In January of this year, the Board of Governors of the Federal Reserve System issued a research and analysis paper titled Money and Payments: The US Dollar in the Age of Digital Transformation, in which the Fed explores potential benefits and risks of a US central bank digital currency (CBDC). The Fed defines a CBDC for purposes of the paper as a “digital liability of a central bank that is widely available to the general public” and is analogous to a digital form of paper money. In line with this definition, a potential US CBDC is often referred to as the digital dollar. The Fed is clear in its paper that it was not intended to advance a particular policy outcome or indicate that the Fed is preparing to issue a US digital dollar. Rather, the Fed states that it does not intend to move forward with a US digital dollar absent “clear support from the executive branch and Congress.” As discussed below, the Biden Administration has recently indicated support for a US CBDC under his executive order covering digital assets.
- Focus on an intermediated model – In its paper, the Fed recognizes that the US has a well-functioning and stable financial system that relies on banks as intermediaries between the Fed and the public. The Fed supports a CBDC model that continues to lean on banks and other financial services companies as intermediaries. Under this model, the private sector would offer accounts, digital wallets, and other tools to facilitate holding and using digital dollars. In such role, these intermediaries would continue to perform important functions, such as acting as an access point and distribution channel, innovating in products and payments solutions, KYC, AML, and helping the Fed to manage cash reserves.
- A digital dollar that is widely transferable – The Fed paper emphasizes the importance of wide transferability of a US digital dollar on a 24x7 real time basis.
- A digital dollar that is privacy protected – The Fed paper identifies protecting consumer privacy as critical to a well-functioning CBDC, but acknowledges the necessity of balancing privacy with identity verification that affords “the transparency necessary to deter criminal activity.”
- A system that supports identify verification – The Fed paper acknowledges the need for a CBDC to support compliance with strict anti-money laundering and terrorist finance laws. As a practical matter, this would mean a CBDC needs to be designed in a way that allows banks and other intermediaries to verify the identity of persons accessing and using CBDCs, similar to how they verify the identity of their customers today.
The Fed paper also identifies certain potential benefits and risks to adoption of a US CBDC. The potential benefits identified by the Fed include:
- Digital money with virtually no credit or liquidity risk – CBDCs, as direct obligations of the Fed, would offer the general public broad access to digital money that is free from credit or liquidity risk. The Fed believes this could also drive innovation in payments and other money-based services, particularly by enabling smaller players that otherwise may not have sufficient assets, resources and reserves to build their own payments and value transfer solutions.
- Improving cross-border payments – The Fed sees a new digital fiat currency as creating possibilities to streamline cross-border payments by “introducing simplified distribution channels, and creating additional opportunities for cross-jurisdictional collaboration and interoperability.” However, this would require significant international coordination, which comes with its own challenges.
- Maintaining the US dollar as the dominant international currency – The Fed paper keeps in mind a potential future state where many countries may move to CBDCs for their own fiat currencies, and if the US does not keep pace with its own digital currency, then there is potential for global use of the US dollar to decrease.
- Promoting financial inclusion – A US digital dollar could reduce barriers to financial inclusion and reduce transaction costs that could be beneficial to lower-income persons, although the Fed paper acknowledges that further study is required to understand the impact of a CBDC on financial inclusion.
- Increased public access to safe central bank money – The Fed paper considers that a US digital dollar could be a viable means to expand public access to safe, central-bank issued cash and related payment options, particularly as consumers are moving quickly towards preferring digital payment options over paper cash.
- Potential disruption to a well-functioning financial system – A key component of this concern is potential disruption to the intermediated model. A CBDC could effectively become a substitute for bank deposits if individuals and businesses prefer holding directly US digital dollars (which have no practical credit or liquidity risk) rather than relying on bank deposits and “bank money”. Given that banks rely on customer deposits to fund loans that produce income for the banks, such a trend could increase bank funding expenses and consequently result in reduced credit availability and increased cost of credit to borrowers.
- Potential for increased risk of runs on banks – Because the digital dollar would be a direct liability of the Fed and so have no credit or liquidity risk (unlike bank deposits which are promises by banks to hold and make customers’ funds available), if bank deposits can easily be exchanged into digital dollars in times of financial stress, customers could make runs on banks to convert their deposits in to direct CBDC holdings.
- Risks related to operational resiliency and cybersecurity – The Fed paper recognizes the importance of building a CBDC system that operates in a safe, sound and resilient manner. It would be critical for system operators to remain vigilant as to operational disruptions and cybersecurity risks. A CBDC network with potentially more entry points than the current payment services systems (where banks largely act as gatekeepers) could amplify these risks.
Following the Fed’s paper on CBDC’s, the Biden administration indicated its support for a US CBDC with President Biden’s Executive Order on Ensuring Responsible Development of Digital Assets. The Executive Order establishes guiding principles for US regulation of digital assets, including a potential US CBDC, with an emphasis on the need for a unified regulatory approach. In line with this policy objective, the EO called for involvement from a broad array of US regulators, including the Fed, the Consumer Financial Protection Bureau, the Federal Trade Commission, the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency in researching and implementing US policy and regulation of digital assets.
While the EO addresses digital assets broadly, regarding CBDCs the EO states that the Biden administration places “the highest urgency on research and development efforts into the potential design and deployment options of a United States CBDC” and acknowledges benefits in “showcasing United States leadership and participation in international fora related to CBDCs.” The EO identifies some of the same priorities for a CBDC system that the Fed paper identifies, including privacy protections, appropriate transparency, and transferability. Among other directives, the EO encourages the Fed to (i) continue researching and reporting on the extent to which CBDCs could improve efficiency and costs of payment systems, (ii) assess the optimal form for a US CBDC, and (iii) develop a strategic plan regarding necessary steps and requirements for potential implementation of a US CBDC. The EO also directs the US Attorney General to report on whether legislation would be necessary to issue a US CBDC and make a legislative proposal. Eversheds Sutherland published a more detailed overview of this Executive Order earlier this year, which can be viewed here.