Digital Dollar: Finding a Solution to the Problem

As the public’s demand for faster payments increases, central banks, including the Federal Reserve, need to respond. Non-bank entities are also seeking to play a greater role in facilitating payments. The payment system is undergoing profound changes. There are also calls for the Federal Reserve to “join in” and issue a central bank digital currency (CBDC) that can be used by the public. On August 5, 2021, Christopher J. Waller, a member of the Federal Reserve Board of Governors, gave a speech at the American Enterprise Institute in Washington, DC. The Institute of Financial Technology, Renmin University of China compiled the core content of this article.

As the public’s demand for faster payments increases, central banks, including the Federal Reserve, need to respond. Non-bank entities are also seeking to play a greater role in facilitating payments. The payment system is undergoing profound changes. There are also calls for the Federal Reserve to “join in” and issue a central bank digital currency (CBDC) that can be used by the public.

Chairman Powell recently announced that the Federal Reserve will publish a discussion paper on the benefits and costs of creating a CBDC. I am particularly interested in this topic because I have been engaged in monetary theory research for the past 20 years, and have researched and written articles about alternative currency forms in the past 7 years. The focus of my speech today is: Will CBDC solve any major problems affecting our payment system? There are also potential risks associated with CBDC, and I will talk about these risks at the end. But in the early stages of Fed discussions, I think the first task is to figure out whether the Fed urgently needs to create a digital currency. I am skeptical about this.

In all the recent upsurges about CBDC, advocates have pointed out the many potential benefits of the Fed’s digital currency, but they often fail to ask a simple question: What problem will CBDC solve? Or, what market failure or inefficiency requires this specific intervention? After careful consideration, I do not believe that no other measures can solve the existing problems faster and more effectively than CBDC.

Before getting into the discussion, let me first clarify what I mean by “CBDC”. In short, CBDC is a liability of the central bank and can be used as a digital payment tool. This time I will focus on general-purpose CBDC (retail CBDC), that is, CBDC that can be used by the general public, not just for banks or other specific types of institutions. General-purpose CBDC may come in many forms, some of which can serve as anonymous cash-like payment instruments. However, in this presentation, I will focus on the account-based CBDC, which the Bank for International Settlements recently described as “the most promising way to provide central bank funding in the digital age.” It should be pointed out that any such generic, account-based CBDC may require explicit congressional authorization.

Currency and account

Central Bank Currency and Commercial Bank Currency

It should be noted that in our daily lives, we use both the central bank’s currency and the commercial bank’s currency for transactions. Central bank currency (that is, the currency that is the Fed’s liability) includes physical currency held by the public and digital account balances held by the Federal Reserve Bank. The funds deposited by banks into these accounts are called reserve balances, which are used for clearing and settlement of payments between banks. On the contrary, the checking and savings accounts of commercial banks are the liabilities of the banks, not the liabilities of the Federal Reserve. In terms of value, most of the transactions conducted by American households and companies every day use the currency of commercial banks as a means of payment.

Federal Reserve Account and Commercial Bank Account

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 currency to settle interbank payments can promote financial stability because it eliminates credit and liquidity risks in the systemically important payment system.

Congress did not allow the Fed to provide accounts directly to the public; on the contrary, the Fed has always provided accounts to commercial banks, and then commercial banks provide bank accounts to the public. Under this 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 make digital payments to households and businesses, but commercial banks promise to convert one U.S. dollar in personal bank accounts into one U.S. dollar in cash. In short, the bank fixes the exchange rate between commercial bank currency and U.S. dollar cash at a one-to-one basis. Due to extensive supervision and supervision and Federal Deposit Insurance, households and companies reasonably believe that this fixed exchange rate is completely credible. Therefore, they regard commercial bank currency and central bank currency as perfect substitutes—they are interchangeable as a means of payment. The credibility of this fixed exchange rate between commercial and central bank currencies keeps our payment system stable and efficient.

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

Thoughts on CBDC

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

Will the physical currency disappear? As I mentioned before, the key to having a reliable commercial bank currency is the bank’s commitment to convert one dollar of digital bank currency into one dollar of US physical currency. But if the U.S. dollar disappears, how will the bank fulfill its promise? Therefore, as the economy and society become “cashless”, many central banks are considering the adoption of CBDC. Currency cancellation is a policy choice, not an economic result. Chairman Powell has made it clear that the US currency will not be replaced by CBDC. Therefore, worrying about the imminent disappearance of physical currency cannot be the reason for the adoption of CBDC.

Is the coverage of the payment system too limited, and the introduction of CBDC will make the payment system larger, wider, and more efficient? In my opinion, it is definitely not like that. 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 at foreign banks. Therefore, the lack of connectivity and geographic breadth of the US payment system is not a good reason to introduce CBDC.

Could it be that the existing payment services are too slow? A group of commercial banks have recently developed an instant payment service (real-time payment service, or RTP). The Federal Reserve is creating its own instant payment service FedNowSM. These services will be available to U.S. commercial bank account holders immediately after the payment is initiated. Transfer funds. Although the efficiency of cross-border payments is generally lower than that of domestic payments, efforts are being made to improve them. In the absence of CBDC, these innovations are moving forward. Therefore, promoting faster payments is not a compelling reason to create a CBDC.

Could it be that too few people can access the payment system? Some people believe that the introduction of CBDC can make it easier for people without bank accounts to access financial services, thereby improving financial inclusion. In order to resolve this argument, we first need to know the size of the population without bank accounts, and secondly, whether the population without bank accounts will use the Fed’s CBDC account. According to a recent survey by the Federal Deposit Insurance Corporation (FDIC), in 2019, about 5.4% of American households did not have a bank account. The FDIC survey also found that approximately 75% of the unbanked population is “not interested at all” or “not too interested” in having a bank account. If the same percentage of the unbanked population is not interested in Fed CBDC accounts, this means that slightly more than 1% of American households have neither bank accounts nor may be interested in Fed CBDC accounts. Developing CBDC is the easiest and lowest cost way to cover this 1% of households, which is incredible to me. On the contrary, we can promote financial inclusion more effectively, for example, through the Urban Financial Empowerment Bank project to encourage the widespread use of low-cost commercial bank accounts.

Is CBDC needed because the existing payment services are too expensive? To answer this question, we need to understand why the price paid may be considered “high”. In economics, the price of a service usually consists of two parts: the marginal cost of providing the service and the markup that reflects the market power of the seller. The marginal cost of processing a payment depends on the nature of the payment (for example, paper checks and electronic transfers), the technology used (for example, batch payments and real-time payments), and other services provided when processing the payment (for example, risk and fraud services) . Since these factors are mainly technical factors, the key question is how CBDC will affect the markups charged by banks for various payment services. The markup that a company can charge depends on its market power and thus 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 pay directly through the Federal Reserve-that is, CBDC will allow the public to bypass the commercial banking system. Deposits will flow into CBDC accounts from commercial banks, which will force banks to reduce fees or increase deposit rates to prevent the outflow of additional 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 through 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-bank institutions entering the payment field. For example, in recent years, “stable coins” have become a particularly important product in the payment field. Stable coins are digital assets whose value is related to one or more other assets, such as being linked to sovereign currencies. If a stablecoin is pegged one-to-one to the U.S. dollar and is backed by a safe and liquid asset pool, it can serve as 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 such stablecoins may be “free” because there is no charge for initiating or receiving payments. Therefore, it is easy to imagine that competition from stablecoins may force banks to reduce the markup of payment services.

Please note that I do not support any specific stablecoins-some of them are not backed by security and liquid assets. The promise of converting stablecoins into 1 U.S. dollar is not completely credible, nor has it been tested in actual operation of stablecoins. Before stablecoins can spread safely, many legal, regulatory, and policy issues need to be resolved. 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 create a CBDC to reduce down payment rent.

Returning to the possible problems that CBDC can solve, people often think that the creation of CBDC will stimulate innovation in payment systems. This makes me wonder: do we think there is insufficient innovation in the payment field? On the contrary, in my opinion, innovation in the private sector is happening quite quickly—in fact, faster than the regulatory agencies can handle it. Therefore, stimulating innovation is not a compelling reason to introduce CBDC.

However, is the type of innovation pursued by the private sector the “wrong” type of payment innovation? When I consider crypto assets (such as Bitcoin, which is often used to promote illegal activities), I see some advantages of this argument. But CBDC is unlikely to prevent the use of encrypted assets designed to evade government supervision.

The question is, do the government authorities have insufficient information on the financial transactions of American citizens? In general, the government tries to strike a balance between personal privacy and the need to prevent illegal financial transactions (such as money laundering). For example, although the government will not receive 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 obtain a wealth of information about the financial transactions and transaction patterns of CBDC account holders. Should the Fed create a CBDC for this reason? I do not think so.

The question may be that the U.S. dollar’s ​​reserve currency status is in danger. Is it necessary to create a Federal Reserve CBDC to maintain the U.S. dollar’s ​​dominance? For example, some commentators expressed concern that the availability of China’s CBDC would damage the status of the U.S. dollar. I think there is no reason to expect that the world will flock to China’s CBDC or any other country. Why does CBDC encourage non-Chinese companies to value their contracts and trading activities in RMB instead of U.S. dollars? In addition, I don’t see why letting the public pay for electricity through CBDC accounts instead of commercial bank accounts will help maintain global dollar hegemony. (Of course, Fed CBDC accounts that can be used by people outside the United States may promote the use of U.S. dollars, but the global availability of Fed CBDC accounts can also cause serious problems related to money laundering, etc.)

Finally, will new forms of private currencies such as stablecoins pose a threat to the Federal Reserve’s monetary policy? Many commentators said that the new private funds will reduce the impact of the Fed’s policy actions because they will act as a competing monetary system. It is recognized in international economics that any country that links its exchange rate to the U.S. dollar will hand over its domestic monetary policy to the United States and import 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 US dollar have acted as channels for US monetary policy and expanded policy actions. Therefore, if any, private stablecoins pegged to the U.S. dollar have expanded the scope of American influence.

After exploring the many possible problems that CBDC can solve, I came to the conclusion that CBDC is still an exploreable solution to the problem. This leaves us with more philosophical reasons to adopt CBDC. For example, one might argue that the public has the basic right to hold risk-free digital payment instruments, and CBDC will do this in a way that privately issued payment instruments cannot. However, due to Federal Deposit Insurance, commercial bank accounts have provided the general public with a risk-free digital payment tool for most transactions.

One might also argue that the Fed should provide a digital option as an alternative to the commercial banking system. The argument is that the government should not force its citizens to use the commercial banking system, but should allow the use of the central bank as a public service accessible to all. However, as I pointed out in my previous speech, the current division of labor between the Federal Reserve and commercial banks authorized by Congress reflects an understanding that the government should compete with the private sector only to solve the problem of market failure. Since its inception, this basic principle has always put the United States in a good position, and I don’t think CBDC is an exception.

In short, 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. There are also potential costs and risks associated with CBDC, some of which I have already mentioned. I have noticed my belief that government intervention in the economy should only be used to resolve major market failures. The Fed’s CBDC competition may disintermediate commercial banks and threaten the division of labor in a well-functioning financial system. Moreover, as network security issues increase, CBDC may become a new target for these threats. I expect that these and other potential risks of CBDC will be addressed in the upcoming discussion paper.


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