Regulators and lawmakers worry that a digital currency from Facebook will compete with established national currencies. They’ve responded by seeking legislation to quash innovation with regulation banning Big Tech from finance.
Yet, there is a threat that no legislation can quell — one that is actually heightened by the blinkered reactions of an unfamiliar Congress in the United States. The prospect of a weaponized Chinese digital currency is a serious challenge to national security, and the U.S. needs to harness and embrace the power of Big Tech to meet and defeat it.
On the other side of the world, China is racing in the opposite direction, ironically also spurred by Facebook’s looming Libra coin. In the midst of an economic Cold War with the U.S., China is developing a potent strategic cyberweapon, the digital yuan, aimed at the U.S. dollar and its global economic dominance.
To respond strategically and to protect national security, the U.S. requires a coordinated response that leverages its tech companies, not disarms them.
The promise, and threat, of a digital yuan is that it can fuel and extend China’s online technology to create a global common market. Vast populations do not have access to banking. Indonesia, for example, has one of the world’s largest populations and more cellphones than people. But more than 60% don’t own a bank account.
They’re not alone. According to the World Bank, 1.7 billion adults globally use cash because they don’t have transaction accounts. However, about two-thirds of these people (1.1 billion) have a mobile phone, which can be used to make and receive payments. In emerging markets and developing economies, mobile phones are poised to become banks.
China pushes forward with mobile-first payments
The Bank for International Settlement reports that over the past decade, cross-border banking relationships have declined by about one fifth. “De-risking” is a major reason. Banks are exiting relationships due to extensive and costly compliance obligations, including Anti-Money Laundering regulations and a crackdown on tax evasion. This results in higher costs that hurt countries that rely on remittances to provide a critical source of household income and a substantial proportion of the gross domestic product. These costs, in turn, create pressure to shift payments outside the banking system to nonbank channels.
China knows how to leverage mobile phones and financial technology to challenge and leapfrog traditional banking. In China, mobile payments caught on like wildfire because there was no existing credit or debit card system. Alipay and WeChat Pay now handle more payments per month than PayPal transacted in 2017 ($451 billion). Combined, they have more than 1.7 billion active customers across China. By contrast, Apple Pay, which is installed on every iPhone, is only activated on 383 million phones.
Alipay and WeChat Pay were developed by Alibaba, the world’s largest retailer and e-commerce company with a market cap that almost touched $600 billion before the coronavirus-led rout (and it still stands at over $510 billion), and Tencent, one of the world’s largest social media companies and the first Asian company to surpass a $500 billion market value. Together, they’ve blended social media, e-commerce and payments to create an advanced online commercial infrastructure that dwarfs the capabilities of Western Big Tech.
Alibaba, for example, has created an online consumer sales engine that is more powerful than Amazon and its peers. In 2019, Alibaba’s Singles Day sales reached more than $31 billion, while U.S. Black Friday and Cyber Monday online sales totaled about $7.4 billion and $9.4 billion respectively. More importantly, during peak 2019 Singles Day spending, the Alibaba engine handled 544,000 orders per second. This far outpaces Visa’s global claimed capacity of 65,000 transaction messages per second.
Success has led these companies to migrate to financial services. Ant Financial, the parent company of Alipay, is the planet’s most highly valued fintech startup. It houses the world’s largest money-market fund, with cash from almost 600 million users of its mobile payments network. Tencent has become one of the world’s largest investment firms.
Tencent and Ant Financial are ideal partners for the rollout of the digital yuan. They can provide the mobile wallet infrastructure and connect users to e-commerce and financial services platforms. Importantly, they can partner with the People’s Bank of China to distribute the digital yuan overseas.
Building the new Silk Road
All this fits squarely with China’s “Belt and Road Initiative,” which aims to build a new Silk Road connecting Asia with Europe and Africa. According to Deutsche Bank, “BRI reaches as much as 65% of the world’s population, while covering half of world gross domestic product (GDP), 75% of all known energy reserves, and a quarter of all cross-border goods and services trade.” International distribution of the digital yuan and mobile wallets will directly connect populations across the new Silk Road and leapfrog incumbent financial infrastructures. It will give the unbanked and many others the means to pay for online purchases and build savings.
Further supporting BRI, global trade finance can be reshaped by combining the digital yuan with advanced trade platform technology to create a global liquidity pool. With backing from Chinese President Xi Jinping, China’s central bank has been moving in this direction. Given that the top four banks in the world are Chinese, it has the asset strength to move forward with immediate credibility.
As the market for tokenized assets emerges, a PBoC-backed digital yuan will have considerable utility (for instantaneous transaction settlement) and influence, particularly in the absence of competition from other state actors. By 2027, 10% of GDP is expected to migrate to digital assets.
These scenarios illustrate how China can leverage a fiat-backed digital currency to capture a once-in-a-generation strategic opportunity to create a multipolar international monetary system and degrade U.S. economic influence.
Is the United States ready for the new paradigm?
It is not clear, however, that the U.S. is well-positioned to address this macro-economic threat. The U.S. central bank, the Federal Reserve, doesn’t see a need for digital currency, and it faces several other ingrained American challenges, including a protectionist industry resistant to innovation and change.
Fed Reserve Chairman Jerome Powell sees little current demand for a central bank digital currency. In a November 2019 letter to U.S. Rep. French Hill, Powell suggested that “many of the challenges that general purpose CBDC could potentially address do not apply to the U.S. context including disuse of physical cash, narrow reaching or highly concentrated banking sectors, and poorly developed payment infrastructure, more generally. The U.S. payments landscape is highly innovative and competitive, with many fast, reliable digital options available for consumers. It is not yet clear what additional value a general purpose CBDC could provide in the U.S.”
He’s dismissed the digital yuan from a privacy perspective, echoing Libra concerns from U.S. lawmakers, commenting that “having a ledger where you know everybody’s payments” would not be attractive in the U.S. However, Powell does acknowledge that Libra is a “wakeup call” that digital currency “is coming fast.”
Powell asserts that the U.S. does not face the challenge of a poorly developed payment infrastructure. But observers highlight that U.S. banking suffers from the same under-inclusion and lack of real-time payments that are recognized use cases for digital currency. According to the Brookings Institute, “America’s outdated payment system exacerbates income inequality at a scale far larger than commonly understood.”
In the U.S., 6.5% of 129 million households are unbanked, alongside a further 24.2 million households that are underbanked. Free or low-cost checking accounts are no longer widely available and fees have increased, particularly overdraft and insufficient fund fees. A lack of real-time payments disadvantages consumers who are lower-income, younger, have less formal education, are of a racial or ethnic minority, disabled, or have incomes that vary substantially from month to month.
(Note: the next section of this article discusses the historical context of the resistance to financial innovation in the U.S. For Jonathan’s closing comments, click the button.)
The historical context of resistance to financial innovation
While the U.S. maintains the largest payment market in the world, it’s years behind Europe in implementing an open, real-time payment system. Critics note that U.S. consumers might have saved over $100 billion if the U.S. had adopted real-time payments in 2007, when the United Kingdom did so.
The vast majority of U.S. payments moves across an automated clearinghouse system, the ACH, which is owned by a consortium of large U.S. banks and operates on design principles put in place years ago when the objective was to migrate away from paper checks. The ACH is a batch operating system that does not offer real-time funds authorization or payments, and only banks can directly connect it. This effectively prevents competition and maintains higher costs for consumers and businesses.
In 2012, an ACH initiative to speed up the system was torpedoed by several large banks. At the time, analysts commented that the major challenges to developing U.S. real-time payments are “the dearth of innovation demonstrated by the financial services industry and its lack of courage to experiment with new payment models that could threaten current revenue streams.” Real-time payments are available via the FedWire system, operated by the U.S. Federal Reserve, but are prohibitively expensive for many consumers, costing between $25 and $40 per transaction.
The ACH is now moving forward with a Same-Day system, but it does not provide instant payments or same-day funds in all cases. Smaller banks are not signing onto the system, as it is operated by their major competitors and they are looking to the Federal Reserve to develop an around-the-clock, real-time payments system. Named FedNow, that system is not expected to launch until 2023 or 2024. Big banks view it as unnecessary competition, while small banks look for it to be fairer, particularly in pricing, than existing private options. Banks have also actively lobbied Congress to prevent the Fed from providing FedNow access to fintech organizations, citing the protections that traditional banks offer customers and the payment system investments they have made.
FedNow will operate in parallel to Zelle, a peer-to-peer payment service created in 2017 and owned by seven large banks. Zelle typically provides instant payments between U.S. bank accounts by leveraging debit Bank Identification Numbers over ACH network rails, although transaction limits are low. Actual settlement is not “real time,” but members agree to make funds immediately available. About 100 financial institutions are on the Zelle network.
Venmo, a PayPal subsidiary, is Zelle’s major peer-to-peer rival. Venmo is an overlay service that emulates real-time payments within a closed-loop system, but funds need to be deposited and withdrawn via linked bank accounts and eligible credit cards, which adds latency to the process.
In other countries, central banks have proactively pressed for faster payments systems and promoted competition by reducing bank dominance and control. By contrast, the Federal Reserve does not have plenary regulatory or supervisory authority over the U.S. payment system.
The European model
In Europe, initiatives to reduce payment times between customer accounts have been underway since 2008, when the U.K.’s Faster Payment Service was launched. The path to the Faster Payment Service began with a review of banking competition commissioned by the U.K. Treasury. It developed into a mandate to drive innovation and offer greater choice, better quality and lower prices for consumers, as well as the creation of a powerful Payments System Regulator. The U.K. initiative was reinforced across Europe by the (first) Payment Services Directive, which provided a regulatory framework for a single EU payments market, or SEPA, and required transactions to be credited to the payee by the next business day.
European governments continue to drive competition, innovation and transparency through Open Banking legislation. The second Payment Services Directive (i.e., PSD2), implemented in 2018 alongside the launch of SEPA Instant Payments (i.e., SCTInst), requires banks to provide third-party connectivity to access customer account data and to initiate payments so that new products and services can be created. In particular, PSD2 allows fintechs, large technology companies and retailers to qualify as Payment Service Providers and go head-to-head with banks. Providers able to initiate payment services from a customer bank account might include Amazon, Google Pay, PayPal and Uber. In 2018, Transferwise was the first nonbank PSP to join a U.K. payment system settling in central bank money.
Excluding fintechs from the financial system
Unlike Europe, the U.S. is grappling with the issue of allowing nonbanks access to the banking system. In 2019, Facebook’s Libra proposal spawned draft legislation titled “Keep Big Tech Out of Finance,” which would bar large technology companies from establishing platforms to operate a digital currency. This response has antecedents in U.S. legislation separating banking from “commerce.”
Originally, the purpose was to stop banks from engaging in non-banking businesses and losing their depositors’ money. But this policy was inverted with the 1956 Bank Holding Company Act, which was enacted to prevent a commercial company, Transamerica, from becoming a national banking conglomerate. Exceptions remained available for some commercial companies until Walmart tried to enter banking, which resulted in protests from community banks and labor groups, moratoriums on grants of banking charters, and explicit blocking legislation. In late 2019, a U.S. judge ruled that a national regulator, the Office of the Comptroller of the Currency, doesn’t have the authority to issue special bank charters that allow fintechs to access the financial system.
A false choice between innovation and security
The history of preventing access by nonbanks contextualizes opposition to Libra on the grounds that Facebook should go through the process of becoming a bank. Opponents urge that if Facebook doesn’t do so, there won’t be sufficient protection of privacy and security, or control of money laundering. But this is a false choice. Critics view Libra as part of a wider trend to blur a line they intend to hold between finance and commerce.
From a broader, macroeconomic perspective, the prospect of Libra and digital currency has alarmed central bankers. States worry that they may lose control over the economy. The U.S. House of Representatives Committee on Financial Services asserts that Libra will lead ”to an entirely new global financial system that is based out of Switzerland and intended to rival U.S. monetary policy and the dollar.” The U.S. has not, however, joined a group of central banks — including the Bank of England, the Bank of Japan and the European Central Bank — that are working with the Bank for International Settlements to assess the potential for a CBDC.
Losing sight of China
While the House Committee on Financial Services points out that Libra raises serious national security concerns, it makes no mention of the challenge from China. This blindspot is curious, because one of the fundamental purposes of the digital yuan is to erode the power of the dollar. Concerned that Libra will reinforce the dominance of the dollar, China is fast-tracking the launch of the digital yuan and will likely outrun the potential threat from Libra by harnessing the payment and social media rails provided by Alipay and WeChat.
The digital yuan, being state controlled, poses a different class of threats to the U.S. than a corporate-sponsored digital currency. The digital yuan could be weaponized as a tactical or strategic weapon. As it expands across the new Silk Road, China would be able to implement total surveillance over the economic activity of more than half the world’s population, tracking everyone’s spending habits and relationships. By holding authorization keys, China could freeze transactions it doesn’t like or seize digital assets by locking customers’ mobile wallets at will. Precursor systems are already rolling out in China, where a “social credit” system punishes or rewards individual behavior. It has already blocked millions from buying airline tickets.
As an asymmetric weapon of cyberwar, the digital yuan could not only shield U.S. adversaries from financial sanctions and enforcing surveillance, but it could also be used as a sword to destabilize hostile governments. Central banks have voiced general concerns that a digital currency can reduce banking deposits, degrading banks’ ability to make loans and finance development. But if social media were used to undermine confidence in a government and the stability of its currency, the flight of money away from domestic banks and in favor of the digital yuan could trigger a national liquidity crisis.
To meet the national security challenge, the U.S. needs to switch gears away from the unwitting unilateral disarmament of banning Big Tech from finance. Support from U.S. technology companies is vital if the U.S. is to safeguard the dollar and prevent China from constructing a dominant global digital marketplace. Without it, the U.S. cannot leverage the power of its technology, skills and agility to preserve its national security.
Consumer demand is the vulnerability in the global attack surface that a weaponized digital currency will exploit. Recognition is, in turn, the core requirement for an effective defense.
According to Chris Giancarlo, former chair of the U.S. Commodity Futures Trading Commission, “The digital 21st century is underserved by an analog reserve currency.” A 2017 survey of 33,000 financial services consumers across 18 markets reveals that more than 50% of Gen Y responders in Thailand, Indonesia and the U.S. would consider banking with a Big Tech company.
The U.S. needs to block and tackle China as it moves forward with the digital yuan. Failing to allow tech companies to leverage their innovative capacity, technology skills and agility risks the emergence of a global currency that will eclipse the dollar and blunt U.S. power.
