The Board of Governors of the Federal Reserve System (FED), on Jan. 20, 2022, released Money and Payments: The US Dollar in the Age of Digital Transformation, discussing the potential of a US central bank digital currency (CBDC) improving domestic payments systems.
This article gives comprehensive coverage of all matters discussed in the paper.
The Fed defines the United States’ existing forms of money as a currency used as means of payment, store of value, or unit of account. The agency lists three subtypes:
In particular, the Fed evaluates the cons of commercial bank money, which offers little credit or liquidity risk due to the following factors:
However, the Fed further states that it considers central bank money the safest form of money because it carries neither credit nor liquidity risk of the other two money forms.
The US payment system links financial institutions, businesses, and households. The most common method used is interbank payment services, such as wire transfers and ACH networks that move money from one bank account to another.
Interbank payment services are crucial for the financial system and the economy’s functioning and stability. The Fed supervises firms that conduct interbank payment services, while systemically important payment firms are subject to even higher supervision and regulation.
Since central bank money carries neither credit nor liquidity risk, its payment systems tend to underpin interbank payments as the backbone of the broader payment system. Using central bank money in recompensing interbank payments facilitates financial stability since it eliminates credit and liquidity risk in systemically important payment systems.
While the current US payment system is effective, it still faces several challenges. For instance, seven million or over five per cent of American households lack access to digital banking and payment services, while a near-twenty per cent still rely on costly financial services like money orders, payday loans, and check-cashing services. In addition, some payments, especially cross-border payments, remain slow and costly.
The challenges faced by cross-border payments are attributed to the mechanics of currency exchange, variations in the legal regimes and technological infrastructure of different countries, time-zone complications, and coordination issues among intermediaries.
Further complications are introduced by regulatory requirements linked to money laundering and other illicit activities, as well as limited competition among certain cross-border payment destinations that embolden providers to charge higher fees. Reducing these costs could improve economic growth, global commerce, and international remittances and reduce inequality.
The Fed recognizes how technological innovation led to a wave in digital assets with currency-like characteristics, such as cryptocurrencies, a combination of cryptographic and distributed ledger technologies that serves as a decentralized, peer-to-peer payment system.
The fact remains that cryptocurrencies are not yet a widely adopted means of payment in the United States. The digital currency is still subject to extreme price volatility, has stringent limitations regarding transactions, and is difficult to access without service providers. They also make consumers vulnerable to loss, theft, and fraud.
Furthermore, there is the recent innovation of stable coins or digital assets backed by other assets, such as a fiat currency or a commodity. USD-backed stable coins are widely used in facilitating trades of other digital assets, but firms are also exploring the ways stable coins can be widely used as a means of payment.
The President's Working Group on Financial Markets (PWG), along with the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC), recently published a report on payment stable coins, which notes how well-designed and -regulated stable coins can potentially create faster, more efficient, and more inclusive payment options.
However, the report also notes how an increase in using stable coins as a means of payment could raise concerns about its potential for destabilizing runs, disruptions in the payment system, and concentration of economic power. Moreover, the report highlights gaps in the regulators’ authority to limit these risks.
The Fed calls the Congress for regulatory action by enacting legislation that would subject payment stable coins and payment stable coin arrangements under a consistent and comprehensive federal regulatory framework. Such legislation would work alongside existing regulations regarding market integrity, investor protection, and illicit finance.
Central Bank Digital Currency (CBDC)
The rapidly changing landscape of digital assets in the United States has urged the Federal Reserve to consider how a CBDC might fit into the US money and payments scene. The main test of a CBDC’s potential is whether it beats other methods in addressing the many money method issues highlighted.
The Fed defines CBDC as a publicly available digital liability of the Federal Reserve. As of now, the US general public only has access to Fed notes, such as physical currency. However, a CBDC can greatly change the US payments landscape for the better by allowing the public to make digital payments without requiring mechanisms like deposit insurance or depend on being backed by another asset to maintain its value. The Fed states that a CBDC would be the safest digital asset available to the general public, with no associated credit or liquidity risk.
While no conclusions have yet been drawn on the pursue of a CBDC, analysis suggests that if one were created, a US CBDC by being privacy-protected, intermediated, widely transferable, and identity-verified.
A CBDC could potentially serve as a new foundation for the payment system and maintain the centrality of currency in a rapidly digitising economy. It could also serve as a bridge between different payment services..
As highlighted by the Fed, the potential benefits of a U.S. CBDC are:
A CBDC would enable the general public to access digital money free from credit and liquidity risk, allowing private-sector innovations to meet the future demands for payment services. In a rapidly digitising economy, the spread of private digital money could create risks for individual users and the overall financial system.
A CBDC also levels the playing field in payment innovation for private-sector firms. It allows private-sector innovators to prioritise new access services, distribution methods, and related service offerings.
Lastly, a CBDC can create new possibilities that match the digital economy’s evolving speed and efficiency, such as carrying out micropayments that traditional payment systems are not designed to facilitate.
Cross-border payments are increasingly being made across the globe. But these transactions are not particularly streamlined and require significant coordination to improve various issues, including the types of intermediaries able to access any new infrastructure and legal frameworks for dealing with cross-jurisdictional issues such as money laundering. CBDC could overcome these barriers, but significant international coordination would require addressing these problems.
A U.S.-issued CBDC could reduce the need for the dollar to be the world's de facto reserve currency or at least buffer the impact. The dollar would still provide this function but could do so with less influence and a loss in its significance.
This is possible because a U.S.-issued CBDC would lower some expenses related to using dollars in transactions. A lower cost of transactions would make it easier for businesses to use dollars from investors worldwide, and also lower borrowing costs for residents and businesses.
The dollar could continue to be used on a global scale because of the size and openness of the U.S. economy and its trustworthiness, thanks to institutions like the SEC, FDIC, and others built to protect investors and their money.
Promoting financial inclusion, particularly for economically vulnerable households and communities, through the use of digital payments to pay taxes and receive federal payments.
Digital payments are becoming a popular form of payment. The Fed is looking into creating the digital currency, and they have stated that they don’t want to get rid of cash or change it in any way. However, the Fed is still looking into the currency distribution and transaction purposes. The US might need a digital currency to keep up with other countries that have begun to transition into digital payments.
Although the introduction of a central bank digital currency (CBDC) could benefit the U.S. economy and its consumers, it comes with risks. Each of the issues described below will require additional research and analysis.
The potential risks and policies considerations of a U.S. CBDC are:
A CBDC would fundamentally change the structure of the financial system. One of its effects would reduce the aggregate amount of deposits in commercial banks and make loans less available or more costly for businesses and households.
If there were an interest-bearing CBDC: it could draw away funds from other low-risk assets, such as money market mutual funds, Treasury bills, and other short-term instruments. A shift away from these other low-risk assets could result in less credit availability or higher credit costs for businesses and governments.
A U.S. CBDC may affect the financial system's stability because it may make runs on financial firms more likely or more severe. Measures traditionally taken to prevent or stop such panics, such as allowing people to keep their money in banks or loans from banks, may not be enough to stave off large outflows of commercial bank deposits into a U.S. CBDC in the event of a financial panic.
In a general-purpose central bank digital currency, data about each user’s financial transactions would be generated in the same ways as today. In an intermediated central bank digital currency model, intermediaries would address privacy concerns by leveraging the existing tools to create and store data.
Financial institutions and other regulated entities in the United States must comply with a robust set of rules designed to combat money laundering and the financing of terrorism. These entities should have private-sector partners with established programs to help ensure compliance. A U.S. CBDC should also be designed to facilitate compliance with these requirements.
Threats to existing payment systems such as operational disruptions and cybersecurity risks would also apply to a U.S. CBDC. Creating a U.S. CBDC would require investments in infrastructure, but taxpayers would not have to absorb these costs since they would likely be recouped by the private sector. Any payments technology could potentially be shut down, including mobile phones and the internet, but some offline alternatives are being considered for a U.S. CBDC as well.
Under the current monetary policy regime that pegs interest rates to a standard level, the Fed influences the level of the federal funds rate and other short-term interest rates primarily through the management of reserves in the banking system. In this framework, the introduction of a U.S. CBDC could potentially impact monetary policy implementation and interest rate control by altering the supply of reserves in the banking system.
If a noninterest-bearing U.S. CBDC was introduced, demand for it likely would increase as it would be an attractive alternative to physical currency or deposit accounts. In this case, a decline in U.S. CBDC that resulted in a corresponding increase in reserves likely would only make reserves more abundant and affect the federal funds rate.
The Fed is not trying to influence any specific policy outcome, but they are signalling that they are open to the idea of issuing a US CBDC. The Fed has been reviewing this topic for the past several months, and this paper is their first step towards that.
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