The Fed’s watershed moment on crypto assets and CBDCs is fast approaching

The Federal Reserve is approaching a watershed decision on CBDCs and digital assets. Will it press on with a digital dollar to compete with China’s digital yuan? Or will it double down on the existing economic system and try to maintain the status quo? 

Last month, the Federal Reserve published a report: Money and Payments: The U.S.Dollar in the Age of Digital Transformation, which weighed up the pros and cons of a US CBDC. There were no policy commitments, but the Fed said it will “take further steps toward developing a CBDC if research points to benefits for households, businesses, and the economy overall”. The threshold for benefits needed to meet the Fed’s criteria is not contained in the report’s 40 pages, but there is a sense that the Fed has been warming to the idea of a US digital currency since last year.

The US, as the largest economy in the world, currently benefits from the US dollar’s use as the world’s reserve currency. The Fed’s report reflects a regulator weighing up how it can maintain this through a transition to digital currencies without being left behind by countries such as China who are seemingly ahead of the curve.

The age of digital transformation

The report outlines the benefits of a US CBDC for maintaining US hegemony by “lowering transaction and borrowing costs for US households, businesses, and government”, and adds that “the dollar’s international role also allows the United States to influence standards for the global monetary system”.

CBDCs could one day become pivotal for processing global transactions, with the report citing that this could decrease the use of the US dollar in global trade. US economic dominance is due to the “openness of its economy”, so a digital dollar could be needed to retain its “openness” in a brave new digitised financial world of the future.

Part of this dominance is reflected in the US’s role for making the majority of the world’s remittance payments, sending up to $68 billion in 2020. A US CBDC could be crucial for maintaining US dollar remittance payments as well as streamlining the effectiveness of transactions. The report states that this would require cooperation with other jurisdictions to put legal frameworks in place to make this feasible.

However, the report also argues that improvements in transaction and processing systems could be detrimental to possible bank runs in the future. A bank run is when everyone tries to withdraw their money at once due to widespread fear in the market. If a US CBDC made it easier to move money around than using the outdated SWIFT payment systems currently in use, this could place unprecedented stress on the financial system in times of widespread economic panic.

Interest-bearing CBDCs are another idea explored. They could be a way for investors to earn low-risk interest on their savings but the Fed says this “could result in a shift away from other low-risk assets, such as shares in money market mutual funds.” This, the bank warns, could “reduce credit availability for business and governments.” This could be a solution to the record-low interest rates seen for US savers over the last 14 years or so, as well as a way to combat the rise of high stablecoin interest yields offered by crypto platforms.

There were also concerns raised on the need to balance security with privacy. “Any CBDC would need to strike an appropriate balance, however, between safeguarding the privacy rights of consumers and affording the transparency necessary to deter criminal activity.”

What’s next for the US and CBDCs? 

Congressman Tom Emmer put out a twitter thread on the topic recently, signposting a bill for Congress to not pursue a dollar CBDC.  A CBDC directly regulated by the Federal Reserve could make the US more authoritarian “like China ‘, the Congressman tweeted.

Competition from China’s own foray into digital currencies could be a catalyst for the shift in US sentiment. Having begun work on a digital yuan back in 2014, China is years ahead of US efforts and recently launched a digital wallet for users. India is to also begin work on a digital rupee with a launch date set for as soon as this year.

News recently emerged from the Fed that Project Hamiliton is entering its second phase. Named after Alexander Hamilton, the US’s first Secretary of the Treasury, Project Hamilton will aim to offer technical recommendations to the Fed on how a digital dollar could be run.

The executive summary of the report’s first phase suggests it will use elements of cryptocurrencies and blockchain technology but will adapt the technology for its own purposes. Specifically, a US digital dollar would likely be a permissioned blockchain rather than a permissionless one like Bitcoin. In short, this means that instead of transactions being verified using mining, they could instead be sent through a trusted third party, in this case the Federal Reserve. This would allow transactions to be processed at a much lower energy cost than “traditional blockchains” but would require trust (or at least accountability) in the Federal Reserve to run it fairly. With trust in America’s institutions at a low, the concept of a digital dollar could prove a hard sell to the American public. 

The Fed has a busy few years ahead of it with rising costs of living, interest rates to manage and a post-pandemic recovery to master. These priorities could take precedence over a digital dollar project in the short to medium term, but the central bank appears to be trying to keep its options open.

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