What are central bank digital currencies?
Money in the United States (as in France) currently comes in three forms: central bank money, which is a liability of the Federal Reserve; commercial bank money, which is a liability of the commercial banking sector and the form of money most used by the public today; and non-bank money, which is a liability held by non-bank financial institutions (such as payment processors like PayPal).
These three types of money carry different levels of credit and liquidity risk. For example, central bank money has no credit and liquidity risk because the Fed can create money ex nihilo. Commercial bank money or bank deposits, on the other hand, pose a medium level of risk because banks can fail or have liquidity problems – although these risks are, for the most part, mitigated by federal deposit insurance and banks’ on-demand access to central bank liquidity. Non-bank money or credit to payment processor accounts do not have the full protection of bank deposits, and are therefore generally considered the riskiest.
Cash or physical money is the only type of central bank money available to the general public today. The other type of central bank money is in the form of “bank reserves“, which are available only to the commercial banking sector and are completely inaccessible to the public. The money most used by the general public today is commercial bank money, which comes in the form of bank deposits created by banks. ex nihilo when commercial banks create loans.
The idea behind CBDCs, then, is to introduce a new form of money that resembles commercial bank money in that it is purely digital and directly accessible to the public, but at the same time is issued by and represents a liability of the Fed (like cash) instead of being issued by commercial banks (like bank deposits). Therefore, this form of money would, in theory, be both the safest and most easily transferable form of money available to the public in the future.
While there are many differences between CBDCs and crypto-currencies like Bitcoin and Ethereum, perhaps the most fundamental is that CBDCs are still someone’s debt – in this case, the debt that the central bank technically owes to CBDC holders – while Bitcoin and Ethereum are bearer assets that are no one’s debt and represent pure ownership.
Signs of the advent of a digital dollar
Although the United States has not yet formally committed to creating and issuing a digital dollar in the form of a CBDC, several signals from government agencies and officials over the past two years suggest that the government is seriously considering the possibility.
On numerous occasions, Fed Chairman Jerome Powell and Treasury Secretary Jenet Yellen have emphasized the need for the government to focus on this issue and to intensify its research and development efforts. “In light of the tremendous growth of crypto-assets and stablecoins, the Federal Reserve is considering whether a U.S. central bank digital currency would enhance an already secure and efficient national payments system“, said Jerome Powell in his message on the international roles of the US dollar conference in June.
A year earlier, Jenet Yellen had said in an interview in the New York Times that he was “that it was logical for central banks to take an interest in the evolution of the world economy” talking about CBDCs, explaining that the U.S. has a financial inclusion problem and that a digital dollar could help. “I think it could lead to faster, safer and cheaper payments“, she concluded.
Perhaps the most telling signs of the advent of a digital dollar are contained in the September 2022 U.S. Treasury report, The Future of Money and Payments that came in response to President Biden’s Executive Order on e-commerce. “Ensuring Responsible Development of Digital Assets.” In March, President Biden ordered several government agencies, including Treasury, to submit reports on potential regulation of U.S. crypto-currencies, including consideration of a CBDC. Subsequent reports indicate that, for the most part, the agencies support the idea.
U.S. Treasury backs CBDC efforts
In its response to the White House, the U.S. Treasury encouraged the Fed to “continue its research and technical experimentation on CBDCs, including its work in analyzing possible technology choices and other design elements of a CBDC“, suggesting that the issuance of a digital dollar might be a desirable goal if it is “determined to be in the national interest“.
In support of the Fed, Treasury also indicated that it would create and lead an interagency task force to support the responsible development of CBDCs. In the report, Treasury noted that the creation of a U.S. CBDC could take several years, but that it is necessary for the government to do so to ensure the primacy of the dollar in the international financial order.
The Fed is already working on a U.S. CBDC
In a January discussion paper titled Currency and Payments: The U.S. Dollar in the Age of Digital Transformation the U.S. central bank said it “is exploring the implications and options for issuing a CBDC“. And while the Fed has yet to make explicit policy recommendations, such as whether or not the government should issue a digital dollar, it has revealed that it is exploring CBDCs from a variety of angles, including through technological research and experimentation.
Specifically, the Federal Reserve Bank of Boston is working with the Massachusetts Institute of Technology to explore potential technological solutions for a “Retail CBDC” that would be available to the public. At the same time, the Federal Reserve Bank of New York partnered with the Bank for International Settlements to work on a “CBDC wholesale” which would be used only for interbank payments. These two initiatives prove that the Fed is serious about creating a digital dollar.
The White House is largely in favor of a digital dollar
Last month, six months after President Biden signed the Digital Assets Executive Order, the White House released its first-ever comprehensive document on crypto-currency regulation. In the document, the White House encourages the Fed and Treasury to pursue research and development of a digital dollar and releases its first policy goals for a U.S. CBDC system. “A U.S. CBDC system, if implemented, should protect consumers, promote economic growth, improve payment systems, ensure interoperability with other platforms, advance financial inclusion, protect national security, respect human rights and align with democratic values “, the objectives state.
Beyond providing broader regulatory guidance on digital assets, the framework represents the first official public endorsement of the idea of developing a U.S. CBDC and the clearest sign yet that the digital dollar could soon become a reality.
Crypto adds external pressure
The main reason the U.S. has ramped up its CBDC research and development efforts over the past two years – and another argument for why a digital dollar may emerge sooner rather than later – is the pressure from the rapid global proliferation of crypto-currencies and the rapid development of competing CBDCs.
Various regulators and legislators have explicitly noted the rapid growth of stable currencies as the primary reason for the need to innovate and improve existing fiat payment systems. While stable currencies pegged to the dollar stimulate demand for dollars internationally, they are still a risky form of currency domestically. Moreover, the U.S. and the Fed are lagging on the CBDC front and are under significant pressure to adapt. According to the Atlantic Council CBDC tracker study 11 countries have launched CBDCs, 15 are running pilot programs, and 26 are in development. The United States and 45 other countries are still in the research phase.
Why should we care?
Perhaps the best way to explain CBDCs and their importance is to quote Agustin Carstens, director of the Bank for International Settlements. Explaining the difference between physical money and CBDCs at an IMF panel in 2020, the Cross-Border Payments discussion, Carstens said:
“We don’t know who uses a $100 bill today and we don’t know who uses a $1,000 peso bill today. The key difference with the CBDC is that the central bank will have absolute control over the rules and regulations that will determine the use of that expression of central bank responsibility, and also we will have the technology to enforce that.”
Beyond absolute control and a complete overview of every economic transaction, the introduction of a digital dollar could completely change the way the Fed conducts monetary policy. Instead of using indirect instruments like open market operations (quantitative easing and tightening) and lowering and raising the federal funds rate to control the money supply, with CBDCs, the Fed could directly control the interest rate on credit or the money supply on many individual accounts.
Moreover, having all transactions in the economy recorded on a blockchain could give the Fed a near-perfect view of where the economy is headed. By combining CBDC with AI and machine learning, the central bank could do a much better job of predicting the behavior of individual users and the economy as a whole, which could prompt it to move from a market economy to a more centralized one.
Because of their programmable nature, CBDCs also give the government the power to set a “expiration date” to money. This would essentially allow them to force people to spend and artificially stimulate economic activity. China has already experimented with this feature with its digital yuan.
It is hard to believe that the introduction of a more centralized and censorable form of bank accountability money would decrease the demand for non-depository and non-censorable hard currency assets like Bitcoin or Ethereum. On the contrary, the appeal of some crypto-currencies as stores of value or even as assets “safe” is expected to grow as governments begin to adopt CBDCs.