CBDC: Is it a good way to solve the problem?

As individuals demand faster payments, central banks, including the Federal Reserve, and non-bank entities seek to play a greater role in facilitating payments, and the payment system is undergoing profound changes. In all these exciting changes, there are also calls for the Federal Reserve to “participate in the game” and issue a central bank digital currency (CBDC) that can be used by ordinary people.

Chairman Powell recently announced that the Federal Reserve will publish a discussion paper on the benefits and costs of issuing a CBDC. I am particularly interested in this topic because I have been studying monetary theory for the past two decades, researching and writing articles about the alternative forms of the past seven currencies. My speech today is mainly about whether CDBC can solve any major problems affecting our payment system. CBDC also has potential risks, which I will mention at the end of my speech. But at this early juncture of the Fed’s discussions, I think the first priority is to understand whether the Fed urgently needs to create a digital currency. I personally highly doubt it.

In recent heated discussions on central bank digital currencies, supporters pointed out many potential benefits of the Fed’s issuance of CBDC, but they often did not ask a simple question: What problems will CBDC solve? Or, which market failures or inefficiencies require this specific intervention? After careful consideration, I still don’t believe that CDBC will solve any problems that other measures of the current monetary system cannot solve more quickly and effectively.

Before we proceed, let me clarify what “CBDC” means. In short, CBDC is a central bank liability and can be used as a tool for digital payment. Regarding the use of CBDC, I will mainly discuss general-purpose CBDC-CBDC for public use, not just CBDC used by banks or other specific types of institutions. General-purpose CBDC may exist in many forms, including some payment tools that can act as anonymous cash. However, for this speech, I will focus on the account-based CBDC, which the Bank for International Settlements recently described as “the most promising way for central bank money supply in the digital age.” Any such generic, account-based CBDC may require explicit authorization from Congress.

Central Bank Currency VS Commercial Bank Currency

It is necessary for us to note that in daily life, we use both central bank money and commercial bank money for transactions. Central bank currency (translator’s note: the currency in which the Federal Reserve is in debt) includes physical currency held by the general public (translator’s note: paper money) and digital fund accounts managed by the Federal Reserve. The funds deposited by banks into these accounts are called bank reserves, which are used for the settlement of payments between banks. In contrast, the checking and savings accounts of commercial banks are the liabilities of commercial banks, not the Federal Reserve. Calculated in terms of the amount of value used, most of the transactions conducted by American households and companies every day are based on the “money” of commercial banks as a means of payment.

Federal Reserve Account VS Commercial Bank Merchant

According to current laws, the Federal Reserve provides account and payment services to commercial banks. These accounts provide risk-free settlement assets for trillions of dollars in daily interbank payments. Importantly, the use of central bank funds to settle interbank payments promotes financial stability because it eliminates the credit and liquidity risks of the very important payment system.

Congress did not allow the Fed to directly provide accounts to the public: on the contrary, the Fed provides accounts to commercial banks behind the commercial banks, and then commercial banks provide bank accounts to the public. Under this dual structure, commercial banks act as intermediaries between the Federal Reserve and the public. The funds in commercial bank accounts are digitized and can be used to complete digital payments to households and businesses, but commercial banks promise that every digital unit in the bank account corresponds to one U.S. dollar. In short, the digital commitment of a commercial bank account is 1:1 pegged to the U.S. dollar. Based on a lot of supervision and supervision and Federal Deposit Insurance, households and companies have reason to believe that this fixed exchange rate is completely credible. Therefore, they regard commercial bank money as a perfect substitute for central bank money—they can be exchanged as a means of payment. The credibility of this fixed exchange ratio between commercial banks and central banks enables our payment system to be stable and efficient. I will come back to this point later.

This division of functions between the Federal Reserve and commercial banks reflects an economic fact: When private sector companies compete to provide consumers and companies with the highest quality products at the lowest possible cost, the market will operate efficiently. Generally speaking, the government should only directly compete with the private sector to solve the problem of market failure.

Thinking of the Federal Reserve CBDC

This brings us back to my original question: What is the problem with our current payment system that only CBDC can solve?

Will physical currency disappear? As I mentioned earlier, the key to credibility in commercial bank accounts is that the bank promises to convert the numbers in the account into real U.S. dollars. But if the physical U.S. dollar disappears, how can the bank keep its promise? Therefore, as the economies of various countries become “cashless”, many central banks are considering the adoption of CBDC. However, eliminating physical currency is a policy choice, not the result of economic operations, and Chairman Powell has made it clear that the US dollar will not be replaced by CBDC. Therefore, the fear of the imminent disappearance of physical currency cannot be a reason for the adoption of CBDC. 7

Will the coverage of the payment system be limited, and the introduction of CBDC will make the payment system stronger, more extensive and more efficient? Of course not in my opinion. Our existing inter-bank payment service covers the whole country, which means that an account holder at a commercial bank can make payments to an account holder at any other U.S. bank. The same applies to international payments-account holders at U.S. banks can transfer funds to account holders abroad. Therefore, the lack of interconnection and limited geographic breadth of the US payment system is not a good reason to introduce CBDC.

Could it be that the existing payment system is too slow? Some commercial banks have recently developed instant payment services (real-time payment services, or RTP), and the Federal Reserve is also creating its own instant payment service, FedNowSM. These services will complete the transfer of funds between account holders of U.S. commercial banks immediately after the payment is initiated. Although cross-border payments are generally not as efficient as domestic payments, efforts to improve cross-border payments have been ongoing. In the absence of CBDC, these innovations are advancing. Therefore, promoting faster payments is not a compelling reason to create a CBDC.

Could it be that too few people can be covered by existing system services? Some people believe that the introduction of CBDC will allow the unbanked population to more easily access financial services, thereby enhancing financial inclusiveness. In order to clarify this argument, we need to know, first, the size of the unbanked population, and second, whether the unbanked population will use the Federal Reserve CBDC account. According to a recent survey conducted by the Federal Deposit Insurance Corporation (FDIC), in 2019, approximately 5.4% of American households were unbanked. The FDIC survey also found that approximately 75% of the unbanked population is “not interested in bank accounts at all” or “not very interested.” If the same proportion of the unbanked population is also not interested in Fed CBDC accounts, this means that only slightly more than 1% of American households have neither bank accounts nor are they interested in Fed CBDC accounts. For me, it is hard to believe that the development of CBDC can cover this 1% of households in the simplest and low-cost way. On the contrary, we can promote financial inclusion more effectively, for example, by encouraging banks to carry out urban financial projects and widely promoting low-cost commercial bank accounts.

Do you need CBDC because of the high price of existing payment services? In order to answer this question, we need to know how to understand the high cost of payment services. In economics, the price of a service usually consists of two parts: the marginal cost of providing the service and the mark-up reflecting the seller’s market pricing power. The marginal cost of processing a payment depends on the nature of the payment (for example, paper checks vs. electronic transfers), the method used (for example, partial payment vs. real-time payment), and other services provided when processing the payment (for example, processing risks and Fraudulent service). Since these factors are mainly technical, and we have no reason to believe that the Fed can develop technologies that are cheaper than private companies, it seems unlikely that the Fed will process CBDC payments at a much lower marginal cost than existing private sector payment services.

Then, the key question is how CBDC will affect the markups that banks charge for various payment services. The markup a company can charge depends on its market pricing power and also on the level of competition it faces. The introduction of CBDC will create additional competition in the payment service market, because the public can use CBDC accounts to make payments directly through the Federal Reserve, that is, CBDC will allow the public to bypass the commercial banking system. Deposits flow into CBDC accounts from commercial banks, which will put pressure on banks to reduce handling fees or raise deposit interest rates to prevent further outflow of deposits.

However, in my opinion, private sector innovation may be more effective in reducing the markups charged by banks than CBDC. If commercial banks earn rents from their market forces, then non-bank institutions will have a profitable opportunity to enter the payment business and provide cheaper payment services to the public. In fact, we are currently seeing a large number of non-banks entering the payment market. For example, in recent years, “stable coins” have become a particularly important way for non-bank institutions to enter the payment market. Stablecoins are digital assets whose value is linked to one or more other assets (such as sovereign currencies). If the stablecoin is pegged to the US dollar 1:1 and is supported by a safe and liquid asset pool, it can be an attractive payment tool. If one or more stablecoins can develop a large user base, they may become the main challenger for banks to process payments. Importantly, payments using this stable currency may be “free” in some scenarios, such as initiating or receiving payments without any fees. Therefore, it is easy to imagine that competition from stablecoins may force banks to reduce the markup of payment services.

Please note that I am not going to support any specific stablecoins-some of them are not backed by safe and liquid assets. Therefore, the promise to convert the stable currency into 1 U.S. dollar is not completely credible, and it has not been tested in actual operation of the stable currency. There are many legal, regulatory, and policy issues that need to be resolved before stablecoins can be safely promoted. 17 However, my view is that the private sector is already developing payment alternatives to compete with the banking system. Therefore, it seems unnecessary for the Fed to promote the reduction of payment costs by creating CBDC.

Returning to the problems that CBDC may solve, people often think that the creation of CBDC will promote innovation in the payment system. This leads to a question: do we think that innovation in payment is insufficient? On the contrary, in my opinion, innovation in the private sector is developing rapidly—in fact, faster than the regulators can handle. Therefore, stimulating innovation is not a compelling reason to introduce CBDC.

Could it be that the type of innovation being promoted by the private sector is the “wrong” type of payment innovation? When I consider crypto assets (such as Bitcoin), and when I consider that crypto assets such as Bitcoin are often used to promote illegal activities, I think this argument makes some sense. However, CBDC is unlikely to prevent the use of encrypted assets designed to evade government supervision.

Could it be that the government authorities have insufficient information on the financial transactions of American citizens? In general, the government has been trying to balance the privacy of individuals with the prevention of illegal financial transactions (such as money laundering). For example, although the government has not received all transaction data about commercial bank account holders, the Bank Secrecy Act requires commercial banks to report suspicious activities to the government.

According to its design, a CBDC account allows the Federal Reserve to access a large amount of information about the financial transactions and transaction patterns of the CBDC account holder. For example, the introduction of CBDC may enable the government to monitor the economic activities of its citizens more closely. Should the Fed create a CBDC for the same reason? As far as I am concerned, I don’t think so.

The question is whether the U.S. dollar’s ​​reserve currency status is at risk, and the Fed’s CBDC is required to maintain the primacy of the U.S. dollar? For example, some commentators worry that the emergence of digital currencies in other countries’ central banks will weaken the dollar’s position. I think there is no reason to expect that the world will flock to other countries’ central bank digital currencies or any other CBDC. Why do companies suddenly want all financial transactions to be monitored by contingent foreign governments? Why does this induce foreign companies to use other currencies instead of U.S. dollars for their business and trade activities? In addition, I do not see that allowing American households to pay their electricity bills through Fed CBDC accounts instead of commercial bank accounts will help maintain the global dollar hegemony. (Of course, the use of Fed CBDC accounts by people outside the United States may promote the use of U.S. dollars, but the Fed CBDC accounts available globally can also cause serious problems related to money laundering.)

Finally, may new forms of private money (such as stable currencies) pose a threat to the Fed’s monetary policy? Many commentators believe that the new private currencies will weaken the impact of the Fed’s policy actions because they will serve as a competitive monetary system. The current pattern of the international economic community is that any country that links the exchange rate to the U.S. dollar will move its monetary policy closer to the United States and follow the U.S. monetary policy. The same logic applies to any entity that pegs exchange rates to the U.S. dollar. Therefore, commercial banks and stablecoins linked to the U.S. dollar will act as channels for U.S. monetary policy and magnify the impact of U.S. monetary policy. Therefore, if there is any difference, it is that the private stable currency linked to the US dollar has expanded the coverage of US monetary policy, rather than weakened the impact of monetary policy.

After exploring many possible problems that CBDC can solve, I came to the conclusion that CBDC is still a solution for finding problems. This will only leave us with more philosophical reasons to adopt CBDC. For example, one can argue that the public has the basic right to own risk-free digital payment instruments, which can be achieved by CBDC, but privately issued payment instruments cannot. 18 But on the other hand, due to the margin of the joint deposit, commercial bank accounts have actually provided the general public with a risk-free digital payment tool that can be used for most transactions.

One can also argue that the Fed should provide an option to digitize the dollar as an alternative to the commercial banking system. The reason is that the government should not force its citizens to use the commercial banking system, but should provide people with public services to enter the central bank. However, as I pointed out in my previous speech, the current division of functions between the Federal Reserve and commercial banks authorized by Congress reflects the understanding that under normal circumstances, the government should only compete with the private sector to solve market failures. Since the founding of the United States, this basic principle has always been beneficial, and I think CBDC is no exception.

In summary, although CBDC continues to arouse great interest in the United States and other countries, I still doubt whether the Federal Reserve CBDC can solve any major problems facing the US payment system. CBDC also has potential costs and risks, some of which I have already mentioned. I have already pointed out my view that government intervention in the economy should only be aimed at solving serious market failures. The Fed’s CBDC competition may make commercial banks no longer play the role of intermediaries and threaten the well-functioning division of labor in the financial system. Moreover, as network security issues continue to intensify, CBDC may become a new target for these threats. I expect that these risks and other potential risks of CBDC will be resolved in future discussion papers. I intend to carry out more in-depth research on the basis of the advancement of digital currencies.

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1. For example, in 2016, a co-author and I published a research paper on how to use a privately issued currency backed by a large-cap index stock to replace the publicly issued legal tender. See David Andorfato, Alexander Berenson, and Christopher Waller, Monetary Policy with Asset-Backed Currency, Journal of Economic Theory 164 (July 2016): 166-86.

2. These views are my own and do not represent any position of the Board of Governors or other Fed decision makers.

3. See the Annual Economic Report of the Bank for International Settlements (Basel: Bank for International Settlements, June 2021). Please note that any CBDC requires some kind of supporting technology. For example, many commentators considered the possibility of CBDC using “distributed ledger” operations. In addition, account-based CBDC may take different forms. For example, the infrastructure of an account-based CBDC can be designed so that the Federal Reserve can directly interact with the public, or it can be designed so that banks or other service providers can maintain all customer relationships with the public. My comment today focuses on policy issues related to the provision of CBDC, rather than the technology or infrastructure required to support CBDC.

4. The Federal Reserve also provides account and payment services to the U.S. government, certain government-sponsored companies, designated financial market utility companies, foreign central banks, and certain international organizations.

5. To this end, I use the term “commercial bank” extensively, including banks, savings institutions, credit unions, and other depository institutions.

6. See, for example, the Committee on Payment and Settlement Systems, The role of central bank currencies in the payment system (Basel: Bank for International Settlements, August 2003).

7. Physical currency can effectively disappear, and everything is still valid. All the central bank needs to do is promise to provide currency payments when needed.

8. These services will complement the existing Automatic Clearing House (ACH) payment network, which is now able to settle ACH payments on the same day.

9. Financial Stability Board, “FSB provides a roadmap to strengthen cross-border payments”, press release, October 13, 2020.

10. The main findings of the Federal Deposit Insurance Corporation “Bank of America: Household Use of Banking and Financial Services”.

11. See https://joinbankon.org/.

12. Please note that Article 11A of the Federal Reserve Act (12 USC § 248a) instructs the Federal Reserve to establish a fee schedule for its payment services. In the long run, the setting of these fees is based on all the direct and indirect costs actually incurred when the [service] is provided, including the actual collection and the project interest credited before the indirect costs, and taking into account the taxes that should have been paid and if The distribution of the calculation cost of the capital return that the service provided by the private business company should have provided…”.

13. See David Andorfato, “Assessing the Impact of Central Bank Digital Currency on Private Banks”, Economic Daily 131 (February 2021): 525-40.

14. The Fed’s long-term policy is to provide new payment services to account holders only when “other providers cannot be expected to provide [these services] with reasonable effectiveness, scope, and fairness”. See “The Federal Reserve in the Payment System” (issued in 1984; revised in 1990 and 2001).

15. A well-designed stablecoin will be similar to a “narrow bank”, which has a long tradition in economic theory, but as a competitor of commercial banks, it has never existed in any serious way. In a narrow sense, a bank assumes deposits and issues debts, in itself, much like a standard bank. However, in a narrow sense, banks only hold very liquid and very safe assets, which can fully support their liabilities. They do not lend or hold risky securities.

16. However, stablecoin payments may not be cost-free, because stablecoin users will allow their financial transaction data to be collected and monetized.

17. The President’s Financial Markets Working Group expects to make recommendations on the issue of currency stabilization in the coming months. See https://home.treasury.gov/news/press-releases/jy0281.

18. See Alexander Berenson and Fabian Schal, “Non-cases of Central Bank Electronic Money and Central Bank Cryptocurrency”, Federal Reserve Bank of St. Louis, Comment 100, No. 2 (Q2 2018).

19. See David Andolfatto “The Federal Reserve: On the Desirability of Central Bank Cryptocurrency”, Hong Kong Blog, February 3, 2015, http://andolfatto.blogspot.com/2015/02/fedcoin -on-desirability-of-government.html.


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