Recently, China piloted a new state-owned cryptocurrency, the digital yuan.  In this article, I will show how this fits into China’s larger economic strategy, and why it is a harbinger of problems for the West and the mainstream payment networks.

On November 24, 2020, the New York Times published an article, “China Says It Remains Open to the World, but Wants to Dictate Terms,” that highlighted why China is viewed as such a threat to the United States and other major world powers.  Building on its manufacturing might, China and its authoritarian leader, Xi Jinping, is increasing seeking to influence the world economy to its own advantage.

Following the Trump Administration’s decision to withdraw from the Trans Pacific Partnership (TPP) in President Trump’s first full week in office, China in mid-November did what many trade experts had feared, stepping into the gap with its own free trade agreement, the Regional Comprehensive Economic Partnership, or RCEP. While not nearly as ambitious as the TPP, which is still being pursued by the other 11 countries, the RCEP does provide an alternative to U.S. manufacturing for countries looking to avoid the tariffs on Chinese goods imposed by the U.S.

At the end of December 2020, China reached an agreement with the European Union that would roll back restrictions on investment, a sign that it is moving ahead with its own economic strategy without waiting for the U.S., and possibly as a way to lock in gains before the new administration starts on January 20, 2021.  The agreement awaits ratification in the European Parliament, so it is not final.

The “Digital Yuan” as a Bid for Independence from the West

In addition to these trade agreements, China has moved to assert itself in the payments space through efforts to have the Renminbi (RMB) more widely adopted as a global reserve currency following International Monetary Fund (IMF) approval in 2015 and the piloting of a digital yuan through lotteries and promotions.  The digital yuan (a unit of RMB) is one of the first state-sponsored cryptocurrencies, and a harbinger of what is to come from other countries.

The payments strategy supports the larger goal of making China less beholden to other countries.  In an opinion article in the South China Morning Post, “How China’s digital currency with thwart US dollar trap and help the world,” Andrew Leung argues that “the dollar is being increasingly [weaponized] to impose economic sanctions on China.”  In response, the digital yuan “does not depend on the US-controlled Society for Worldwide Interbank Financial Telecommunication (Swift) banking system. It is thus immune to dollar-based US sanctions.”

Reliance on Payment Systems for Sanctions Enforcement is Driving the Search for Alternatives

This last point is something I have been concerned about ever since various U.S.-based financial intermediaries, including Visa, Mastercard, PayPal and Western Union decided not to process payments for Wikileaks in 2010 following the release of classified diplomatic cables. In a 2017 blog post, I worried that by relying on potential violations of their terms of service, rather than a legal order, the companies were highlighting the enormous discretionary power they had to punish disfavored organizations.

SWIFT, which was called out specifically by Lueng, played a major role in enforcing sanctions against Iran, effectively blocking its access to international markets in March 2012.  Leung is wrong that SWIFT is “US-controlled;” in fact, according to its website, the cooperative is run out of Belgium on behalf of central banks in 10 western countries as well as the European Central Bank.  In fact, the exclusion of Iran came because of a regulation by the European Union.  However, his general point is valid: western powers are increasingly using their control of global payment systems to pressure other nations.

This desire for independence is not only a concern for authoritarian countries; the European Union has itself several times tried to create an EU-owned card network to counter Visa and Mastercard.  Russia has also established its own credit card network, MIR.  These efforts have been slow to gain traction due to the powerful network effects I described on my blog, but cryptocurrency provides a way to build an alternative payments system without the need for it to be widely accepted at launch.

Cryptocurrency Can Be Used to Undermine Western-controlled Payment Networks

Back in 2017, I wrote a piece called “The Unbundling and Rebundling of Payments,” in which I asserted that a credit card was actually a bundle of related services, including a credit line and a funds transfer mechanism, and that you could deliver these elements separately if you wanted.  With cryptocurrency established as a viable funds transfer mechanism, all that would be needed to turn it into a credit card substitute is a line of credit.  Furthermore, since cryptocurrency transactions are irreversible, it would be even more secure than traditional credit cards (for sellers, at least).

I would not be surprised to see China extend the digital yuan to include debit and credit cards; China already has its own national card network, China Unionpay, and it could switch the rails underneath it without disrupting its functionality.  Visa and Mastercard are already experimenting with digital currency as an extension to their existing settlement mechanisms.  A third service that could be bundled is the exchange function; such a “crypto credit card” could operate in fiat currency, only converting to cryptocurrency for the actual settlement function. In China, it wouldn’t even have to do that, since the digital yuan can settle natively.

If other central banks go the same way, it could not only cut Bitcoin off at the knees, but also undermine the viability of the global card networks.  By being heavy-handed in using payments as an instrument of government power, the U.S. could end up losing a lot of its power.  This risk has to be considered when deciding how to impose sanctions.  Cutting off payments is easy, but incents people to find alternatives, thereby weakening the tactic over time.

As I discussed in my article on stablecoins, companies like BitPay have already pioneered cryptocurrency-based prepaid cards, so it is not that much of a stretch to get to a credit card.  Acceptance remains an issue, especially given the control that Visa and Mastercard have, but in an economic zone like the RCEP, I think it would be much easier to accomplish, especially if it were coupled with lower costs.  In this way, China could outflank Visa and Mastercard, and effectively shut them out of the whole country.

What do you think?  Is this something that the payments industry should be concerned about?  How might it go differently?  Sound off in the comments, and I will revisit this topic again.