Why The US Is Taking So Long To Build A Digital Dollar

What Happened

On January 20^th 2022, the US Federal Reserve Board released its initial concept paper for a CBDC, a key innovation for the future of the dollar.  It defines a CBDC as a “digital liability of the Federal Reserve that is widely available to the general public” and as such would be “analogous to a digital form of paper money.”  The stated benefits of a US CBDC include providing households and businesses directly with a convenient electronic form of central bank money, with adequate levels of liquidity and security mechanisms.  It would offer a platform on which to innovate financial products and services, advancing faster and cheaper payments domestically and internationally, and promoting financial inclusion.  

On the other hand, a US CBDC also poses risks and policy questions with respect to its impact on the financial market structure, cost and availability of credit, financial system safety and stability, and efficacy of monetary policy.

For a US CBDC implementation to proceed, the benefits must exceed the risks.  The Fed’s priorities for a CBDC design would be to ensure privacy protections, an intermediated structure where specialized external parties would address privacy issues regarding financial transaction data, a wide transferability to ensure accessibility, and robust user identity verifications for the purposes of AML/CFT.[1]

For breaking news, market insight, and in-depth analysis, subscribe to our premium research service, Forbes CryptoAsset and Blockchain Advisor.

Key Actors

Jerome Powell Chairman, Federal Reserve

Janet L. Yellen Secretary of the Treasury; Convened President’s Working Group on Financial Markets (PWG) 

Chris Giancarlo Executive Chairman, The Digital Dollar Project; Former Chairman, US Commodity Futures Trading Commission (CFTC)

Robert Bench CEO, Boston Fed

Broader Context

CBDCs are coming, and the question is no longer if but when.  On December 8^th 2021, the House Financial Services Committee held a hearing on digital assets, largely as an educational session where Congress representatives asked questions to senior executives from the digital asset ecosystem.  One of the main concerns was how to maintain the global dominance of the dollar, particularly in the context of rapid CBDC and broader cryptocurrency developments.  Much of the regulatory discussion on stablecoins, which rose to the forefront since the initial Libra proposal[2] and continue to be a major area of focus, would also apply to a US CBDC given the parallels in structure and use cases.  

The US has been slow playing this new technology.[3]  The Fed’s concept paper had been expected since the summer of 2021, and an assessment of the costs and benefits of a CBDC was announced by Fed Chairman Jerome Powell in September.  For several months, US regulators had not even shed light on what such a digital token may look like, leading to concerns from some interested parties and suspicions of a lack of agreement on a CBDC outlook.  For instance, on January 12 Congressman Tom Emmer (MN-06) introduced a bill that would prohibit retail CBDCs accessible directly to individuals, despite the fact that the Fed had not yet released its initial CBDC concept paper. 

While Washington’s response to the first wave of the Internet in the 1990s was to “do no harm,” the response to the rise of digital assets has often been to revert to the status quo, as opposed to a dynamic regulatory approach that adjusts with innovation.  The US President’s Working Group on Financial Markets (PWG) released a Report on Stablecoins in November of 2021, proposing recommendations^[4] that are unlikely to be implemented soon and point toward maintaining the existing regulatory structure.  Although the report accurately discussed requirements for issuance, systemic risks, and potential shortcomings of digital money as it becomes a matter of public interest, it didn’t fully identify the opportunities of the Internet of Value to modernize the financial system.

The PWG report represents a step toward greater harmonization of a regulatory approach, as it involved collaboration with the OCC and the FDIC in the context of a very fragmented regulatory landscape.  Without a cohesive national policy or single supervisory body for digital asset activities, several US agencies at the federal and state level hold various degrees of oversight over digital asset activities.  These agencies also vary in their approach to digital assets, ranging from enforcement actions,[5] bespoke state-specific regulatory regimes,[6] interpretive letters,[7] etc.  This regulatory landscape is unlikely to change and despite the challenges, may be beneficial with the right level of collaboration among agencies.

In the long run, it could be argued that having multiple regulators promotes healthy competition leading to better regulatory responses.  The very strength of the US capital markets historically has depended on its robust regulatory framework, which has upheld the standards of security, credibility, and competitiveness that provided the dollar with the credibility to become accepted as the world’s reserve currency.  With respect to digital assets, several US regulators have devoted significant time and resources to understand the space and support its growth.  

For instance, the Boston Fed has been collaborating closely with MIT to develop technical standards for a US CBDC.  Project Hamilton developed a platform for testing operations and experiment with several CBDC features.  The New York Fed also launched a New York Innovation Center (NYIC) to collaborate with the Bank for International Settlements (BIS) Innovation Hub, the Federal Reserve System, and experts from the public and private sectors to design and experiment with CBDC related innovations.  The Digital Dollar Project has conducted several US CBDC use case pilots in the spirit of Web 3, in collaboration with Accenture and other key stakeholders.  Initiatives like these can ultimately draw on the Fed’s concept paper as a thoughtful analysis and further step toward key stakeholder alignment.

“The Digital Dollar Project commends the Federal Reserve’s CBDC policy paper.  As our nation takes up exploration of a US Central Bank Digital Currency, we must ensure that the values that are enshrined in the dollar today – global acceptance, stable economics, the rule of law, free enterprise, freedom of speech, and yes, individual privacy – are embraced in the digital future of money.”            

–     Chris Giancarlo, The Digital Dollar Project

Key Numbers

The dollar has maintained, and even strengthened, its global presence in the recent year, reaching 12-month highs with the start of 2022.  Data from record US annual economic growth in decades, US labor costs and steady yields, as well as the relative performance of other world currencies, all support a market consensus for a strong dollar going well into 2022.  According to IMF data, dollar denominated currency reserves globally have risen from 6,927.23B in Q3 2020 to 7,081.39B in Q3 2021.  Yet over a longer term, the percentage of total foreign exchange reserves in dollars has declined consistently, from 71% in 1999, the year the Euro was launched, to 55% in Q3 2021.

Official Foreign Exchange Reserves by Currency (US Dollars, Billions)

The foundations being set for the Internet of Value, where money can be exchanged much like email, also rely on the dollar as a main currency of the Internet.  CBDC implementations around the world will need interoperability with the existing dollar-based infrastructure.  Even today, most stablecoins are already pegged to the dollar and hold their reserves in commercial banks, which ultimately depend on the US banking system and the Fed.[8]  The vast majority of stablecoin reserves are held in dollars.  Tether, USD Coin, and Binance USD are the three major stablecoins by market cap, representing close to $120B combined.  Hence many DeFi applications built with these stablecoins point to the concept of CeDeFi (centralized decentralized finance).

Top Stablecoins by Market Capitalization (Billions)

Outlook and Implications

A tokenized form of the dollar would be expected to future proof its strength and determine its trajectory as the world’s reserve currency.  A stronger reserve currency benefits the US not only by lowering transaction and borrowing costs for US persons and businesses, but also by preserving US influence on the global monetary system.  This implies upholding the underlying values of free markets and individual freedoms that have been key to US governance and are likely to guide the design features of a US CBDC.  The Fed, Treasury, and national security agencies will likely have a prominent role in the trajectory of sovereign digital money.[9]

A US CBDC would directly provide households and businesses with a convenient, electronic form of central bank money.  Although not explicitly stated by the Fed and still pending further discussion, this seems to suggest a retail model where individuals could access central bank money directly through digital wallets, rather than a wholesale model where access to such accounts is reserved to commercial banks.  Central bank money is considered the safest form of money as a direct liability of the Fed, as opposed to commercial money and nonbank money, which require deposit insurance to ensure public confidence, and also backing by an underlying pool of assets to maintain value respectively.  Physical currency is the only form of central bank money available to the public today.[10]  Thus, a US CBDC has the potential to provide be the safest digital asset available to the public, with no credit or liquidity risk associated with it.

The openness of the US economy, depth and liquidity of its financial markets, and stability of governance structures have contributed to the credibility of the dollar as the most widely used currency for payments and investments around the world.  As traditional financial market infrastructures transition toward increasing digitalization and disintermediation, the strength of the dollar would also determine the strength of a US CBDC for such use cases.  Automation will increasingly facilitate transactions across all types of assets through tokenization, and the role of a US CBDC would likely take up center stage in this context.  Financial infrastructure plumbing and software are already shifting toward open systems that allow sharing of information across participants.

As the Internet of Value becomes a matter of national interest, the network effects of relying on the dollar would support further use cases for a US CBDC.  The specific role of CBDCs in the context of stablecoin and DeFi developments is yet to be determined and will largely depend on these network effects in addition to design features.  A US CBDC would preserve the use of the dollar, and thus its international role, with the advent of digital money.  The future of money points to a world of multiple complementary currencies, likely both sovereign and non-sovereign, coexisting to facilitate the provision of tailored user-centric financial products and services.  These solutions will enable a truly global and inclusive financial system that will benefit all.

At this point, however, the Fed does not intend to support any policy outcomes or take any steps toward CBDC issuance without clear support from the executive branch and Congress, preferably through an authorizing law.  Thus, the concept paper is the first step in a broader public discussion on CBDCs in general, as well as the specific risks, benefits, policy considerations, and design of a US CBDC.  Moving ahead, the Fed intends to engage key stakeholders from the public and private sectors through a notice and comment period, where the public can submit responses to a questionnaire by May 20, 2022.  The resulting discussion will provide input for the Fed as it proceeds to explore design options and implementations for a US CBDC.  

Decision Points

A successful US CBDC implementation would ensure functionality and complementarity with existing forms of money and financial services.  Future proofing the dollar implies a strong sense of responsibility and will involve a gradual, thoughtful process that goes beyond merely defining design priorities.  A broader mindset is key in order to enable adequate stakeholder alignment and underlying infrastructure.  This would require clarity with respect to the following:

·      Consistent Regulation: Harmonized rules, whether or not under a single entity, require a mature commensurate framework that is dynamic and principles based.  Regulators need to move beyond focusing on how to classify the activities and assets being traded and lent, which only assesses which of the various state and federal agencies have jurisdiction and how to apply it.  There needs to be a clear sense of parity, where digital asset innovations can be treated as delivering traditional functions through digital mechanisms, and thus treated under existing frameworks.  Rule of law is fundamental for credibility and security from fraud and manipulation.

·      Robust Public Private Partnerships:[11]  Central banks and private banks need to collaborate closely on implementation and agree on standards, privacy, security, identity, and interoperability. Alignment across stakeholders is fundamental.  Otherwise, a purely public sector approach, where CBDCs would only be available through Fed accounts, could destabilize the current two-tiered banking system and how people access financial services.  It would forego the technological competitiveness of the private sector.  On the other hand, a purely private sector approach could easily be deemed unregulated and non-compliant with safety and security measures which are key to managing risks and ensuring sustainability.  

·      Adequate Financial Market Infrastructure: The plumbing, and processes to support automated transactions require a modernized financial system.  A widespread adoption of a US CBDC would require important shifts in underlying market infrastructure.  The Principles for Financial Market Infrastructures (PFMIs) established by the Committee on Payments and Market Infrastructure (CPMI) of the Bank for International Settlements (BIS) and the International Organization of Securities Commissions (IOSCO) have set 12 standards that preserve financial stability.  These principles should be taken into account, especially in the context of lessons learned from the 2008 financial crisis, so as to reduce systemic risk and prevent financial breakdowns.  For instance, the role of role of narrow banking where deposits are fully backed by central bank reserves,[12] and the ability to transact within and across blockchains[13] could be key considerations.  

·      Privacy: Data from customer transactions, as well as personal identification data about customers, should be safeguarded, with privacy treated as a public good.  The Fed has yet to clarify this with respect to the government’s ability to collect this data and make use of it, especially since the US CBDC concept paper does not seem to support a KYC threshold where transactions below a certain amount would be fully anonymous, but would rather require customer identification for every transaction.  Without adequate privacy protection mechanisms, users may become incentivized to adopt other cryptocurrencies for specific transactions as opposed to a US CBDC, which would undermine the dollar.

Further Reading

·      Money and Payments: The US Dollar in the Age of Digital Transformation

·      President’s Working Group Report on Stablecoins

·      House Financial Services Committee Hearing on Digital Assets

·      Philadelphia Fed Panel: Crypto, DeFi, and Quantum Computing Discussion

·      Exploring a US CBDC

·      Principles for Financial Market Infrastructures

·      Digital Dollar Project Statement Regarding the Federal Reserve Board’s Central Bank Digital Currency Discussion Paper

·      Blockchain Intra- and Interoperability

·      Parasitic Stablecoins

[1] Anti-Money Laundering/Combating the Financing of Terrorism controls, when implemented effectively, not only mitigate the economic impact of criminal activity but also promote financial market integrity and stability.  These rules include customer due diligence, recordkeeping, and reporting requirements.

[2] Regulators at a global level voiced concerns on the implications of a global stablecoin with respect to issues like privacy, monetary policy, and financial stability.  

[3] Declining trust in institutions, particularly financial institutions, largely spurred the momentum toward digital asset growth, separate from regulators.

[4] Recommendations include calling Congress to define who can issue a stablecoin, which would be unlikely to take place soon.  The report also calls the Financial Stability Oversight Council to research systemic risks of stablecoins, which would likely be a gradual process.

[5] The Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) have asserted jurisdiction over certain aspects the digital asset space through enforcement actions.  They have also established FinHub and LabCFTC respectively, as offices focused on engaging directly with innovators and providing support on conducting operations in a compliant manner.

[6] The New York State Department of Financial Services has established the BitLicense, which requires robust regulatory compliance standards for digital asset activities.  Wyoming has enacted over a dozen bespoke crypto and blockchain friendly pieces of legislation, aimed to attract these activities to the state.

[7] The Office of the Comptroller of the Currency (OCC) has released a series of interpretive letters clarifying the applicability of existing regimes to digital asset activities.

[8] In 2020, stablecoin volumes traded on-chain aggregated to $1 trillion, which would comprise a growing shadow banking sector that remains largely anonymous and outside the purview of financial regulations (Swanson, 2022).

[9] Other agencies like the SEC and CFTC are likely to continue their focus on regulating other cryptocurrencies as forms of non-sovereign digital money.

[10] Commercial banks today also have access to central bank money through digital balances at the Fed, but this is not available to the public.

[11] Two historical examples of public private partnerships are the Manhattan Project and the early Internet.  The Manhattan Project in the 1940s involved a period of research and development, leading to a highly coordinated strategy and cross-country collaboration that brought forth the first nuclear weapons to bring an end to World War II.  The advent of the Internet in 1969 came from research and development in an emerging discipline, initially funded by the US Defense Advanced Research Projects Agency (DARPA), that led to distributed commercial networks and basic protocols on which to build applications with various functionalities including interoperability across countries.

[12] Narrow banking studies have shown no negative impact on economic growth, but rather more robust risk mitigation mechanisms with respect to excessive lending activity that may exceed deposit insurance available in the banking system (Grasselli & Lipton, 2019).

[13] Blockchain intraoperability would enable automated transactions within a blockchain enabled by smart contracts, while interoperability would allow exchanges across different blockchains and systems, including legacy systems (Lipton & Hardjono, 2020).