By: Chase Tavernier
In the U.S. today, there are only two forms of central bank money available to the general public: federal reserve notes (dollar bills) issued by the Federal Reserve, and digital balances that are held by commercial banks at the Federal Reserve. However, the importance and utility of U.S. currency (the “Dollar”) greatly exceeds the mere bounds of domestic business and transactions. As of September 2022, it was reported that roughly half of all international trade was invoiced in Dollars, and half of all international loans and global debt securities were denominated in Dollars.[1] Such dominance of the Dollar in the international economy can largely be attributed to its continued strength and safety as demonstrated by the fact that the Dollar has managed to function as the world’s dominant reserve currency and preferred settlement mechanism for over half a century. [2]
Unfortunately, the future strength and utilization of the Dollar seems uncertain as an overwhelming number of the world’s central banks have recognized the popularity and utility of cryptocurrencies and have begun looking to digital alternatives to the Dollar in a widespread phenomenon appropriately titled “de-dollarization.” This phenomenon’s principal goal is to alter existing economic infrastructure by supplementing current forms of currency with digital alternatives pursuant to economic, legislative, regulatory, and political changes. An alternative that has become extremely popular in recent years are central bank digital currencies (“CBDC”).
Currently, 114 countries representing over 95% of global GDP are exploring the utility and development of CBDCs, as compared to the mere 35 countries considering them in 2020.[3] Of these 114 countries, 60 have surpassed mere exploration stages and have begun focusing on the actual development and launching of a CBDC or pilot program, and 11 countries have fully launched a form of digital currency. This data demonstrates both the sheer growth of cryptocurrency that has erupted since its creation in 2008, as well as the potential impact and influence it will have in transforming the future of money and payments. In consideration of such potential impact, this blog post will set out to explain what CBDCs are, the risks and benefits associated with establishing CBDCs, whether the U.S. will seek to institute its own CBDC, and how the U.S. should respond to the looming threat to the Dollar in international markets.
What is a Central Bank Digital Currency?
In order to properly understand what a CBDC is, one must first understand what “fiat currency” is as an underlying concept. Fiat currency is currency that is not backed by a physical commodity such as gold or silver but is rather backed by the government issuing the currency. Fiat currency derives its value from the relationship between 1) supply and demand and 2) the stability of the issuing government and its economy. Stated more simply, fiat currency derives its value from public trust and perception of the stability of the issuing government. An example of a fiat currency is the Dollar.
Turning to CBDCs, a CBDC is essentially the digital form of an issuing government’s fiat currency. A CBDC takes the form of electronic coins or accounts, as opposed to physical paper currency, and is similarly backed by the full faith and credit of the issuing government. As such, CBDCs constitute a liability on an issuing governments’ central bank, and central banks are afforded complete control over the entire digital system underlying the digital currency. Importantly, this is very different from traditional forms of digital money we are accustomed to, such as bank accounts, which instead exists as a liability on a commercial bank.
The advents of CBDCs have become extremely popular in recent years for their many associated benefits, some of the most important of which include the fact that CBDCs can provide a cheaper and more efficient alternative to other forms of digital money. This is due in large part to their capacity to be managed on a digital ledger that expedites payment processes between institutions, banks, and individuals while simultaneously charging less in fees. It is important to recognize, however, that while there may be many benefits associated with CBDCs, the general international consensus thus far seems to be to utilize them as a supplement to fiat currency (physical currency) as opposed to replacing fiat currency entirely.
What Are Some of The Negative Effects of CBDCs?
As recognized by legal scholars, there are numerous risks associated with CBDCs which could be exploited to compromise an issuing government’s financial system. First, the implementation of a country wide CBDC would require a complex privacy and consumer protection framework in order to protect sensitive payment and personal identifiable information from security threats. The foundation upon which CBDCs are built are information systems, and as such they will be subject to comprehensive legal and regulatory frameworks to meet the balancing needs between individual rights of privacy and the government’s need for transparency. This obviously raises concerns as a governmental need for transparency may differ depending on the policies and values of the issuing government’s country. The potential for abuse is enormous as issuing governments may use CBDCs to improperly monitor consumer transactions and accumulate personal information.
In addition to the potential for governmental abuse, CBDCs also present an opportunity for financial criminals due to the novelty surrounding this recent merge of monetary policy and financial technology. Without the requisite understanding of this technology, its application, and the regulatory frameworks it is guided by, threats to national security may arise pursuant to gaps in policy and standards that reduce a country’s ability to track cross-border flows of money. The failure to accurately and effectively track cross-border flows of money will undoubtedly create an opportunity for money laundering and financing of terrorism schemes, thereby posing a threat to the international financial system and national security.
Thirdly, the increasing entanglement between digital assets and a country’s financial systems poses a significant problem for commercial banks. In application, CBDCs will consist of a transference of money out of deposit accounts and into digital currency form. This transfer out will negatively affect a commercial bank’s ability to issue bank loans or lines of credit, both of which are critical bank assets that depend heavily on general bank deposits. This presents the opportunity for instability in times of economic uncertainty as a disruptive run involving significant transfers to CBDCs could cause a shrinkage of bank assets which may only further worsen any economic situation. Pursuant to this understanding, the creation of CBDCs will fundamentally change the future roles played by the private sector and central banks in financial systems.
Finally, CBDCs present a threat to the effectiveness of sanctions on foreign countries as promulgated by western countries or UN Security Council Resolutions. Such foreign sanctions are promulgated through punitive financial measures such as tariffs on goods, restrictions on purchases of foreign debt, trading restrictions, and freezes on central bank foreign exchange reserves. CBDCs threaten the effectiveness of such measures as foreign countries may seek to utilize CBDCs as an alternative to western-controlled payment mechanisms in order to nullify the harsh effects of such sanctions while also avoiding western political influence generally. Several US-sanctioned countries have even explicitly stated that they are exploring CBDCs and other digital alternatives for this very reason. Such countries include China, Russia, Venezuela, and Iran.
What Are Some of The Benefits of CBDCs?
As reported by the Federal Reserve, for the year 2018-2019 22% of Americans were either unbanked entirely or underbanked and had to seek out and utilize costly alternative financial services such as check cashing, which can range from 1-12% of the value of the check.[4] With nearly 5% of American households being unbanked entirely—many of which exist in marginalized communities—CBDCs represent an opportunity for inclusion by providing access to financial tools as a result of their associated lower transactional costs. Such inclusion will be actualized pursuant to the increased competition between financial service providers that will occur pursuant to the creation of CBDCs. Such competition will drive down the costs and burdens associated with financial services thereby making them more readily available. This will be of particular importance in many underdeveloped countries around the world, many of which traditionally limit financial services to wealthy consumers.
Additionally, as recognized in an article published by the World Economic Forum, CBDCs could also be used to assist underbanked and unbanked individuals in creating a financial identity.[5] This would be done by providing individuals with a digital wallet that could be used to establish lending history, build credit, as well as provide individuals with access to personal financial data such as income, repayment, and loan histories, among other financial information. The access and availability of such information will allow individuals to overcome transactional barriers and more readily secure personal or commercial financing.
Despite the privacy concerns discussed above, a CBDC could also be used—if properly designed—to generate information about user transactions that will assist in ensuring compliance with anti-money laundering (“AML”) and counter-financing of terrorism (“CFT”) laws. Such information has the potential to play a critical role in the future deterrence or detection of financial crimes.
Finally, as discussed above, CBDCs also have the potential to more effectively facilitate cross-border transactions which have been historically slow and expensive. This can be made possible as CBDCs involve a more disintermediated process of settlement that is not only more direct but can be done at a lower cost. However, an important prerequisite to the creation of a CBDC with effective cross-border functionality is immense international cooperation in order to establish an integrated international payment infrastructure that consists of the appropriate standards. While this may prove to be difficult, the possibilities for a more optimized business payment system seem endless where the proper underlying framework is created.
Why is the Development of A CBDC of Critical Importance to the U.S.?
As recognized above, many countries are pursuing CBDCs in order to lessen the dominance of the Dollar in the international market and to avoid the effectiveness of sanctions and western influence. Accordingly, the emergence of CBDCs, and the associated digitization and modernization of global financial infrastructures, represents a key opportunity for the U.S. to develop, or assist in developing, a technological infrastructure that has the potential for three principal effects: 1) it can preserve U.S. global financial and technological leadership and reaffirm its central role in those international realms, 2) it can counter the development of infrastructures that promote monetary sovereignty thereby ensuring the effectiveness of sanctions as well as AML and CFT laws and regulations, and finally, 3) it can further promote traditional democratic values on an international scale such as consumer privacy and free markets.
Generally, with 114 countries now considering the creation of CBDCs, a time sensitive opportunity has been presented to the U.S. to achieve these effects by aiding international standard-setting bodies in the development of policies, regulations, and guidance concerning the creation of digital currencies. As recognized by the vice chair of the U.S. Federal Reserve, Lael Brainard, the failure to appreciate this and respond to the changes in the global financial system will leave the U.S. at “risk of falling behind in the race for the future of money.”
At What Stage is the U.S. with Respect to Implementing a U.S. CBDC?
In understanding where U.S. policy stands with respect to the creation of a U.S. CBDC, one must consider several documents published in 2022 from varying sources. First, in January 2022 a discussion paper titled Money and Payments: The U.S. Dollar in the Age of Digital Transformation was released by the Federal Reserve. This paper summarized the then-current U.S. domestic payments system and digital types of payment methods and assets, therein concluding with an important discussion of the potential benefits, risks, and policy considerations associated with CBDCs. Despite ongoing research and experimentation into CBDCs, as of November 4, 2022, the Federal Reserve has made no explicit decision regarding the creation of a U.S. digital currency.
However, on March 9, 2022, the Biden-Harris administration (the “Administration”) issued Executive Order 14067 (the “Executive Order”) which explicitly outlined U.S. policy objectives with respect to digital assets. This Executive Order specifically outlined six priorities warranting consideration with respect to the future design and deployment of any U.S. CBDC. These priorities include 1) protecting consumers, investors, and businesses in the U.S., 2) protecting global financial stability and mitigating systemic risk, 3) mitigating illicit finance and national security risks, 4) reinforcing U.S. leadership in the global financial system, 5) promoting access to safe and affordable financial services, and finally, 6) supporting technological advances that promote the innovation of digital assets.
Since the Executive Order, the White House website has released two relevant documents concerning the creation of a U.S. CBDC. Both documents were released in September of 2022, one of which is titled Policy Objectives For A U.S. Central Bank Digital Currency System. This document provides further discussion with respect to the choices and limitations that should inform the design and development of a U.S. CBDC, therein expanding upon the policy objectives discussed in the Executive Order. The second document released is titled FACT SHEET: White House Releases First-Ever Comprehensive Framework for Responsible Development Digital Assets. This document explains that agencies across the government have began working together in order to develop frameworks and policy recommendations for the creation of a CBDC that advances the six priorities highlighted in the Executive Order. Furthermore, it explains that the President has since received nine reports which can be combined to articulate a “clear framework for responsible digital asset development,” paving the way for “further action at home and abroad” concerning CBDCs.[6]
Finally, on November 4, 2022 the Federal Reserve Bank of New York issued a report summarizing the results of the first phase of “Project Cedar.” This project involved research into the creation of a framework for a wholesale CBDC in the Federal Reserve context. While this project has yet to lead to any affirmative decisions by the Federal Reserve, it did reveal that blockchain technology can in fact be used to deliver faster and safer settlements on international transactions.
Conclusion
In conclusion, at this time it is not yet clear whether the U.S. will be issuing a U.S. CBDC in the future nor what form the underlying infrastructure may take. There are significant security concerns and opportunities for misuse presented by the innovative blockchain technology underlying CBDCs that must first be addressed and overcome. However, it is clear that CBDCs are likely to continue to drastically change the landscape of the international finance system. With this potential for change, it is important that the U.S. play a central role in the creation of international laws, regulations, and guidance in order to not only affirm its role as an international financial and technological leader, but also in order to promote the democratic values in which this country believes.
[1]https://crsreports.congress.gov/product/pdf/IF/IF11707#:~:text=About%20half%20of%20international%20trade,nearly%2090%25%20of%20all%20transactions.
[2] https://www.federalreserve.gov/econres/notes/feds-notes/the-international-role-of-the-u-s-dollar-20211006.html
[3] https://www.atlanticcouncil.org/cbdctracker/
[4] https://www.federalreserve.gov/publications/2019-economic-well-being-of-us-households-in-2018-banking-and-credit.htm
[5] https://www.weforum.org/agenda/2022/10/4-ways-to-ensure-central-bank-digital-currencies-promote-financial-inclusion/
[6] https://www.whitehouse.gov/briefing-room/statements-releases/2022/09/16/fact-sheet-white-house-releases-first-ever-comprehensive-framework-for-responsible-development-of-digital-assets/
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