The Technology Behind the Digital Yuan – 3 Core Foundations

The Digital Yuan, also known as the e-CNY or digital RMB, is China’s bold leap into the world of central bank digital currencies (CBDCs). Unlike traditional cryptocurrencies like Bitcoin, the Digital Yuan is issued and backed by the People’s Bank of China, giving it a level of stability and legitimacy that other digital currencies can only dream of.

But the Digital Yuan isn’t just a fancy new form of money – it’s a technological marvel that’s pushing the boundaries of what’s possible in the world of finance. From its cutting-edge cryptography to its innovative two-tier distribution system, the Digital Yuan is a testament to China’s growing dominance in the digital space.

#1 The Cryptographic Foundation: Ensuring the Security and Integrity of the Digital Yuan

The Digital Yuan uses specialized security methods to keep transactions safe and reliable. Two key techniques are the SM3 hash function and the SM2 digital signature algorithm.

• SM3 Hash Function: This is like a complex mathematical formula that takes any digital information and turns it into a unique set of numbers and letters, called a hash. Think of it as a fingerprint for data. This hash helps make sure the information hasn’t been tampered with from the time it was created.
• SM2 Digital Signature Algorithm: This works a bit like a digital ID card. When a transaction is made with the Digital Yuan, this algorithm creates a signature that proves the transaction came from a legitimate source. It’s a way to ensure that the person spending the Digital Yuan is who they say they are and not a fraudster.

Here’s a step-by-step explanation of how the Digital Yuan’s cryptographic foundation works:

Step 1: Transaction Initiation

• A user initiates a transaction using their Digital Yuan wallet.
• The transaction details (e.g., amount, recipient) are collected.

Step 2: Data Hashing

• The transaction details are passed through the SM3 Hash Function.
• The SM3 Hash Function generates a unique digital fingerprint (hash) for the transaction data.

Step 3: Digital Signature Generation

• The transaction data and hash are passed through the SM2 Digital Signature Algorithm.
• The SM2 algorithm generates a digital signature using the user’s private key.

Step 4: Signature Verification

• The digital signature is verified using the user’s public key.
• The verification process ensures that the signature matches the hash and the transaction data.

Step 5: Transaction Validation

• The validated transaction is broadcast to the Digital Yuan network.
• The network verifies the transaction using the SM3 hash and SM2 digital signature.

Step 6: Transaction Confirmation

• Once verified, the transaction is confirmed and added to the Digital Yuan ledger.
• The recipient receives the Digital Yuan funds.

Step 7: Ledger Update

• The Digital Yuan ledger is updated to reflect the new transaction.

These techniques help prevent problems like counterfeiting or spending the same digital money twice (double-spending). By using these advanced security measures, the Digital Yuan aims to be as secure and trustworthy as traditional money while being easier and faster to use in digital form.

#2 The Digital Yuan’s Distributed Ledger Technology:

The Digital Yuan uses a special type of technology called Distributed Ledger Technology (DLT), but with a twist. It combines the traditional blockchain system — where transactions are recorded across many computers — with a central system controlled by a central authority.

• Why Mix the Two? This hybrid approach helps make transactions faster because the central authority can quickly verify transactions. It also scales up well, meaning it can handle lots of transactions without slowing down, which is a common problem in traditional blockchains.
• Keeping an Eye on Things: Having a central authority also means better control and oversight. This is useful for sticking to laws and spotting any suspicious activities quickly.

How the Digital Yuan’s Distributed Ledger Technology (DLT) works:

Step 1: Transaction Collection

• Multiple transactions are collected from users’ Digital Yuan wallets.
• These transactions are grouped into a batch.

Step 2: Ledger Node Selection

• A subset of nodes (computers) on the Digital Yuan network is selected to form a “ledger node” group.
• These nodes are responsible for verifying and validating transactions.

Step 3: Transaction Verification

• The ledger nodes verify each transaction in the batch using the SM3 hash and SM2 digital signature.
• Nodes check for valid digital signatures, correct hashes, and ensure transactions are properly formatted.

Step 4: Consensus Mechanism

• The verified transactions are broadcast to the entire Digital Yuan network.
• A consensus mechanism (e.g., Byzantine Fault Tolerance) is used to achieve agreement among nodes on the validity of transactions.

Step 5: Block Creation

• A group of verified transactions is combined into a block.
• Each block is given a unique identifier (block number).

Step 6: Block Hashing

• The block’s transactions are hashed using the SM3 Hash Function.
• The resulting hash is stored in the block header.

Step 7: Ledger Update

• Each ledger node updates its copy of the Digital Yuan ledger with the new block.
• The ledger now reflects the latest transactions.

Step 8: Ledger Synchronization

• Ledger nodes synchronize their ledgers to ensure consistency across the network.
• Any discrepancies are resolved through consensus.

Step 9: Transaction Confirmation

• Once the ledger is updated, transactions are considered confirmed.
• Users can now see the updated balance in their Digital Yuan wallets.

Step 10: Ledger Maintenance

• The Digital Yuan network continuously monitors and maintains the ledger.
• Nodes ensure the integrity and accuracy of the ledger.

Thanks to Mr Mark from yuanprofit.com for providing inights on Digital Yuan’s (DLT) system, as it was bit technical for me to cover that by myself alone. Well this unique setup of the Digital Yuan aims to bring together the best of both worlds — the security and transparency of blockchain and the efficiency of centralized systems.

#3 The Two-Tier Architecture: Balancing Centralization and Distribution

The Digital Yuan operates on a two-tier architecture, an innovative structure designed to balance control with widespread usability. Here’s how it works:

1. Issuance: The process begins with the People’s Bank of China, the central bank, which creates and issues the Digital Yuan. This initial step ensures that the currency’s creation remains under strict regulatory oversight, preserving economic stability and security.
2. Distribution: Once issued, the Digital Yuan is handed over to various commercial banks. These banks serve as the secondary tier in this architecture, responsible for distributing the currency to the general public. By involving commercial banks, the system leverages existing financial infrastructure, which facilitates broader accessibility and faster integration into the market.
3. Control and Accessibility: This two-tier system allows the central bank to maintain solid control over the total money supply, crucial for preventing inflation and other financial instabilities. At the same time, it enables the efficient distribution of the currency to millions of users through a network of commercial banks that already have established customer relationships.

Tier 1: Central Bank (People’s Bank of China)

1. Issuance: The People’s Bank of China (PBOC) issues Digital Yuan to commercial banks.
2. Management: PBOC manages the money supply, sets monetary policies, and monitors overall circulation.
3. Regulation: PBOC ensures compliance with regulations, anti-money laundering, and know-your-customer requirements.

Tier 2: Commercial Banks

1. Receipt: Commercial banks receive Digital Yuan from PBOC.
2. Distribution: Commercial banks distribute Digital Yuan to their customers (individuals and businesses) through various channels (e.g., mobile apps, online banking).
3. Exchange: Commercial banks exchange Digital Yuan for physical currency or other digital currencies, if needed.
4. Customer Service: Commercial banks provide customer support, handle transactions, and manage user accounts.

Working Process:

1. User Requests: A user requests Digital Yuan from their commercial bank.
2. Commercial Bank Verification: The commercial bank verifies the user’s identity and account details.
3. Digital Yuan Transfer: The commercial bank transfers Digital Yuan from its reserve to the user’s account.
4. User Transaction: The user makes a transaction using Digital Yuan (e.g., payment, transfer).
5. Clearing and Settlement: The commercial bank clears and settles transactions with other banks and PBOC.
6. PBOC Monitoring: PBOC monitors overall circulation, money supply, and ensures regulatory compliance.

This two-tier architecture allows the central bank to:

• Maintain control over the money supply and monetary policy
• Ensure regulatory compliance and oversight
• Delegate distribution and customer service to commercial banks

While enabling:

• Widespread distribution and accessibility through commercial banks’ existing infrastructure
• Efficient and convenient transactions for users

This structure balances centralization (PBOC control) with distribution (commercial banks’ involvement), ensuring a secure, efficient, and accessible digital currency ecosystem.