Part 1
Fueled by the rise of new technology and sweeping digitization, an evolution in finance and payments is underway. As a natural component of this trend, and accelerated by the COVID-19 pandemic, the use of physical cash has been decreasing, giving way to alternative, digital mediums of exchange. The phenomenon has spurred the exponential growth of new payment companies, as well as the advent of new digital forms of currency, such as Bitcoin, Ethereum, and a host of others. Digital coins, and the underlying blockchain technology through which they are derived, are changing our notion of “money” and have created a conundrum for the traditional world of finance, regulators and businesses alike. Importantly, the phenomenon has also spurred national monetary authorities to explore digital forms of sovereign currencies (i.e., digital dollars).
Currently, more than 90 countries are actively researching, piloting and, in some cases, officially implementing a new form of government money known as CBDC (Central Bank Digital Currency). China, the world’s second largest economy, is well underway piloting its e-CNY (digital yuan), and most advanced economies, including the EU, the UK, Japan, and Canada have dedicated significant efforts to research and development.
In the U.S., the Federal Reserve recently released its long-awaited research and analysis on CBDCs, as well as the results of its Project Hamilton, a collaborative effort between the Boston Fed and MIT exploring the technical functionality and design options of a U.S. digital dollar. Fed leadership has outwardly maintained a cautious and calculated position on implementing an “e-USD”, but progress on CBDCs around the rest of the world may leave it little choice. Accordingly, on March 9, 2022, President Biden signed an Executive Order declaring further exploration of a U.S. CBDC a matter of national priority.
If a digital dollar is in our near future, it is important to consider its implications and the new risks it may pose for financial institutions. To do so, it is necessary to first understand exactly what a CBDC is and what improvements it offers to the highly digitized system of money that we currently use.
In the present day two-tiered financial system, the U.S. Federal Reserve serves as the central monetary authority, and commercial banks and financial institutions function as the custodians and operators of money. The Fed puts physical cash (USD) into circulation by issuing notes to commercial banks for distribution to the public through account withdrawals. Each USD note, or bill, is representative of a direct claim on the Fed’s balance sheet, and thus its value is established and secured by the U.S. government. It is this backing by the U.S. government that makes the USD the most widely used currency in the world.
The Fed, however, provides no retail banking services and one cannot store their money directly with the Fed. Rather, this responsibility lies with commercial banking institutions, which hold their customers’ USD, guarantee its accessibility, use it as collateral for lending (a key component of the financial system and the economy), and transfer it amongst other financial institutions to settle electronic payments and transactions.
A U.S. CBDC, or “e-USD”, would effectively serve as a U.S. bank note in digital form. Similar to today’s dollar bills, it would be issued and secured by the Fed, and represent a direct claim on its balance sheet. In some respects, it would not present much of a change from the current way money is stored and transferred, which, as noted earlier, is already highly digitized. However, it offers some significant economic benefits, and beyond simply competing with the technology advancements of monetary authorities around the world, there is good reason for the Fed to launch a U.S. CBDC. The primary benefits include:
Realizing these benefits depend on several factors, specifically the form (wholesale v. retail), architecture (e.g., retail – direct, indirect, hybrid), and infrastructure (conventional v. distributed ledger technology, or “DLT”) through which a CBDC is implemented. Notwithstanding such design options, the potential advantages of a CBDC are a worthy basis for why an “e-USD” may be coming in the not-too-distant future.
With change comes risk – risk that financial institutions have been or soon will be addressing. As governments continue to study and analyze the implications of creating CBDCs, financial institutions and commercial businesses need to also consider the potential exposures and risks associated with the adoption and implementation of this new form of money. Although there is no shortage of questions to consider, there are a few key issues that are particularly important due to the potential impacts they could create.
There is much discussion around whether a CBDC should pay interest to its holders. If the Fed issues a CBDC that carries the benefit of interest payments, it is certain to have an impact on financial institutions and commercial businesses. For example, if the CBDC pays a higher interest rate than that offered by commercial banks to their depositors, banks could (i) see an outflow of funds from checking accounts into the CBDC and would (ii) need to raise the interest rates offered to their depositors.
As a result, the cost of funding for banks would be increased by losing access to cheap funding from deposits, and having to compete with the CBDC for depositor funds by offering higher rates. In turn, this could have a ripple effect that would influence banks’ behaviors when it comes to the amount of capital on hand for lending and interest rates charged for loans. Because a CBDC with an interest rate is a potentially valuable tool for the Fed to influence economic activity, this topic will continue to evolve and receive significant focus from financial authorities and stakeholders.
With the entrance of CBDC into the monetary system, banks and regulators will need to consider the potential impacts to liquidity. The ability to quickly convert money (such as a bank deposit) into a CBDC could create an increased exposure to mass withdrawals from depository accounts (i.e., “bank runs”). In particular, this would be a concern during times of financial stress when access to central bank liquidity or deposit insurance might not be sufficient to stave off a financial panic. Although some potential solutions have been discussed such as setting caps on the total amount of CBDC an individual can hold or establishing limits on short-term accumulation of CBDC, this is a risk that is still being closely studied.
Privacy and data protection risks are already a focus for financial institutions, but CBDC can complicate these exposures. The design infrastructure of a U.S. CBDC needs to walk a fine balance between safeguarding the privacy of its users, but also being transparent enough to discourage any illegal activity. Currently, financial institutions need to comply with a plethora of rules designed to detect and prevent money laundering, terrorism financing, and other illicit activity. With the potential implementation of a CBDC, they will need to adapt their compliance systems and processes (with the help of regulators) to continue to uphold those standards, and protect customer data and privacy.
Although interest payments, liquidity, privacy and data protection are some of the primary risks to financial institutions if the Fed were to launch an “e-USD”, there are many more topics to be considered when contemplating the future impacts of a national digital currency. Some examples include: how might a CBDC affect the financial sector differently than stablecoins or nonbank currency? To what extent could it “disintermediate” traditional payments and settlements, and disrupt revenues derived from processing fees? What will the impact be on cross-border payments, and how will banks recognize and process CBDCs from other nations? How will they manage different sovereign data security and privacy requirements of foreign CBDCs?
Due to how nascent this technology is, there are no clear answers to any of these questions at this time. As governments continue to test and implement this new form of money, institutions and regulators will gain greater clarity on its impacts. For now, much is still left to be answered.
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