How a U.S. Central Bank Digital Currency Could Impact Payments

The release of the first technical design for an American CBDC makes abundantly clear that a digital currency would be a revolutionary change for the U.S. economy, its citizens and the banking industry. Many questions remain, yet the pressure to move forward is growing.
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Just how fast is the United States moving toward a central bank digital currency and in what form? Is it something banking executives need to worry about? A detailed new paper confirms that the technology is moving forward, even whiled debate continues over policy questions.

Patrick Toomey, ranking Republican member of the Senate Banking Committee, is worried about the U.S. getting lapped by China. He wrote to Treasury Secretary Janet Yellen and Secretary of State Antony Blinken, asking to have their staffs observe and investigate the rollout for international users of China’s central bank digital currency during the Winter Olympics.

“The importance of remaining a leader in the global digital economy and supporting new innovations like digital currencies is a significant domain of strategic competition with other countries, including China,” the Pennsylvania Senator wrote. He asked the two officials for reports on many areas, including user experience and distribution, to what extent China’s government could capture user and transaction data, and what lessons the U.S. government could learn from China’s pilot.

A paper from the Bank for International Settlements, in which the Federal Reserve participated, observed that innovations in digital payments haven’t been waiting for governments.

“Technological innovation has been transforming the markets for retail payments at pace over recent years, with many new payments methods, platforms and interfaces evolving to become faster, cheaper and safer. These new non-financial market players have shown a strong understanding of what users need from their payments products and what conditions are necessary to facilitate adoption. Central banks would need to take into account this evolving context if they choose to launch a CBDC.” [Emphasis added.]

Toomey’s letter was bookended by two major developments, on the U.S. CBDC front.

In late January the Federal Reserve issued a white paper on policy issue basics it needs to consider. Following that, the Federal Reserve Bank of Boston and the Massachusetts Institute of Technology Digital Currency Initiative released a much-awaited joint paper on the first phase of its “Project Hamilton,” a technological blueprint for an American central bank digital currency.]

(Project Hamilton’s name has two sources: Margaret Hamilton, an MIT director who developed flight software for NASA’s Apollo program, and Alexander Hamilton, the first Treasury Secretary, who appears on the $10 bill.)

Joint Effort Produces a U.S. CBDC Prototype

The Boston Fed/MIT paper — quite detailed and technical — is more of an overture than a concert. Taken with the Fed’s initial policy paper, the paper demonstrates the numerous challenges to creating a digital dollar issued by the government.

The researchers actually produced a hypothetical model, with two major variations, to demonstrate how a dollar CBDC could work. They made it clear this isn’t anywhere near ready for implementation. It’s a working guide to issues to be solved. It was also clear that policy, regulatory and legal issues weren’t being addressed, only technology and mechanics.

“Our primary goal was to design a core transaction processor that meets the robust speed, throughput, and fault tolerance requirements of a large retail payment system,” they stated.

Creating a U.S. CBDC will be technologically challenging. A few details from the paper illustrate this. The researchers said that to support U.S. retail transactions alone, a CBDC processor would have to be able to handle “tens of thousands of transactions per second in real-time and scale to account for the potential growth in payment volumes.”

Don't Blink While You're Paying with CBDC:

The Fed/MIT research team set a goal that 99% of transactions be completed within five seconds. That's faster than most people can count out change.

As discussions about a U.S. CBDC have progressed, Fed Chairman Jerome Powell has stressed that the digital fiat dollar will co-exist with paper currency and digital payment services already in use. How that will work was beyond the tech paper’s scope, except for its recognition that there would be times that offline exchange of U.S. CBDCs would have to be accommodated.

Related to this are two key questions of more than academic interest: how people hold their digital dollars and where the record of that transaction winds up when completed.

“Cash can be held directly by the public and used to conduct transactions without the need for a financial institution to process the payment on their behalf,” the paper states.

Think of all the ways people use cash and you can see that this can almost become an emotional consideration. David Birch, in his book The Currency Cold War, wrote that “if there is to be a digital fiat, then it will have a cultural context. As The Economist has noted, people might well be ‘uncomfortable with accounts that give governments detailed information about transactions, particularly if they hasten the declilne of good old anonymous cash’.”

“Anonymity is a feature of physical cash that payment cards and instant credit transfers do not have, and some observers see it as a freedom that is being taken away.”

— David Birch, The Currency Cold War

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A Taste of the Tech that Would Make U.S. CBDC Fly

One of the surprises in the paper was the conclusion that blockchain technology, so much a part of other digital currency types such as cryptocurrencies and stablecoins, may not have to be the foundation for a U.S. CBDC.

“We found that using a blockchain-based system in its entirety was not a good match for our requirements,” the paper states. This hinged partly on the team’s conception of a CBDC as something that would be administered by the Fed as central bank, as opposed to blockchain’s ability to function with decentralized authority. Variations on the theme could in time incorporate blockchain approaches.

The sheer detail of making a currency work when the dollars going through it are real money, not payment instructions, is stunning, as portrayed in the paper. A few details illustrate this:

  • Minting: One of the Fed’s key roles in managing the nation’s money supply. “In practice, CBDC will need to be minted or removed from circulation depending on the flow of money into and out of the system.”
  • Avoiding double spending. When money changes hands, there’s a point where mine becomes yours, or vice-versa. A viable CBDC has to digitally destroy the dollars in my account and create them in yours. A similar concern would be avoiding “replays” — a recipient attempting to grab a balance twice.
  • A CBDC has to work all the time. Systems have to be able to deal with and counteract attempted hacks and denial of service attacks. The thought of the nation’s money being held captive by ransomware begins to sound like a James Bond plot.
  • Recordkeeping and how far it goes. Project Hamilton’s prototype did not include the retention of data about the ownership and use the dollars it would handle. Just how much data in a real system would be retained and who could access it, are all matters for policy discussions. The paper noted that privacy will be a major issue to be weighed.

These factors all involve basic functionality of a CBDC. Proponents of a U.S. digital currency envision more than just digital dollars, but “smarter money” that could carry programming with it.

Lurking behind all the technology of CBDC remains the key question of the role for the traditional banking system. Generally CBDCs are conceived as backed 100% by reserves, which doesn’t permit the volume of lending activity permitted by the fractional reserves policy of traditional banking. A point made in Richard Turrin’s Cashless: China’s Digital Currency Revolution is that CBDC designers and policy makers have to avoid creating a currency that winds up disintermediating banks.

On the other hand, the CBDC paper from the Bank for International Settlements makes the point that ideally a CBDC could be integrated into private financial firms’ payment services, allowing innovations in payments to continue as a “money” evolves.

Read More: How Banks Will Mint Their Own Stablecoins

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