In January 2022, the U.S. Federal Reserve released a long-awaited discussion paper on its thinking about a central bank digital currency, or CBDC. The paper builds on prior work by the Bank of International Settlements (BIS). At the end, it provided a list of questions for public comment. I thought it might be helpful to outline my responses to the questions posed by the Fed, as well as explain some of the primary issues they are considering.
Digital Currency and the Forms of Money
One of the key points of the paper is that there are three main forms of money: central bank money, which the paper considers to be the safest form; commercial bank money, which is what we all use on a day-to-day basis and is at risk of liquidity crises; and nonbank money, which can be anything from a passthrough of commercial bank money to entirely synthetic forms of value, such as cryptocurrency.
Crypto enthusiasts will certainly debate the categorization of central bank money as the “safest” form. The whole point of cryptocurrency is to provide an alternative to central bank money, which adherents see as dangerously vulnerable to political manipulation. Indeed, there are many countries where central banks are weak and subject to political manipulation, and in these places, we are seeing a significant amount of wealth being shifted into cryptocurrencies. The United States, however, with its low level of corruption, has a highly stable currency, and so has less need for alternatives.
Cryptocurrency’s response to the recent inflation must be disappointing to its fans. Not only has it not been an inflation hedge, as so many claimed, but it dropped in response to high inflation. In fact, over the past year, there have been four major crashes, as shown to the right (some are multiday).
As I have noted previously, cryptocurrency’s value is in fact far more volatile, and far more responsive to public sentiment, than central bank money. Therefore, the Fed is on strong ground in making this claim. At some point, cryptocurrency may stabilize, but right now it is certainly not safer than central bank money, and one must resort to extreme scenarios (such as a general default on Treasuries) to argue the point. In those scenarios, currency valuation will be the least of our problems.
However, cryptocurrency is not the only form of digital money. Commercial bank money is primarily digital, consisting of accounting entries in a digital ledger. Many blockchains have been established to trade tokens, which may have some intrinsic value, but are used in the context of smart contracts to enable governance schemes or to link to off-chain assets, such as non-fungible tokens (NFTs). I have written more about NFTs here. The main difference is the inclusion of a blockchain, which is a distributed ledger that uses cryptographic techniques to prevent alteration of previous entries. Blockchains are primarily useful in trustless environments, where independent users wish to avoid depending on an intermediary.
Is Cryptocurrency a Threat to the Economy?
Not yet, but it could be. There are two main fears:
- Enough money shifts over to cryptocurrency (and is removed from commercial banks), that Fed actions to increase or reduce the money supply have less effect. This would reduce the Fed’s ability to manipulate interest rates to respond to economic downturns (as it did in 2020) or overheating (as it is doing in 2022). Recessions would be deeper and longer lasting, and inflation would become entrenched, as it did in the 1970s.
- The creation of a CBDC itself could accelerate this process because central bank money is safer than commercial bank money. Given the choice, many people might choose to keep their money with the Fed, or with a CBDC, than with a commercial bank or credit union. Not only does this give commercial banks less capital to work with in the event of a crisis, but it also limits their lending capacity, because banks are required to have a certain percentage of their loans backed by deposits. Without enough credit, the economy would stall or contract.
One of the Fed’s main concerns is to “do no harm.” This limits what it can consider. For example, the Fed asked whether a CBDC should be interest-bearing. I said no, because cash is not interest-bearing, and I don’t want to incentivize people to hold CBDC. Instead, it should be withdrawn (like cash) and used immediately (like cash).
Three Ways to Distribute a CBDC
There are three basic ways that a CBDC could be distributed:
- Direct – this is the way China has opted to do it. The Fed could sell digital currency directly to consumers and require banks and merchants to accept it.
- Indirect through commercial banks and credit unions – In this model, the Fed trades with commercial banks and credit unions for CBDC the way it does now for cash, through internal transfers. Each financial institution would have an account with the Fed holding CBDC, which they could then sell to their customers. Again, there would need to be some legal requirement for merchants to accept the CBDC.
- Indirect through non-banks – Here, the Fed would make CBDC accounts available to companies that are not chartered financial institutions, such as PayPal, Circle, Square, Coinbase, etc. Those companies would use the CBDC in place of whatever internal measures of value they employ, removing the need for external bank accounts.
Benefits of Giving Non-Banks Direct Access to a CBDC
Allowing non-banks to hold accounts at the Fed would put them on a level playing field with banks and credit unions and disintermediate the banks by removing the need for non-banks to hold bank accounts. It would also bypass all the traditional payment methods, such as payment cards, checks, ACH, and wires, by allowing nonbanks to create alternatives that are less expensive and faster than legacy payment products. On the other hand, it would defend the money supply against stablecoins such as Tether and provide the Fed with greater visibility into cryptocurrency markets.
I personally favor a combination of options two and three, because it would drive more innovation in the financial industry and provide alternatives to interchange for merchants. The risk of draining commercial banks of capital could be addressed through limits on how much CBDC can be held and transferred (which will be necessary anyway to reduce fraud and money laundering).
All three would require legal and regulatory changes on the part of Congress, which is hard and slow. In the meantime, unregulated stablecoins such as Tether will continue to grow.
Note that a CBDC would not displace existing stablecoins, because there are uses that a government-backed stablecoin would not be able to support, such as unrestricted trade in all cryptocurrencies. This is why Tether is so powerful, despite its shaky underpinnings. Only a few cryptocurrencies, such as Bitcoin and Ethereum, have enough adoption to allow direct trading; all the others need an exchange or bridge currency like Tether, or else reserve accounts at exchanges like Coinbase. Unregulated cryptocurrencies cannot be destroyed by design, they can only be made more difficult to access. However, a CBDC would reduce the market share of private stablecoins, which would be beneficial for the economy.
Does a CBDC Actually Need to be a Cryptocurrency?
If we assume for the moment that some mix of the second and third distribution models is most likely, then we must question the need for an actual cryptocurrency. Much of what is stored on blockchains these days is not actual stores of value, but tokens referring to assets held elsewhere. Indeed, given the throughput limitations of blockchain technology, it could hardly be otherwise. So, the Fed could just create tokens rather than minting coins. These tokens would be claims on the Fed just as cash is today. No one actually presents cash to the Fed in exchange for goods or services; instead, cash circulates, and everyone treats it as money because they know that Fed is backing it.
Let’s go further, though, and question the need for even a blockchain. Remember, a blockchain is just a means for all parties to a payment scheme to record and verify the amount of value held by an individual (represented by a unique address on the blockchain). As cryptocurrency is exchanged, addresses are incremented and decremented by the same amounts, so that the overall amount of currency remains the same, except for mining rewards, which create new currency for those addresses that have solved the most recent proof of work problem.
Blockchains are necessary in a trustless environment, but the U.S. money supply is hardly that; in fact, it is the exact opposite. As I just pointed out, we all go around exchanging cash as if it were money based solely on a collective belief that it is so.
This is why the Fed refers to a Central Bank Digital Currency, rather than a Central Bank Cryptocurrency (CBC or CBCC). Proof of work and the blockchain are entirely superfluous, except to the extent that they provide advantages over conventional secure databases.
I support the idea of a Fed-sponsored digital currency for a variety of reasons:
- It would unlock innovation by enabling non-banks to operate independently of commercial banks, preventing those banks from setting rules that hinder competition.
- It would vastly strengthen the Fed’s influence over payments, bringing the U.S. in line with most other modern nations that have national payments regulators. The need to constantly get cooperation from commercial banks and the payment card networks has slowed the implementation of faster payments, and has prevented meaningful regulation of interchange, raising costs on merchants and consumers alike.
- It would defend against risky stablecoins like Tether, which pose a serious systemic risk to the cryptocurrency markets.
- It would give the Fed greater visibility into digital currency markets, which will be necessary as these markets become a greater part of the economy.
That said, we are a long way from a CBDC in the United States. As mentioned, there will need to be new laws authorizing the creation and use of a national digital currency, and there will be robust debates about every aspect. Following that, regulators will need to write new rules for CBDCs and requirements for nonbanks to use them.
This is a major step, but we are still at the very beginning of this journey.