Tuesday, January 25, 2022

The Fed Weighs in on a 'Digital Dollar'

Vast Cross-border Implications for Central Bank Digital Currencies

Author: David Schwartz J.D. CPA



A discussion paper published on January 20th invites the public to explore with the U.S. Federal Reserve Board the creation of a digital version of the U.S. dollar. A Central Bank Digital Currency (CBDC) backed by the Federal Reserve would be designed, according to the Fed’s paper, to compete with cryptocurrencies like Bitcoin and Ethereum. Comments are due by May 20, 2022.


Official issuance of a U.S. Federal Reserve sponsored CBDC could change the global payment system as much as the 1971 U.S. decision to float the dollar and exit the gold standard. Setting aside monetary, legal, and legislative policy issues, a U.S. CBDC could force reengineering of the existing cross-border payment systems of companies and financial firms. For example, settling securities financing transactions through global custodian banks might no longer be the only option for cross-border traders using fintechs with a digital dollar account at the Federal Reserve.  


Other nations’ central banks have also explored digital versions of their own fiat currencies. Nine relatively small, mainly offshore nations have already launched central bank digital currencies. [1] While stressing that no final decisions about a digital currency have yet been reached, the Fed's paper said it would likely follow an "intermediated model" under which banks or payment firms would create accounts or digital wallets. [2]


CBDC’s are Not Cryptocurrencies


Cryptocurrencies lack sovereign backing or official convertibility and store value for their holders in tokens encrypted on a blockchain. By contrast, CBDC’s represent fiat currency, e.g., notes and coins, held in a digital wallet for conversion into physical cash at an ATM or bank.[3] The Bank for International Settlements defines state-backed CBDCs as either the retail equivalents of cash or as wholesale claims used for interbank payments.


The Fed’s paper distinguishes CBDCs from what it calls “commercial bank money” and “non-bank money,” which currently allow businesses and consumers to conduct digital commerce and transfer funds electronically.[4] A U.S. CBDC dollar, according to the Fed, would be a liability of the central bank, not a liability on the books of private banks or other financial institutions.[5]


Both cryptocurrencies and CBDCs are dependent on networked computer resources to create, track and validate transactions. In the case of most cryptocurrencies, those resources are anonymous and distributed through decentralized ledgers. For CBDC’s, a central bank ultimately controls issuance by providing every "e-dollar" with a unique identifying serial number, like a physical dollar. Because CBDCs are electronic analogs of a nation’s hard currency, central banks would be expected to peg the value of their digital currency to their existing fiat currency.[6]


Cryptocurrencies, according to a 2021 study by the Bank for International Settlements, have not yet made any real inroads into commercial cross-border transaction settlements. Their novelty, volatility, and general lack of centralized monetary controls have so far made them unsuitable to use as a medium of exchange for most businesses and financial firms.


 U.S. Dollar Hegemony is at Risk from Competing Digital Currencies


The Fed’s report acknowledges that without a dollar-denominated CBDC, the U.S. Dollar runs the risk of being eclipsed by competing countries’ CBDCs. 


“Today, the dollar is widely used across the globe because of the depth and liquidity of U.S. financial markets, the size and openness of the U.S. economy, and international trust in U.S. institutions and rule of law. It is important, however, to consider the implications of a potential future state in which many foreign countries and currency unions may have introduced CBDCs. Some have suggested that, if these new CBDCs were more attractive than existing forms of the U.S. dollar, global use of the dollar could decrease—and a U.S. CBDC might help preserve the international role of the dollar.”[7]


A digital dollar would compete with other nations’ CBDCs for cross-border transactions. For example, China’s digital currency, the renminbi (or e-CNY), could allow Chinese firms and their trading partners to reduce the usage of the U.S. dollar for cross-border transactions and perhaps circumvent channels that may be vulnerable to U.S. sanctions or jurisdictional control. To compete, the Fed must address the pain points in the cross-border payment markets.


“Accordingly, efforts aimed at reducing the costs of existing payments channels for large-value cross-border transactions denominated in U.S. dollars should be accelerated, and Washington should support public- and private-sector efforts aimed at leveraging new technologies to improve the efficiency of large-value cross-border payments [or else] the United States risks losing its leading influence over global payments infrastructure."[8]


CBDCs can Improve Efficiency of Cross-border Trading


Inefficiencies and high costs associated with the current cross-border payment systems have been a focus of global policymakers for years. The G20 countries agreed in 2020 to a multiyear roadmap to identify and deploy improvements to cross-border payments, including exploring the potential benefits of CBDCs to help address these frictions.[9]


“Cross-border payments currently face a number of challenges, including slow settlement, high fees, and limited accessibility. The sources of these frictions include the mechanics of currency exchange, variations in different countries’ legal regimes and technological infrastructure, timezone complications, and coordination problems among intermediaries, including correspondent banks and nonbank financial service providers. Regulatory requirements related to money laundering and other illicit activities introduce further complications."[10]


Champions of a digital dollar estimate that the streamlining cross-border exchanges made possible by CBDCs could dramatically reduce transaction costs, freeing up capital that could be more productively employed.


“Global corporates move nearly $23.5 trillion across countries annually, equivalent to about 25% of global GDP. To do this, they have to rely on wholesale cross-border payment processes which remain sub-optimal from a cost, speed, and transparency standpoint. As well as resulting in significant transaction costs of $120 billion per annum, these processes also result in additional costs from FX conversion, trapped liquidity and delayed settlements."[11]


In a trial conducted by the Bank for International Settlements (BIS), cross-border transactions employing CBDCs could be made in a few seconds, instead of the three to five days necessary using payments passed through a network of banks.[12]


[1] Nine countries have launched CBDCs: Antiqua and Barbuda, Dominica, Grenada, Montserrat, Nigeria, Saint Vincent and the Grenadines, Saint Lucia, Saint Kitts and Nevis, and The Bahamas. Fourteen nations, including China and Saudi Arabia, have CBDC pilots. Sixteen countries have CBDCs under development, including Canada, Brazil, Russia, and Australia. https://www.atlanticcouncil.org/cbdctracker/ 

[2] The Fed is also exploring an alternative system that permits the issuance of digital dollars directly to consumers. But as the paper notes, “the Federal Reserve Act does not authorize direct Federal Reserve accounts for individuals, and such accounts would represent a significant expansion of the Federal Reserve’s role in the financial system and the economy.” 

Federal Reserve Board, “Money and Payments: The U.S. Dollar in the Age of Digital Transformation,” Jan. 2022, p. 13. (“Fed CBDC Report”).

[3] Chadha, Sunainaa, "Digital Currency vs Cryptocurrency: What the Row is all About," Times of India, Nov. 25, 2021. 

[4] According to the Fed:

  • Commercial bank money is the digital form of money that is most commonly used by the public. Commercial bank money is held in accounts at commercial banks. 
  • Nonbank money is digital money held as balances at nonbank financial service providers. These firms typically conduct balance transfers on their own books using a range of technologies,  including mobile apps.  Fed CBDC Report, p. 15.

[5]  Fed CBDC Report, pp.13-14.

[6] CBDCs are alternatively called “digital fiat currencies.”

[7] Fed CBDC Report, p. 15.

[8] Greene, Robert, "Beijing’s Global Ambitions for Central Bank Digital Currencies Are Growing Clearer," Carnegie Endowment for International Peace, Oct. 6, 2021 

[9] See “Financial Stability Board, “Enhancing Cross-border Payments: Stage 3 Roadmap”, Oct. 2020 

[10] Fed CBDC Report, p. 9.

[11] JP Morgan & Oliver Wyman, “Unlocking $120 billion in Cross-Border Payments: How Banks can Leverage Digital Currencies for Corporates,” 2021. 

[12] Bank for International Settlements, “Project Helvetia Phase II: Settling tokenised assets in wholesale CBDC,” Jan. 13, 2022