Background: This year prior to starting the war on inflation, the Fed published a paper asking for comments on a Fed coin or a CDBC (Central Bank Digital Currency) to be issued by the Federal Reserve Bank in the US. This is a big deal and to quote the paper will be a “highly significant innovation” since it is the first step taken by Fed in showing it’s seriousness about issuing a CDBC. As mentioned in a prior post, ‘FRB Bitcoin’ a CDBC is a digital form of paper money issued by the central bank i.e. Federal Reserve directly and not by a commercial bank . As a liability of the Federal Reserve, a Fed CBDC would not require mechanisms like deposit insurance to maintain public confidence and nor would a Fed CBDC depend on backing by an underlying asset pool to maintain its value like stablecoin.
Why is the Fed exploring CDBC? In some sense the Fed issuing a CDBC is not breaking new ground since the Fed has precedent in establishing payment systems to facilitate payments between the banks it regulates. In the 1970’s, the Fed developed the automated clearinghouse (ACH) system that then offered an electronic alternative to paper checks. ACH can only be used the banks that are subject to federal regulation and as a result majority of inter-bank payments in United States use ACH to move money from an account at one bank to account at another bank. ACH is not instant as all of us who have move money between banks painfully know and this criticism is jarring in the age of instant payments and is one of the reasons the Fed is launching the ‘FedNow’ service in 2023. As their website states, FedNow will be a new instant payment service that aims to provide safe and efficient instant payment services in real time, around the clock, every day of the year. The Fed coin takes an even bolder step and will be a digital currency issued by the Fed and available to households.
Why now? Besides the fact that ACH is not instant; 2 reasons making the Fed act faster on development of CDBC are popularity of stablecoins and exploration of CDBC by other countries.
Stablecoins and the Digital Yuan: The growth of stablecoins and their attractiveness to users as well as their risks as shown by the collapse of Terra Luna most recently will make the Fed act faster on CDBC. If left unrestricted, the growth of bitcoin and stablecoins (broadly nonbank payment services) can cause an irreversible shift of money from commercial banks to non-banks (as has happened in China) and since these nonbank payment systems lack the protections that come with commercial bank money this could cause introduce instabilities to the financial system.
Secondly, given that most of the other central banks are contemplating CDBC if any of them become more popular than the US Dollar then it would threaten the dominance of USD as reserve transaction of the world and the international currency of choice across world. Recent BIS (Bank of International Settlements) survey shows that nine out of 10 central banks in advanced countries are in some phase of assessment of CDBC as shown below.
The greatest threat of CDBC replacing the USD as the reserve currency could come from China. China’s CDBC is most advanced with a retail pilot already in progress since Aug 2019 when their central bank unveiled the pilot (summarized in a previous post ) and stated that had been working on it for last 5 years.
What are features and attributes of Fed CDBC: Coming back to the Fed paper, the 2 key features that need to be pointed out is that the Fed CDBC is meant to complement and not replace current form of money i.e. physical currency, USD and that it will both protect consumer privacy while not offering anonymity to deter criminal activity. To achieve the above objectives, the Fed wants their CDBC to “privacy-protected, intermediated, widely transferable, and identity-verified” and the implications of these 4 attributes are further elaborated below.
- Intermediated – this is the most imp piece. The Federal Reserve Act of 1913 does not allow the Fed to maintain individual accounts and so the Fed CDBC will need to be issued by commercial banks and non-bank services (with appropriate supervision from Fed).
- Identify Verified – Unlike bitcoin, the Fed wants commercial banks to verify identify of each CDBC holder. This will mean the commercial banks and non-bank firms who participate in a Fed CDBC will need to adopt their KYC program to a Fed CDBC.
- Privacy Protected – While aiming to verify the identify of the CDBC holder at the same time, the Fed CDBC will protect the privacy of individual and so this could take form of data masking.
- Transferable: For a CBDC to serve as a widely accessible means of payment, the Fed wants it to be readily transferable between customers of different intermediaries effectively eliminating need for inter-bank and wire transfer and cross border remittances.
What are the Goals of the Fed CDBC: The stated goals of the Fed CDBC as noted in the Fed paper are summarized below with implication;
- maintain centrality of safe and trusted central bank money in a digitized world – Fed wants the Fed CDBC to be the reserve currency of the world as use of cryptocurrencies increases.
- offer general public access to money that is free from credit risk and liquidity risk – as a liability of the Fed, there will be no credit and liquidity risk
- could be programmed to deliver benefit payments to individuals directly – this will be very powerful and as an example stimulus payments could be directly sent to individuals without being intermediated through banks.
- could be used to collect taxes – similar to above this will have a powerful impact in increasing tax collection and making it more efficient
- optimize cross border payments – currently average cost of remittance is 5.41 of notional value as noted in the Fed paper and this would be eliminated with a Fed CDBC
- support dollar dominant international role of USD – the Fed CDBC aims to act against movements of other central banks most specifically China who are trying to promote their CDBC to be adopted across the globe.
- promote use of digital payments that is safe – the stability and absence of credit and liquidity risk of the Fed coin will offer a stark contrast to risks of stablecoins and the extreme volatility of bitcoin.
What are the potential drawbacks of Fed CDBC? As paper notes “A CBDC could fundamentally change the structure of the U.S. financial system, altering the roles and responsibilities of the private sector and the central bank”.
Two effects of a CDBC would be that it could prove to a be a better alternative to consumers than some current alternatives like bank deposits and short term investments choices given that it will have no credit or liquidity risk. In particular,
- an interest-bearing CBDC would serve as a substitute for commercial bank money and would reduce the amount of deposits held at commercial banks which would increase funding costs for banks and reduce credit availability or raise credit costs. This poses one of the biggest threat to the funding source of commercial banks and would be a risk that Fed is keen to avoid.
- an interest bearing CDBC would also serve as an attractive alternative to low risk assets such as money market mutual funds, Treasury bills and raise credit costs for businesses and governments.
The above two concerns could be addressed by making the Fed CDBC to be non-interest bearing.
Another consequence of a Fed CDBC would be that it would become the default for risk-averse users during times of stress in the financial system and could make runs on financial firms more likely or more severe. The paper proposes to address this by limiting the total amount of CBDC an end user could hold, or it could limit the amount of CBDC an end user could accumulate over short periods.
There are also monetary policy implications since the Fed will need to increase size of it’s balance sheet to accommodate issuance of CDBC similar to balance sheet impacts of issuing physical currency and a build up of reserves would put upward pressure on Fed funds rate.
Lastly, the CDBC infrastructure would need to be resilient to operational disruptions and cybersecurity risks which would become even more critical.
Conclusion: The Fed CDBC paper is the first step being taken in a bold journey and will have significant conclusions on the financial landscape and money and payments across the globe and so will be watched very closely.