Impact of a United States Federal Reserve Digital Currency

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In a recent article (https://www.braumillerlaw.com/executive-order-digital-assets-start-responsible-regulation/) I provided a snapshot of the many reports made by the Executive Order on Ensuring Responsible Development of Digital assets are required to be issued on March 9, 2022. A key objective of this federal government effort is to assess and analyze the digital asset sector to determine whether it is advisable to develop a central bank digital currency (CBDC). This article provides an overview of the issues surrounding CBDCs in a Q&A format to provide a lens for analysis of the many government reports due in September, October and through to the end of this year. These reports will look at a CBDC that protects consumers, investors, businesses and innovative organizations using blockchain technology while promoting financial stability, dominating illicit finance and leading to increased international cooperation around digital assets.

What are CBDCs?

The Federal Reserve is at the center of analyzing and developing new United States CBDC laws and regulations that would be the digital equivalent of a paper dollar, but would only exist on balance sheets and blockchain accounts and wallets.

A CBDC is a digital form of central bank money that is available to the general public. “Central bank money” refers to money that is a central bank liability. There are currently two types of central bank money in the United States: physical currency issued by the Federal Reserve and digital balances held by commercial banks with the Federal Reserve. While Americans have long held money primarily in digital form — for example, in bank accounts, payment apps, or through online transactions — a CBDC would differ from existing digital money available to the general public because a CBDC is a liability of the Federal Reserve would be, not a commercial bank. (https://www.federalreserve.gov/faqs/what-is-a-central-bank-digital-currency.htm)

Have any countries issued them?

“As of March 2022, 87 countries are considering issuing a CDBC, according to the Atlantic Council, an independent organization based in Washington, DC. Of these, 9 countries – the Bahamas, Nigeria and 7 countries in the Eastern Caribbean Union – have already adopted a centrally managed digital currency. About 2 years ago, in May 2020, only 35 countries were considering issuing a CBDC.” (https://www.ndtv.com/business/here-are-the-timelines-and-status-of-central-bank -digital-currencies-in-some-countries-2820164; see also: https://www.atlanticcouncil.org/cbdctracker/)

As can be seen from the reference above, efforts by the United States government to analyze CBDCs could certainly result in legislation and eventual legal and regulatory requirements. Should these efforts be successful, the digital asset and cryptocurrency sector will finally have a framework that can lead to significant new investment and participation in the mainstream economy. The industry’s lack of regulation, fraud, insecurity, underdeveloped infrastructure, and lack of open source code can be left behind fairly quickly, and a new era of improved security and adoption could greatly accelerate the advances already made.

Why use them?

Key benefits for countries issuing CBDCs include:

  • Money laundering could be easier to spot
  • Simplified and efficient cross-border payments, eliminating major supply chain friction
  • Financial inclusion for the unbanked to participate in transactions
  • Eliminate the risk of commercial bank failures
  • Simplified tracking, data analysis and understanding of financial flows
  • Dealing with the risks of private money creation (cryptocurrencies)

The main difference for individuals between a CBDC and existing digital and fiat dollars is that no one would need to hold CBDC assets in a commercial bank account. This would open up the economy to far greater participation by the unbanked or disenfranchised. At the same time, the digital ledgers on blockchain(s) would simplify and speed up transactions and settlement times, making the payment system significantly more efficient. (See: https://www.fool.com/investing/stock-market/market-sectors/financials/cryptocurrency-stocks/central-bank-digital-currency/)

The main reason people would prefer CBDC over a bank account is that CBDC is not at risk if banks go bust. Eliminating this risk would be beneficial for both individuals and the economy. In addition, transferring money across banks and country borders becomes much easier. Different banking systems would not have to interact with each other to enable such payments. All that is required is an update of the record at the central bank. This simplicity makes the process faster and cheaper. (https://blog.digitalasset.com/developers/what-is-a-central-bank-digital-currency-and-why-should-people-prefer-cbdc-over-bank-accounts)

Are there potential problems with adopting CBDCs?

There are also significant potential problems that regulation can address:

  • Each country could have its own CBDC, and each government’s total control of the currency could result in vastly different usage restrictions.
  • Every transaction would be transparent to any entity that can read the blockchain, and increased access to large transaction data could lead to data breaches.
  • The transition to digital currency could be slow for many in the population, although the user experience is likely to be similar to using a credit or debit card.
  • Commercial banks could lose a large part of their retail banking business, affecting the share prices and profits of many small local banks, as well as larger banks dependent on retail banking.

A recent pilot program under the auspices of the Bank for International Settlements found that a multi-CBDC platform could be developed, but some harmonization or collaboration between central banks would be needed to optimize the efficiency of real-world usage. (https://www.hinrichfoundation.com/research/wp/tech/fast-tracking-blockchain-interoperable-inclusive-trade/) Such harmonization and common approaches can be difficult to negotiate. In all likelihood, multilateral agreements will be required that will take years to negotiate, ratify and enter into force among the signatory countries over an extended period of time.

The Federal Reserve recently conducted a study Money and Payments: The US Dollar in the Age of Digital Transformation, January 2022, (www.federalreserve.gov/publications/files/money-and-payments-20220120.pdf). As part of this study, the Fed asked the public for comments on twenty-two issues related to the potential introduction of a US CBDC. Hundreds of replies will be posted online, but it will be an arduous process to wade through them and filter out the truly valuable contributions from the praise or taunts with little factual relevance to the topic. (https://www.federalreserve.gov/cbdc-public-comments.htm) This is also often the case with rulemaking with notices and comments. Unsurprisingly, some of the larger players in the cryptocurrency space are also contributing their views in hopes of shaping laws and regulations.

Can we reconcile centrally controlled financial institutions and decentralization?

One of the key debates surrounding innovation with blockchain-based systems is whether decentralized activities, which are at the heart of distributed ledger technology (DLT), can thrive in a financial system based on heavily regulated, government-authorized central institutions? There is a great fear among innovators that the government will step in and essentially wipe out the more innovative aspects of cryptocurrency by issuing a CBDC that remains centrally controlled and provides the means for greater government intervention in everyone’s financial affairs who use the CBDC. and displace all private money represented by cryptocurrencies.

The current cryptocurrency situation has been proven to be plagued by high levels of fraud, volatile price swings for supposedly stable investments, and uncertainty about the usage, adoption, and staying power of the crypto economy. But the promise of decentralized collaboration, improved and simplified financial transactions, and the inclusion of many people currently disenfranchised by the banking system makes the government reports called for by the recent executive order even more important in shaping the landscape for potential regulation to introduce a CBDC. It is also crucial for civil society, big business and other interested stakeholders to consider responsible and sensible implementation approaches that protect consumers, investors, businesses, non-profit organizations and disenfranchised people alike.

A particularly important consideration for the government’s analytical efforts is addressing the impact of a CBDC (public cryptocurrency) on stablecoins and existing forms of private cryptocurrency. Private money has been created in a variety of ways in the United States, generally in response to the inadequacies of public money spent by the federal government. Once the shortcomings have been remedied, private money will always disappear from the scene until the next currency failure occurs. (See: https://www.clevelandfed.org/newsroom-and-events/publications/economic-commentary/economic-commentary-archives/2007-economic-commentaries/ec-20070101-private-money-in-our-past-present- and-future.aspx#:~:text=Coal%20mining%20and%20lumber%20companys,served%20by%20goment%2Dprovided%20money.) As a result, many cryptocurrency providers and exchanges fear that public CBDC will supplant private forms the cryptocurrency. However, there are many private moneylenders today, and commercial banks also fear that they will lose so much retail business to CBDC and crypto wallets instead of bank accounts that their business could potentially collapse. (See: https://www.coindesk.com/policy/2022/05/23/wall-street-says-a-fed-digital-dollar-spells-destruction-for-banks/)

Threading the needle between these extreme outcomes takes skill, but it is within the ability of all people and institutions involved to find an approach or approaches to regulation that ultimately works. Imagine instant tax refunds within hours of filing in your account, along with rebates and other incentives for using CBDC “Fed Coin”. What about the immediate availability of funds instead of delays in verification, as is often the case now, and many more changes that will positively affect users, holders, regulators and innovators of the new currency. We are able to work together to create laws and regulations that will truly make as big a difference in society and the economy as the Internet has since 1990. I look forward to working to make these changes happen.

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