When Will the U.S. Have Its Own ‘Central Bank Digital Currency’ (CBDC)?

Crypto backers and some fintechs favor an American central bank digital currency but the Fed's first detailed take on the controversial concept illustrates how adopting a CBDC could fundamentally alter banking.

A long-awaited paper by the Federal Reserve Board on the feasibility of an American central bank digital currency is — to borrow from Winston Churchill — “not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

The Fed’s paper, “Money and Payments: The U.S. Dollar in the Age of Digital Transformation,” takes no explicit stand on whether the country should have a national digital currency. But it does make clear that going ahead with an actual U.S. CBDC is a decision for Congress and the executive branch, and not the Fed by itself. “The paper is not intended to advance any specific policy outcome, nor is it intended to signal that the Federal Reserve will make any imminent decisions about the appropriateness of issuing a U.S. CBDC,” it states.

But in the course of laying out the different directions a federal CBDC could go, the Fed illustrates how some variations could significantly affect the future of the traditional banking business. How banks and credit unions fund loans, for example, could change substantially, as could the relative roles of the Fed and the private banking industry including fintechs.

CBDCs and Unintended Consequences:

The importance of deposit insurance in times of financial stress could lessen if people could move their funds to a U.S. CBDC perceived as safer than money in a bank.

Much of what the Fed discusses revolves around what “money” is. For example, while we call it all “dollars,” currency issued by the Fed now is technically more secure than dollars that are digital blips in a bank’s records.

A dollar-denominated CBDC is simple in concept but potentially revolutionary in application and evolution. The Fed paper discusses variations on the theme, like a CBDC dollar that would pay interest in some fashion. Another variation would be a CBDC that could be programmed to deliver payment at a specified time, which would apply an aspect of so-called “smart contracts” executed through the blockchain that function independently of human control once launched. The report also suggests that a CBDC could be used to execute micropayments.

The Fed CBDC paper set out policy alternatives and posed a long series of questions for public comment, due by May 20, 2022. However, other than a bulleted summary of its digital currency efforts to date, the central bank did not detail any of that work in progress. Among those projects are a collaboration between the Boston Federal Reserve Bank and Massachusetts Institute of Technology to develop a CBDC based on the blockchain and other leading-edge tech, and pending creation of a hypothetical CBDC by the Fed’s own Technology Lab.

Basics of a U.S. CBDC, According to the Fed

For many in the payments and crypto fields the U.S. is far behind other nations in developing a CBDC concept. The largest nation to take concrete steps with this is China, which is running a pilot with its Chinese CBDC, called e-CNY.

The Fed has made it clear it “gets” the U.S. appearance on the international monetary stage. It speaks of the dominant role the dollar plays and adds that other nations’ CBDCs could become more attractive internationally compared to current forms of the dollar.

“A U.S. CBDC might help preserve the international role of the dollar.”

— Federal Reserve Report on Central Bank Digital Currency

For purposes of the Fed paper, a U.S. CBDC is discussed as a digital liability of the Fed, much like U.S. currency — Federal Reserve notes — represents a central bank liability.

“A CBDC would be the safest digital asset available to the general public, with no associated credit or liquidity risk,” the paper states.

The Fed sets out four points that would be important for a U.S. CBDC, at least as seen at this point:

Privacy-protected: There would need to be a balance between user privacy and the need to have transparency in order to deter criminal activity.

Intermediated distribution: The Fed makes it clear that it doesn’t want to be in the business of consumer and business banking accounts. “The private sector would offer accounts or digital wallets to facilitate the management of CBDC holdings and payments,” the paper says. The private sector parties would include “commercial banks and regulated nonbank financial service providers.”

The paper states further that: “An intermediated model would facilitate the use of the private sector’s existing privacy and identity-management frameworks; leverage the private sector’s ability to innovate; and reduce the prospects for destabilizing disruptions to the well-functioning U.S. financial system.”

Transferable: A CBDC would need to be able to move seamlessly from one institution’s customer to another, even though the CBDC dollars were actually liabilities of the Fed, rather than dollars on the books of either organization.

Identity-verified: With today’s currency there is an extensive system for tracking funds to prevent money-laundering and terrorist financing. The Fed notes that any CBDC would need to be designed so that users of CBDC could be identified similarly.

“A U.S. CBDC would offer the general public broad access to digital money that is free from credit risk and liquidity risk,” according to the Fed paper. “As such, it could provide a safe foundation for private-sector innovations to meet current and future demands for payment services. All options for private digital money, including stablecoins and other cryptocurrencies, require mechanisms to reduce liquidity risk and credit risk. But all these mechanisms are imperfect.”

The Fed also suggests that a U.S. CBDC could change the nature of payments business competition, creating a common digital currency that would be safe. In a side-note, the paper raises the issue of what happens during natural disasters and other major interruptions, when the internet is not available — offline means of tapping CBDC balances might be necessary.

Read More: Will 2022 Be the Year Crypto, Stablecoins and ‘CBDCs’ Take Off?

How Could Banking Change If the U.S. Adopted a CBDC?

While a CBDC might seem like a swap of a digital form of money for paper money, the implications go much further depending on how a U.S. CBDC eventually were to take shape.

“A widely available CBDC would serve as a close — or, in the case of an interest-bearing CBDC, near-perfect — substitute for commercial bank money,” states the paper. “This substitution effect could reduce the aggregate amount of deposits in the banking system, which could in turn increase bank funding expenses, and reduce credit availability or raise credit costs for households and businesses.” The paper points out that if some form of interest-bearing CBDC were introduced, this could also affect demand for such assets as money market mutual fund shares and Treasury bills.

The Bank Policy Institute has been putting forth this argument and makes some key points in an analysis about CBDCs. An excerpt:

“[I]f a CBDC is to remain a CBDC to the business or consumer that owns it, it could not be ‘deposited’ in a bank, because then it would become a liability of the bank. It could be transferred into a customer’s digital CBDC wallet managed by the bank and held in custody — like an equity security or money placed in a safety deposit box — but for it to remain a CBDC, the liability for repayment must continue to rest solely and completely with the central bank. And that means it cannot at the same time also be a liability of bank, used to fund loans and other bank assets. It cannot fund both Fed assets and bank assets.”

The Fed paper points out that CBDCs would be seen as the safest form of money and could be seen as a refuge in time of financial stress.

“The ability to quickly convert other forms of money — including deposits at commercial banks — into CBDC could make runs on financial firms more likely or more severe.”

— Federal Reserve Report on Central Bank Digital Currency

In a financial panic deposit insurance and other traditional safeguards could seem less attractive compared to moving assets into apparently safe CBDC form. (Alternatively, according to the paper, if CBDCs didn’t exist, the public might lean towards stablecoins.)

One measure that the Fed suggests would be limiting the amount of CBDC an individual could hold or could build up over a short period. That said, that seems counterintuitive if any U.S. CBDC is intended to fulfill broader purposes like faster payments.

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