Back in January, the U.S. Board of Governors of the Federal Reserve (the “Federal Reserve”) released its long-awaited discussion paper, “Money and Payments: The U.S. Dollar in the Age of Digital Transformation” (the “Report”), beginning a public dialogue about central bank digital currencies (“CBDCs”) and weighing the merits of a U.S. CBDC.
For the purposes of the Report, a CBDC is defined as a “digital liability of a central bank that is widely available to the general public” and further, a “digital form of paper money.” In this respect, a CBDC is like a stablecoin because a CBDC also seeks to maintain a stable value and become an alternate payment mechanism that can be used to facilitate trading and lending, lessen the friction surrounding cross-border payments, and help foster more financial inclusion. However, unlike a stablecoin backed by reference assets like a national currency, commodities, or another digital asset, a U.S. CBDC (i.e., a digital dollar) would be backed by the full faith and credit of the United States in the same way as a physical dollar and, as described in the Report, would be digital money that is “free from credit risk and liquidity risk.” Thus, as discussed in our recent post on stablecoins, a CBDC enjoys many of the same benefits as stablecoins and, as described in the Report, “could spur innovation by banks and other actors and would be a safer deposit substitute than many other products, including stablecoins and other types of nonbank money.” Still, the Report suggests that CBDCs may bring their own risks to the safety and stability of the monetary system, particularly during times of financial stress, and otherwise affect the Fed’s ability to implement monetary policy. Plus, there is the added complexity of harnessing and updating the government’s infrastructure to launch such a digital dollar. On the whole, the Report cautions that a CBDC “could fundamentally change the structure of the U.S. financial system.”
Despite neither committing to nor ruling out development of a CBDC, the Report shows that the Federal Reserve has been thinking critically about how a CBDC would impact the financial system and alter the respective roles and responsibilities of the private sector and the central bank. In seeking further study of the potential upsides and downsides of this new digital asset, the Federal Reserve was quick to couch development of a CBDC in terms of its mandate: to promote the effective operation of the U.S. economy by fostering monetary stability, financial stability, and a safe and efficient payment system.
In the Report, the Federal Reserve offered insight into important factors that would influence its decision: The Fed will only move forward with a CBDC if the benefits of a CBDC outweigh its risks, the concept has “broad public support,” and it has “clear support from the executive branch and from Congress, ideally in the form of a specific authorizing law.” Thus, given that a U.S. CBDC would be a significant financial innovation, one envisions in the coming years further study, consultation with international financial regulators, and heavy lifting in terms of legislative and regulatory processes before a consensus is reached on when and how to launch a CBDC. Of course, the Federal Reserve’s deliberation on the issue would not be occurring in a bubble, as a number of private stablecoins have already been developed and are gaining popularity. Moreover, in the intervening time, there might be other types of digital assets that have yet to be unveiled (not to mention rollouts of CBDCs in other nations) that may change the Federal Reserve’s risk/benefit calculus and timeline.
The Federal Reserve additionally signaled that a U.S. CBDC would best serve the interests of the United States by being “privacy-protected, intermediated, widely transferable and identity-verified”:
- Privacy-protected: The Report notes that a CBDC must strike a balance between consumer privacy rights and enough transparency to deter criminal activity.
- Intermediated: Practically speaking, the Federal Reserve Act does not authorize direct Federal Reserve accounts for individuals, so a CBDC must be intermediated (barring new legislation in Congress); that is, the Federal Reserve must rely upon the private sector to offer accounts or digital wallets to facilitate the management of CBDC holdings and payments. While commercial banks and nonbanks would offer services to consumers to manage their CBDC funds and payments, the CBDC itself would remain a liability of the Federal Reserve.
- Widely-transferable: As per the Report, for a CBDC to serve as a widely accessible means of payment (as opposed to a narrower-purpose CBDC designed primarily for large institutional payments only), it would need to be readily transferable between customers of different intermediaries.
- Identity-verified: As noted in our previous posts, blockchains are immutable and transparent, meaning anyone can track the movement of money between wallets throughout history. Still, CBDCs, despite being a new digital innovation, would still have to be designed to comply with existing AML/KYC rules.
Beyond the basic contours of what a CBDC would look like, the Report represents a continuation of the discussion surrounding stablecoins and CBDCs. Shortly before the Report’s release, Jerome Powell, Chairman of the Federal Reserve, restated his position on the co-existence of CBDCs and private stablecoins, assuring members of Congress that a CBDC can coexist with private stablecoins. Though, as the Report states, a U.S. CBDC could mitigate some financial systemic risks from the “proliferation of private digital money,” while still supporting private sector innovation. The answers to these concerns are still being considered, as the Report concludes with a host of open queries about CBDC policy and design considerations.
In the meantime, regulators and legislators will continue to study the issue. On February 8, 2022, the members of the House Financial Services Committee held a hearing to consider legislative recommendations from the President’s Working Group (PWG) report on stablecoins. The PWG’s three-pronged framework examines the risk of stablecoin runs, payment system risks, and the risks due to concentration of power. This framework seeks to encourage “responsible financial innovation that can create efficiencies and increase growth; but it is also equally important to protect investors and consumers and to mitigate risk to financial stability and payment system integrity.” While agreeing that some form of stablecoin regulation is needed, members of Congress may have differing views on certain issues as compared to the Administration. Some legislators have even begun thinking about a version of a digital dollar. For example, a bill introduced in Congress on March 28, 2022, the Electronic Currency and Secure Hardware (ECASH) Act, would require the Treasury Department to launch pilot programs to develop an electronic version of the dollar for the public that would be distinct from any CBDC backed by the Federal Reserve.
Regulators appreciate that they need to prepare for the future of payments in the dynamic and evolving digitization of finance. Congress is actively learning about the technology, and debating the most effective approach to developing a regulatory regime or filling existing regulatory gaps. Of note, the President also recently signed an executive order that articulates a high-level, wide-ranging national strategy for regulating and fostering innovation in the burgeoning digital assets space, including directing the Federal Reserve and others to continue its study in the area of CBDCs, where the President sees “merit” in U.S. leadership. While the Fed’s Report on CBDCs took a more middle ground on the topic, the tone of the executive order suggested the Administration thought it either a worthy venture or inevitable (or both), thereby encouraging agencies to step up their efforts to prepare for the future of finance in conjunction with other international partners. The executive order directed multiple agencies to study and report back on multiple issues surrounding digital assets, including CBDCs, so we will see the fruits of that work in the coming year. It’s clear that Washington recognizes that the financial system is not standing still, so both legislators and financial regulators will be heavily engaged in studying and deciding the best course forward with respect to a possible digital dollar and other innovations.