to address privacy concerns. Multilateral strategies should focus on the interoperability of CBDCs and on information exchange among states. Key issues include identification schemes, payment system compatibility, technical infrastructure compatibility, clearing mechanisms, and domestic regulatory standards. The global standard setters—such as the Committee on Payments and Market Infrastructures (CPMI) at the Bank for International Settlements (BIS), the G20, and the World Bank—may be the forums to produce global regulatory frameworks.

Addressing the crowding out effect calls for what we refer to as “regulation coordination strategy.” Governments can reach a consensus on their regulatory action related to the overuse of the CBDC beyond borders. The receiving jurisdiction can cooperate with local merchants and issuing jurisdictions to track the amount of foreign CBDC circulated within the receiving jurisdiction’s borders. The receiving jurisdiction can also introduce regulations which address circulation of CBDC in their own economies.

In addition, establishing a single clearing agency will help governments to acquire information on capital movement and pick up capital flows which might otherwise destabilize the local currency. However, a single clearing institution is not necessarily one step ahead. During the initial period of CBDC’s development, states may rely on multiple clearing agencies to process cross-border transactions. We refer to this as the “single clearing institution strategy.” The compatibility and transparency of these institutions will be the main issue in multilateral discussions.

Another way central banks can combat destabilization is by exchanging information on suspected currency speculators. Central banks may also seek to monitor unreported CBDC transfers in their respective countries’ capital markets. Information per se does not necessarily reveal the identity of the traders, but it reveals the magnitude and frequency of their trades. Such efforts can be referred to as the “multilateral capital control monitoring strategy.”

CBDCs’ infringement on privacy is perhaps the most important issue that needs to be tackled by multilateral policy responses. In theory, a government can set weak privacy protection standards or violate its privacy protection commitments, if it so desires. However, a CBDC that cannot guarantee user privacy is unlikely to be popular in cross-border use. To remedy this, an issuing jurisdiction should participate in a multilateral regulatory framework to demonstrate its resolve of protecting privacy.

Multilateral cooperation may begin by building a common guideline for KYC requirements. A mutually recognizable ID system is the foundation of cross-national cooperation on the illicit use of CBDCs. Under such a system, each state manages its own ID system, but the design of such a system will allow for compatibility between the states. We call this the “coordinated digital ID scheme strategy.” Cooperation in creating the ID system can be a gradual process in which states initially only achieve compatibility between their own respective systems.

The discussion in our paper covers the unilateral, bilateral, and multilateral strategies aimed at combating the spillover effects of CBDC use. Most of the spillover effects are better tackled by use of bilateral and multilateral strategies. This suggests that cooperation between the issuing jurisdictions is particularly important, and is even more salient if the issuing jurisdiction distributes an internationally popular currency.

Cheng-Yun Tsang is an Associate Professor at College of Law, National Chengchi University (NCCU) and Director of the RegTech/SupTech Innovation Lab, FinTech Research Center, NCCU.

Ping-Kuei Chen is an Associate Professor at Department of Diplomacy, NCCU, and Associate Director of the RegTech/SupTech Research Lab, FinTech Research Center, NCCU.

This post has been adapted from their paper, “Policy Responses to Cross-border Central Bank Digital Currencies – Assessing the Transborder Effects of Digital Yuan” available at SSRN.

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