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U.S. Federal Reserve Board Releases Discussion Paper on Potential U.S. Central Bank Digital Currency

On January 20, 2022, the United States Federal Reserve Board (the "Federal Reserve") released a discussion paper titled Money and Payments: The U.S. Dollar in the Age of Digital Transformation (the "Discussion Paper") examining the pros and cons of a potential U.S. central bank digital currency ("CBDC"). The Federal Reserve has stated that the Discussion Paper does not favour a particular policy outcome. Rather, the Federal Reserve hopes to begin a dialogue about whether and how to implement a CBDC.

A CBDC is defined in the Discussion Paper as "a digital liability of a central bank that is widely available to the general public". The Federal Reserve begins its discussion on the presumption that a CBDC should:

  • Provide benefits to households, businesses and the overall economy which exceed any costs and risks;
  • Yield such benefits more effectively than alternative methods;
  • Complement, rather than replace, current forms of money and methods for providing financial services;
  • Protect consumer privacy;
  • Protect against criminal activity; and
  • Have broad support from key stakeholders.

The Discussion Paper provides a description of the current state of the U.S. payment system, its relative strengths and challenges, and the various digital assets which have emerged in recent times, before delving into its principal overview of the economic context, key policy considerations and potential risks and benefits of a CBDC.

The features of a CBDC would in part depend on its design. Generally, a CBDC would enable the public to make digital payments without the credit or liquidity risk associated with many other current forms of digital assets. As a liability of the Federal Reserve, a CBDC would not require mechanisms like deposit insurance to maintain public confidence and would not be backed by an underlying asset to maintain its value.

According to the Discussion Paper, the Federal Reserve has been studying CBDCs closely for several years. Its analysis to date has found that a CBDC would best fulfill its purpose by being privacy-protected, intermediated, widely transferable and identity-verified.

  • Privacy-protected: A CBDC would need to effectively balance consumer privacy rights and the transparency necessary to deter criminal activity.
  • Intermediated: Private-sector businesses would offer accounts or digital wallets to facilitate CBDC holdings and payments, using the private sector's existing privacy and identity-management frameworks, leveraging the private sector's ability to innovate, and reducing the potential for destabilizing disruptions to the U.S. financial system.
  • Transferable: CBDC would need to be capable of being transferred seamlessly between different intermediaries, allowing money to move freely throughout the economy.
  • Identity-verified: The identity of a person using CBDC would need to be verified by intermediaries, similar to how banks and other financial institutions currently verify the identities of customers.

Potential Benefits of a CBDC

The Discussion Paper explores a number of potential benefits which could be realized by effectively implementing a CBDC:

Safely meet future needs and demands for payment services

A CBDC could provide the general public with access to digital money which is free from credit and liquidity risk, providing a safe foundation for private-sector innovations to meet current and future needs and demands for payment services. For example, a CBDC might help generate the capability to meet the evolving speed and efficiency requirements of the digital economy.

Support the dollar's international role

CBDCs introduced by foreign countries and currency unions in the future may be more attractive than the U.S. dollar in its existing form. A U.S. CBDC could help preserve the international role of the U.S. dollar by maintaining its global use.

Improvements to cross-border payments

A CBDC could streamline cross-border payments by using new technologies, introducing simplified distribution channels and creating additional opportunities for cross-jurisdiction collaboration and interoperability.

Extend public access to safe central bank money

Cash is currently the only central bank money available to the general public. If consumers increasingly turn to the use of digital payments, as has occurred in some other jurisdictions, a CBDC may be attractive due to its lack of credit and liquidity risk.

Financial inclusion

A CBDC could reduce common barriers to financial inclusion for underserved and lower-income households by reducing transaction costs.

Potential Risks of a CBDC

The Discussion Paper also explores certain potential risks of implementing a CBDC:

Change to financial sector market structures

The adoption of a CBDC could change the responsibilities of the private sector and central bank. Currently, banks largely rely on deposits to fund loans. Depending on its features, a widely available CBDC could serve as a substitute for commercial bank money, reducing the aggregate amount of deposits in the banking system. A decrease in aggregate bank deposits could result in increased bank funding expenses and credit costs and reduced credit availability in general. An interest-bearing CBDC could attract funds away from other low-risk assets, further reducing credit availability or raising credit costs for businesses and governments.

Safety and stability of the financial system

As a form of central bank money, a CBDC would be attractive to risk-averse actors, particularly during times of financial stress. The ability to quickly convert other forms of money into CBDC could amplify the impacts of financial panic. Traditional measures such as prudential supervision, government deposit insurance and access to central bank liquidity may be insufficient to prevent large outflows of commercial bank deposits into CBDC.

Efficacy of monetary policy implementation

Monetary policy implementation and interest-rate control could be impacted by introducing a CBDC. If a CBDC is non interest-bearing, the level and volatility of the public's demand for CBDC might be comparable to other factors that affect the quantity of reserves in the banking system. Over the long term, the Federal Reserve might have to increase the size of its balance sheet to accommodate CBDC growth, similar to the balance sheet impact of issuing increasing amounts of physical currency. A surge in demand for CBDC could push the aggregate quantity of reserves in the banking system below the "ample" level and put upward pressure on the federal funds rate.

The effect of an interest-bearing CBDC on monetary policy implementation would be more pronounced. The demand for CBDC could be substantial if consumers, businesses and other actors decide to reduce their bank deposit, treasury bill and money market mutual fund investment holdings and increase holdings of CBDC. 

Foreign demand for CBDC, changes in interest rates and other market factors could also affect public demand for CBDC and present challenges for managing federal reserves and effectively implementing monetary policy.

Privacy and data protection and the prevention of financial crimes

Privacy concerns regarding the data generated from CBDC users’ financial transactions would need to be addressed by intermediaries with existing tools. Similarly, a CBDC would need to be designed in a manner allowing for compliance with anti-money laundering and counter-terrorism financing rules.

Operational resilience and cybersecurity

A CBDC network could have more entry points than existing payment services, making it difficult to design appropriate defences to the threats of operational disruptions and cybersecurity risks. Conversely, a CBDC could improve the payment system's operational resilience if it were designed with offline capability, allowing it to function during natural disasters or other large disruptions.

Seeking Comment and Next Steps

Implementing a CBDC would be a significant innovation. The Federal Reserve has stated it will only take additional steps towards developing and implementing a CBDC if there is support from the executive branch, Congress and the broader U.S. public.

The Discussion Paper concludes by requesting responses to a series of questions on the benefits, risks and policy and design considerations of a CBDC. Comments will be accepted for a 120-day period. The results of this consultation, as well as targeted outreach and public forums to foster a broader dialogue about CBDC, will determine the next steps taken by the Federal Reserve.

CBDC in Canada

The Bank of Canada has also been actively researching and publishing on various issues relating to CBDCs. Timothy Lane, Deputy Governor of the Bank of Canada, has stated that the COVID-19 pandemic has added increased urgency to the Bank of Canada’s work to explore a CBDC.[1] However, this work is still in the planning stages and the Bank of Canada has stated that it does not have any current plans to issue a CBDC.[2] 

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