A Digital Dollar: Pending Homework for the Fed

The history of money is entering a new chapter. The world’s central banks are realizing that they need to respond to the increasingly proliferating cryptocurrencies and stable coins. The alternative they propose is a digital fiat currency backed by central banks that functions similarly to traditional fiat money, so-called Central Bank Digital Currency (CBDC). It will operate just like cash, but instead of carrying it in a physical wallet or putting it into a bank account, it would be stored and accessed digitally, make payments more cost-efficient, and increase access to financial services. All told, as of February 2022, 91 countries are exploring CBDC at one level or another with some researching, some testing, and a few already distributing CBDC to the public.

As for the United States, the Federal Reserve finally released an authoritative paper on CBDC in January 2022, following past Fed experiments with a hypothetical CBDC. This marks the first step in a public discussion between the Fed and stakeholders about CBDC. In the paper, the Fed takes a comprehensive look at the advantages of CBDC, such as speeding up electronic cross-border payments in an already highly digitized world. The paper also highlights CBDC’s potential to support the U.S. Dollar’s international role and promote financial inclusion by expanding access to digital money for unbanked persons. Further, the Fed suggests that a U.S. CBDC would best serve the needs of the U.S. by being privacy-protected, intermediated, widely transferable, and identity-verified. However, the paper also discusses some issues with a CBDC, such as financial stability, changes to the structure of the financial sector market, and maintaining privacy while guarding against fraud. To explore design options for a CBDC, the paper includes 22 items for public feedback in a 120-days comment period.

Many CBDC enthusiasts, as well as some cross-border payment associations, welcomed the Fed’s paper as the first key milestone in the U.S. digital dollar policy. Still, the paper made no clear policy recommendations and offered no clear signal on where the Fed stands on the launch of CBDC, causing some economists to see this project as a long shot. The Fed emphasized that they would not proceed with creating CBDC without support from the executive branch and authorization from Congress. In fact, the executive branch gave the green light on March 9 through the President’s Executive Order on Ensuring Responsible Development of Digital Assets. One key takeaway from the order is that the Biden administration “places the highest urgency on research and development efforts into the potential design and deployment” of a U.S. CBDC. On the other hand, Congress is still divided over the need for a CBDC. Some members of Congress are concerned about privacy and surveillance issues, while others support a digital dollar to boost financial inclusion.

In contrast to the U.S. government’s slow pace, a handful of countries have firmly expressed their interest in CBDC through accelerated experimentation. Nine countries have already successfully launched a digital currency. Claimed as the first nationwide CBDC, the “Sand Dollar” in the Bahamas has been in circulation for more than a year. It holds an identical function and legal status as Bahamian cash dollars. Individuals, including non-residents of the Bahamas and businesses, can use the Sand Dollar through mobile e-wallet applications for many transactions in authorized merchants. In addition, 14 countries, including China, are now piloting their CBDCs ahead of a potential full launch.

China, as one of the world’s leading countries in the payment industry, started its research on CBDC in 2014 as part of its broader efforts to internationalize the Yuan, maintain control over its financial system amidst proliferating private cryptocurrencies, and increase surveillance over individuals’ transactions. Further, a digital Yuan would also allow Chinese firms and their trading counterparties to reduce reliance on the U.S. dollar for cross-border payments and potentially circumvent payment channels subjected by U.S. sanctions. A pilot program of China’s digital Yuan, launched by the People’s Bank of China two years ago, has reached 87.57 billion yuan ($13.68 billion) in cumulative transactions. To push the development of its CBDC, earlier this year China’s central banks released pilot versions of a digital yuan wallet mobile application (e-CNY) to expand CBDC access for selected users such as domestic banks, followed by a nationwide rollout. Furthermore, to secure the legal foundation of its CBDC, China is also drafting a general revision on the People’s Bank of China Law, which suggests that Chinese currency includes both physical and digital forms (e-CNY). The draft law provides the central bank with the broad power to plan, organize, and supervise the payment system and financial infrastructure. The Central Bank of China will have the responsibility to coordinate the work on national financial security, with the goal of developing a cyber-resilient CBDC.

As stated by a Bank for International Settlements economist, digital currencies, including CBDCs, are the next wave in the evolution of the nature of money in the digital economy. However, CBDC in the U.S. is still in its infancy. There remain unsolved issues and commonly identified obstacles. Once the world leader in digital payments and technological innovation, the U.S. is now being outpaced by its top global adversary and much of the industrialized and the developing world.