What is it and how does it work?

GUANGZHOU, China – China is likely to lead the world in developing a national digital currency, a project it has been working on since 2014.

The People’s Bank of China (PBOC) was the head of the work on the digital yuan, a so-called central bank digital currency (CBDC) that aims to replace part of the cash in circulation.

Real world trials 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 – the Digital Currency Electronic Payment (DCEP).

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

It is a legal tender in China and no interest will be paid on it.

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

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

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

In a separate article, Fan outlined how a CBDC can make payments more efficient and improve the transfer of monetary policy. Fan also argues that a digital yuan can help with financial stability through a system of ‘controllable anonymity’. This is where payments would be anonymous to some extent, but data analysis tools can help the central bank engage in illegal activities.

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

“The existing system is privately owned. Should Alipay or WeChat go bankrupt, which is highly unlikely, it would create systemic risks,” 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 is perhaps to create a new platform for payment platforms that will increase efficiency.”

There are two aspects to the question: distribution and ultimately how it will be spent.

Distribution will take place via a so-called two-level system. This means that the PBOC will distribute the digital yuan to commercial banks. The commercial banks will be responsible for getting the currency into the hands of consumers. This could include services that allow consumers to exchange their coins and cash for digital yuan.

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

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

WEF’s Xiao says commercial banks are likely to be able to integrate similar features into their applications. And that Alipay and WeChat Pay may have a portion of their digital yuan programs. Meanwhile, smartphone makers can also create digital yuan wallets for their devices.

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

The PBOC’s Fan also said that commercial banks already have the infrastructure to distribute the digital yuan, and it is better that they do so rather than the central bank.

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

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

“As I see it, digital yuan is not a direct competitor of Alipay or WeChat Pay, but a new platform that enables other players to compete with WeChat and Alipay,” said Bao of Trivium China. “It could be commercial banks or other payment companies.”

The PBOC’s Fan also said the proposed two-tier model could help “prevent disintermediation in the financial sector” because the central bank would not compete with the commercial banks.

No. Bitcoin is a so-called decentralized cryptocurrency. This means that it is not controlled by any central government such as a central bank, unlike the digital yuan issued by the PBOC.

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

Proponents of bitcoin also point to the anonymity of the digital currency.

The PBOC’s Fan said the digital yuan would have ‘controllable anonymity’. It involves those who operate digital yuan wallets to disclose transactions to the PBOC as the “only third party.” Users would have a “loose link of accounts”, which means that their current bank account is not necessarily closely linked to their digital yuan account.

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

The PBOC says agencies providing digital yuan services must submit transactions to the central bank in a timely manner. This will enable the PBOC to “keep the necessary data” to curb money laundering and criminal offenses.

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

China has fueled the internationalization of the yuan and some commentators have seen the digital yuan as a way to do so.

But currently the digital currency has a local focus and international use is ‘not the immediate priority’, according to Bao of Trivium China.

But the PBOC has begun to lay the groundwork for the use of digital currencies in cross-border transactions. Last month, the PBOC joined central banks from Thailand, the United Arab Emirates and Hong Kong to jointly investigate a digital currency border payment project.