CIPS vs. CHIPS: China’s alternative to the U.S.-dominated financial system | Live with Lizzi Lee

In this episode of Live with Lizzi Lee:

Emily Jin, research assistant for the Energy, Economics, and Security Program at the Center for a New American Security (CNAS), talks about how CIPS, China’s version of the U.S.-dominated CHIPS payment system, may provide a new alternative to shift the global financial order.

Below is a transcript of the video:

Lizzi Lee: Joining me today is Emily Jin, a research assistant for the Energy Economics and Security Program at CNAS. Emily’s research focuses on alternative payment systems and their national security impact.

Emily Jin: Thank you so much for having me here.

Lizzi: So, Emily, help us understand the basics of payment systems. What’s the key difference between CHIPS and SWIFT and its Chinese counterpart, in addition to pure scale?

Emily: So, you’re right. Besides the scale issue where CHIPS is less than 1% of SWIFT in terms of transaction volume, it’s helpful to look at the contexts where the two are created and their functional differences.

SWIFT had the first mover advantage, so it was a collective that was created in 1977 by the United States, the EU, and some G7 countries to really secure the messaging between global financial institutions. So, it facilitates the movement of funds by providing the messaging infrastructure, but it doesn’t move the funds itself.

And in contrast, CIPS [Cross-border Interbank Payment System] was, as an idea, conceived in 2012, established in 2015, and was created to really increase the efficiency and lower the costs of RMB transactions. So, it helps move funds. It clears and settles the RMB and most of the time uses SWIFT-enabled messaging to clear and settle RMB cross-border.

CIPS’s closest U.S. analog really is CHIPS, which stands for Clearing House Interbank Payments System. It’s the largest private sector USD clearing system in the world. And CHIPS clears and settles the USD. And really the only similarity between SWIFT and CIPS, I would say, is the networking capability.

SWIFT connects global financial institutions to each other with its messaging capability. CIPS connects mostly domestic Chinese payment systems with one another. But that’s where the similarity stops.

And I think maybe I could go a little bit deeper into the differences between CIPS and SWIFT by talking through a scenario if that’s helpful. It is important to establish the baseline of how cross-border transactions work. So cross-border payments are usually conducted with the correspondent banking model. Correspondent banks are third-party banks that act as the middleman, if you will, between different financial institutions.

If a specific transaction must go through multiple corresponding banks at each step of the way, they must be communicated or messages have to be communicated through SWIFT normally before a transaction reaches or the messaging reaches the final destination accounts. Cross-border payments are very tricky because payments often include currency conversions, different tax regimes, and processing fees.

So how does CIPS fit into this cross-border payment picture? CIPS specifically works in this equation by facilitating payment orders between correspondent accounts of different financial institutions.

Financial institutions can either be direct participants of CIPS or indirect, which just means direct participants can directly send or receive financial messages and clear and settle RMB through CIPS. Indirect will just have to go through direct participants to do so. And I hope this is helpful in clarifying the key differences between CIPS and SWIFT.

Lizzi: Absolutely. And going back to the adoption of CIPS, I wonder if you can tell us a little bit more about the relationship between RMB internationalization or the, you know, the opening of China’s capital account and the adoption of that.

Emily: Right. So bottom line up front, CIPS in the short to medium term will not be helping with RMB internationalization. You alluded to in your question, the kind of conditions that need to be present for the RMB to be an attractive currency, it doesn’t lie in CIPS, but rather in the political-economic model that China offers.

The RMB really needs to become a reliable medium of exchange and store value. As it currently stands, it’s just not considered a safe asset, at least compared to so many other currencies like the U.S. dollar.

Since China’s state-controlled political-economic model does not lend its way to investor confidence and we don’t really need to look that far for comparison.

The United States has the historical and institutional advantages of having the most tradable and convertible currency in the world, helped by the United States’ deep capital markets and open political economic system.

And also, a related and important point is that the PRC can’t really afford to bear the burden of maintaining a major global currency just because the PRC can’t really afford to have an appreciating RMB as its economy is still highly export reliant.

It also can’t have, as you mentioned before, an unrestricted capital account inside mainland China and increasingly in the offshore RMB market in Hong Kong, given the concerns over capital flight and the consequent instability, should that happen.

But while CIPS may not help with making the Chinese currency more appealing, it could help make Chinese alternative rails in international finance more appealing. My thinking and my research indicate that the Chinese government ultimately is trying to make a play for influence in the international financial system via CIPS.

So, this likely means any accomplishments on CIPS, which can mean more individuals, firms, and banks adopting CIPS, would likely make the Chinese alternative rails more attractive. But the attractiveness of these rails does not automatically make the currency itself more appealing. And I hope that makes sense.

Lizzi: Fascinating. If you recall, during the Beijing Olympics, China’s digital currency pilot program received a lot of media attention. I wonder if you can give us an update on that front. What’s the latest development in terms of the development of a digital Chinese yuan, or e-CNY? How do Chinese policymakers envision the future of its digital currency?

Emily: Yeah, you’re right. There’s a lot of media attention because there’s just a dizzying array of pilot programs being implemented across China is an impressive level of penetration of the e-CNY or the related digital and data efforts. It’s across all provinces, municipalities, and financial institutions in central China.

I can give a couple of examples, but rest assured, it’s a long list — I’ll spare you from the entire list. In terms of provinces, for example, the Fujian provincial government released this document called Key Points of Digital Fujian Work in 2022. So, it includes a lot of objectives to promote the e-CNY pilots in many different cities.

And in terms of municipalities, I think the Chongqing municipal government issued its 14th Five-Year Plan for the development of strategic emerging industries in Chongqing.

Inside this document which spans from 2021 to 2025, it explicitly earmarked support for e-CNY R&D and pilot exploration.

And in terms of financial institutions, many banks, including Bank of Beijing, Bank of China, and Dalian Bank, I believe they announced the winning bids for projects that are developing the e-CNY into business scenarios and some anti-fraud facial recognition projects.

So, in terms of financial scale the three banks that I mentioned, and these winning bids are around 500,000 RMB, so it’s a little bit under 70K U.S. dollars per project. But if you add it all up on the aggregate, it’s certainly very impressive because it’s happening across municipalities and all kinds of financial institutions and banks inside of China. And this is just the domestic picture too. I’m getting excited talking about it because there’s just a lot going on. The Chinese central bank, the PBOC, is also making moves internationally.

First, it’s making moves through exerting influence and standards-setting bodies. I believe in February of this year, Chinese experts and representatives spearheaded the international standard for third-party payments. So, this is part of the ISO, which is the International Organization for Standardization.

It’s a cooperative of, I believe, a little bit under 170 national standards bodies with the Secretariat in Geneva. You can see that the PBOC is at the forefront in standard-setting and in other international moves, the PBOC is also building the foundation for potential cross-border applications of the e-CNY.

And one great example would be the PBOC collaborating with the Bank for International Settlements, which is a collective of global central banks, on this proof of concept of CBDC-to-CBDC transactions across the globe.

So it’s important to caveat it, though. As far as I’m aware, this multiple CBDC transaction project, it’s not facilitating any more transactions just yet, and e-CNY currently remains mostly domestic and retail use cases. But this might be an application or capability that will get developed later and which would fit into China’s overall push to build alternative financial rails and institutional RMB transactions.

And I am just going on and on, but I think Chinese policymakers, with all of this going on, they’re really envisioning a future for e-CNY, where it is domestically saturated through all levels of governance and that it’s adopted by all aspects of Chinese society willingly. It also envisions a future for e-CNY where it is internationally accepted in cross-border transactions. And perhaps more importantly, China has a leadership role in shaping the future of the global CBDC and larger digital assets ecosystem.

And in fact, I’ve been workshopping this concept called Digital Legibility, which I think could be a counterweight model to the digital privacy model that’s right now accepted by most economies. And legibility is this political science concept that measures the extent to which one can make sense of complex realities. Using simplifying metrics and digital legibility in this case would be describing a state’s ability to use data-rich technology to analyze activity and behavior of its populace.

And I think bring it back to your question. I think the end game for Chinese leadership is that it might want to transform the People’s Republic of China to the People’s Republic of Digital Legibility.

It sounds a bit cheesy, but I truly believe Chinese policymakers are thinking in this data-rich framework. And Chinese policymakers probably believe that digital legibility or some framework around that is a prerequisite to the state leveraging its populace as a resource to accrue national power. And Chinese policymakers want the buy-in from its domestic audience, but also international buy-in.

Lizzi: If anything, the current ongoing sanctions against Russia can underscore the urgency for Chinese authorities to develop alternatives to the U.S.-dominated financial system. But what are the hurdles confronted by Beijing as you can see them?

Emily: Yeah, you’re right. Beijing is motivated to develop alternatives to the current mainstream financial plumbing and rails. And Chinese policymakers are certainly taking notes, I would imagine, on how the United States and allied economies are leveraging their economic and financial influence to kneecap the Russian economy.

Chinese policymakers could only assume some kind of economic and financial measures will be imposed against itself or its own economy should there be a scenario on Taiwan, for example, or some other geopolitical conflict initiated by China or where China plays a major role.

The main hurdle I can think of right now is the reputational cost of Chinese financial institutions or any Chinese actors explicitly helping bad actors evade sanctions through either CIPS or the e-CNY. So just imagine if a group of Chinese financial institutions or firms are found explicitly to have used CIPS to help bad actors seek relief from sanctions. I think the potential punishment in the likely form of financial sanctions from the U.S. and other economies, it’s just way too costly now.

And another potential hurdle I think lies in the technical reliance on mainstream financial systems. So CIPS may have some messaging capability and I’m sure it’s certainly refining its functionality, but most of its cross-border payments or transactions are still facilitated through SWIFT.

And it’s likely to stay that way in the foreseeable future. If it’s reliant on SWIFT to do the bulk of its cross-border work, I think CIPS will not be able to serve as a full alternative to SWIFT. So, some major hurdles in a way.

Lizzi: What’s your recommendation for U.S. policymakers? Should the United States seek to maintain its dominance, or should the United States embrace a multipolar future and decide accordingly?

Emily: I think a U.S. state-dominated financial institutions are here to stay. I don’t think a multi-polar financial future is in the books for the foreseeable future. But the U.S. dollar is going to continue to be the world’s reserve currency.

The associated financial infrastructure will continue to be the main structure through which banks around the world move and store value. If there are currencies that are catching up, it is more likely to be the Euro rather than RMB. But even that is very fraught for debate.

I do, however, believe that there is innovation from other countries such as China refining its financial alternative and rails through CIPS and the e-CNY. This could make alternative systems more attractive as more potential escape valves under financial sanctions from the United States or other countries. Although, regardless of this production rate, I think the United States should maintain its leadership in global financial institutions. It still has work to do and the course of action the U.S. government needs to take sooner rather than later to counter China’s influence in building its global alternative financial rails.

I can think of the like in a couple of different categories. There are some analytical actions.

There are also defensive and also proactive actions.

So, in the analytical category, I recommend some kind of concentrated U.S. government effort in monitoring the U.S, the growth, and also the connectivity of all of these alternative payment rails outside of the United States. A signpost to watch out for would be whether more banks are starting to adopt or join the CIPS network, or whether Chinese and Russian alternative systems and rails are collaborating in any meaningful sense.

So, this is important. The United States knows whether there’s a critical mass of escape valves forming outside of the mainstream financial system. In terms of what it looks concretely, this could mean the United States Treasury Department maybe should mandate an annual report on the use of the dollar in the context of global payments systems, which should also track the development of alternative payment systems. And that’s just like an analytical policy that I recommend.

But in terms of the defensive policy, the United States government should consider economic measures that could restrict the advancement of alternative payment rails. For example, if certain actors are trying to evade sanctions by facilitating transactions through CIPS, and if there’s clear evidence of that, the Treasury Department should consider levying secondary sanctions on entities that helped or facilitated these transactions.

But before devising a sanctions program for this scenario, the Department of Treasury will really need to study and anticipate to the extent that it can, the impact of such secondary sanctions before using this tool, given the potential unintended consequences from these measures.

And finally, in the more proactive kind of policy bucket, I recommend efforts from both the public sector, but also the private sector in improving U.S. cross-border payment pipelines to make sure that dollar transactions still stay efficient or become more efficient.

And the United States, more importantly, needs to be proactively engaging in standards, setting bodies for digital assets and financial rails. The United States doesn’t need to create its own digital dollar just to counter China’s efforts in influence or standards-setting bodies, but it should be at the table for these discussions.