Should the Federal Reserve Establish Its Own Digital Currency?

Should the Federal Reserve Establish Its Own Digital Currency?

The Federal Reserve recently took its first step toward establishing a central bank digital currency (CBDC). Its paper, entitled Money and Payments: The U.S. Dollar in the Age of Digital Transformation (Fed Paper), explores the risks and benefits of CBDCs and solicits feedback from stakeholders.

What Is a Central Bank Digital Currency?

The Federal Reserve defines a CBDC as a digital liability of a central bank that is widely available to the general public. In many ways, CBDCs are a digital form of paper money.

As the Federal Reserve notes, rapid technological advances have resulted in a host of new private-sector financial products and services, including digital wallets and mobile payment apps, as well as new digital assets such as cryptocurrencies and stablecoins. These technological advances have also led central banks around the globe to explore the potential benefits and risks of issuing a CBDC.

While there are already numerous forms of digital money, a CBDC would differ because it would be a liability of the Federal Reserve, not of a commercial bank. As the Fed Paper explains, central bank money carries neither credit nor liquidity risk, and is therefore considered the safest form of money.

“Today, Federal Reserve notes (i.e., physical currency) are the only type of central bank money available to the general public. Like existing forms of commercial bank money and nonbank money, a CBDC would enable the general public to make digital payments,” the Fed Paper states. “As a liability of the Federal Reserve, however, a CBDC would not require mechanisms like deposit insurance to maintain public confidence, nor would a CBDC depend on backing by an underlying asset pool to maintain its value. A CBDC would be the safest digital asset available to the general public, with no associated credit or liquidity risk.”

Risks and Benefits of CBDC

The Fed Paper discusses how a CBDC might fit into the U.S. monetary policy, as well as how it may help address existing challenges to the country’s existing payment system. While improvements to the U.S. payment system have focused on making payments faster, cheaper, more convenient, and more accessible, the Federal Reserve notes that many still lack access to digital banking and payment services, and some payments—especially cross-border payments—remain slow and costly.

The Fed Paper goes on to discuss whether a potential CBDC would address these needs. In doing so, the Federal Reserve highlights several risks and benefits of establishing a CBDC.

With regard to potential benefits, the Fed Paper states that a CBDC could potentially serve as a new foundation for the payment system and a bridge between different payment services, both legacy and new. It could also maintain the centrality of safe and trusted central bank money in a rapidly digitizing economy. Other specific benefits include:

• Meeting Future Needs and Demands for Payment Services: A U.S. CBDC could offer the general public broad access to digital money that is free from credit risk and liquidity risk. As such, it could provide a safe foundation for private-sector innovations to meet current and future needs and demands for payment services.
• Improvements to Cross-Border Payments: A U.S.-issued CBDC has the potential to streamline cross-border payments by using new technologies, introducing simplified distribution channels, and creating additional opportunities for cross- jurisdictional collaboration and interoperability.
• Support the Dollar’s International Role: Another potential benefit of a U.S.-issued CBDC could be to preserve the dominant international role of the U.S. dollar. As the Federal Reserve highlights, this benefits the United States by, among other things, lowering transaction and borrowing costs for U.S. households, businesses, and government.
• Financial Inclusion: A U.S.-issued CBDC could reduce common barriers to financial inclusion and could lower transaction costs, which could be particularly helpful for lower-income households. As the Federal Reserve notes, private-sector electronic transactions accounts facilitate access to digital payments; enable rapid and cost-effective payment of taxes; enable rapid and cost-effective delivery of wages, tax refunds, and other federal payments; provide a secure way for people to save; and promote access to credit.
• Extend Public Access to Safe Central Bank Money: While cash remains an important and popular means of payment in the United States, it is quickly being replaced by digital payments in countries like Sweden and China. According to the Fed Paper, if these trends were to emerge in the United States, consumers might want the option of digitized central bank money that, like cash, would have no credit or liquidity risk attached to it.

The Federal Reserve also emphasizes that a potential CBDC is not without risks and raises complex policy issues and risks. The Fed Paper specifically discusses the following:

• Changes to Financial-Sector Market Structure: 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. For instance, 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. 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, according to the Federal Reserve. 
• Safety and Stability of the Financial System: The Federal Reserve notes that 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. Traditional measures such as prudential supervision, government deposit insurance, and access to central bank liquidity may be insufficient to stave off large outflows of commercial bank deposits into CBDC in the event of financial panic.
• Efficacy of Monetary Policy Implementation: Under the current “ample reserves” monetary policy regime, the Federal Reserve exercises control over the level of the federal funds rate and other short-term interest rates primarily through the setting of the Federal Reserve’s administered rates. As set forth in the Fed Paper, in this framework, the introduction of CBDC could affect monetary policy implementation and interest rate control by altering the supply of reserves in the banking system. In the case of a non-interest-bearing CBDC, the level and volatility of the public’s demand for CBDC might be comparable to other factors that currently affect the quantity of reserves in the banking system, such as changes in physical currency or overnight repurchase agreements. In this case, a decline in CBDC that resulted in a corresponding increase in reserves would only make reserves more ample and would have little effect on the federal funds rate.
• Privacy and Data Protection and the Prevention of Financial Crimes: The Federal Reserve emphasizes that any CBDC would need to strike an appropriate balance between safeguarding consumer privacy rights and affording the transparency necessary to deter criminal activity. The Fed Paper specifically notes that a general-purpose CBDC would generate data about users’ financial transactions in the same ways that commercial bank and nonbank money generates such data today. In the intermediated CBDC model that the Fed would consider, intermediaries would address privacy concerns by leveraging their existing tools.
• Operational Resilience and Cybersecurity: Threats to existing payment services—including operational disruptions and cybersecurity risks— would apply to a U.S. CBDC as well. Accordingly, any dedicated infrastructure for a CBDC would need to be resilient to such threats, and the operators of the CBDC infrastructure would need to remain vigilant as bad actors employ ever more sophisticated methods and tactics. The Fed Paper also notes that because many digital payments today can’t be executed during natural disasters or other large disruptions, and affected areas must rely on in-person cash transactions, central banks are currently researching whether offline CBDC payment options would be feasible.

What’s Next?

As the Federal Reserve expressly states, the Fed 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. Rather, the Federal Reserve is “committed to soliciting and reviewing a wide range of views as it continues to study whether a U.S. CBDC would be appropriate,” the Fed Paper states.

The Federal Reserve’s request for public comment is the first step in a “broad consultation” that will also include targeted outreach and public forums. The Fed Paper also expressly states that the Federal Reserve does not intend to proceed with issuance of a CBDC without clear support from the executive branch and from Congress, ideally in the form of a specific authorizing law.

Feedback must be provided by May 20, 2022, using the form at https://www.federalreserve.gov/apps/forms/cbdc. Given the potential impact of CBDCs on the financial industry, we encourage businesses to consider providing feedback and staying on top of legal developments in this rapidly developing area.

If you have questions, please contact us

If you have any questions or if you would like to discuss the matter further, please contact me, Maryam Meseha, or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.