In January, the Federal Reserve released the much-awaited report on the prospect of issuing a digital dollar. The 40-page-report was called Money and Payments: The U.S. Dollar in the Age of Digital Transformation. The report authored by seven board members of the Federal Reserve outlined the advantages and disadvantages of a central bank-issued digital currency, calling it “a highly significant innovation in American money”. Within hours of the report’s release, the stock market witnessed its worst week in two weeks, and the prices of cryptocurrencies like Bitcoin and Ethereum dropped significantly. The report underlined the advantages of a central bank digital currency (CBDC) which combines the best of both worlds – the safeguards of being backed by the central bank and the agility of cryptocurrency.
This report was welcomed by CBDC enthusiasts and advocates who looked at it as a key milestone to developing a central digital currency. The report was expected to be released in the summer of 2021 but was delayed. Even though the report extensively talks about the benefits of the digital dollar, it does not take a firm stand on the issuance of the digital dollar; instead, it leaves the issue to Congress. Feds specifically mention that they would not proceed until they receive a specific authorizing law from Congress. Currently, the Fed is taking public feedback on a list of 22 items in the report for a period of 120 days.
The mainstream adoption of cryptocurrencies, particularly Bitcoin, has piqued the interest of regulators all over the world to make their own digital currencies. According to a recent report, around 86% of central banks in the world are exploring the prospect of issuing their own central bank digital currency to protect their economy from the decentralizing effect of cryptocurrencies. The growing adoption of cryptocurrencies by major institutions, companies, and industries has challenged the monopoly of fiat currencies, which until now was the undisputed leader. But the new generation has demonstrated wide interest in cryptocurrencies due to their decentralized nature and their general mistrust in central banking institutions.
This is why central banks all over the world have become alarmed to take progressive steps for the adoption of a centralized digital currency. The US is not the first country to do this. Its competitor, China, has been envisaging its own digital yuan for quite some time now. It has invested millions in real-world trials of digital yuan in several cities such as Shenzhen, Chengdu, and Suzhou. While other countries are still deliberating the prospect, China is leading this race with its own CBDC project. China’s lead in the digital currency space could threaten the hegemony of the US dollar. However, Feds are not concerned with that because they are stressing to get this right rather than just get it done fast.
Opportunities and Risks Related to the Digital Dollar
The report highlighted that the Fed is considering an “intermediated model” for issuing digital currencies. Under this, banks and payment firms will allow people to create accounts or digital wallets where they can store their cryptocurrencies. And alternatively, the Fed can directly issue the digital currency in a centralized manner. There are several opportunities and risks associated with the issuance of central bank-backed digital currencies. CBDCs can act as a substitute for money in commercial banks which will ultimately reduce the amounts of deposits in banks and reduce banks’ reliance on that cash to fund loans. In a highly digitalized world, the digital dollar will speed up electronic payments globally and give consumers greater financial control over their money. Currently, most electronic transactions are facilitated through a large number of commercial banks and only the physical cash is backed by the central bank. The digital dollar will completely change this scene because customers can get a direct claim to the central bank as the digital dollar will be backed by the central bank. US regulators have mixed feelings towards the new CBDC. Some felt that it could pave a path to greater financial inclusion, while some were concerned about its usage for illicit purposes. Others also expressed concern over the central bank competing with commercial and private banks.
In the report, the Fed highlighted that a CBDC will offer the general public access to digital currencies that are void of credit and liquidity risks. This will make the current and future needs for payment services and give way to safe private-sector innovations. Additionally, the CBDC will generate new opportunities for cross-jurisdictional collaboration and interoperability to streamline cross-border payments by making use of new technologies. Another potential benefit of CBDC is its role in strengthening and preserving the dominant role of the US dollar internationally. They could reduce financial barriers by lowering the transaction fee that will lead to greater financial inclusion, especially serving the underbanked and lower-income households.
Some of the risks associated with CBDCs were also incorporated in the report. The Fed underlined the potential of CBDC in altering the structure of the US financial system and changing the responsibilities of both the central bank and private/commercial banks. It could also alter the broader financial system since the digital dollar might reduce the amount of physical money people actually deposit in their accounts. This will affect banks’ ability to give out loans and lend to people, businesses or organizations. Besides that, there are several privacy and data protection concerns associated with CBDCs. Storing sensitive financial customer data on the government infrastructure may lead to more cyberattacks, security threats and breaches especially from non-national entities.
The Bottom Line
The release of this new report on digital currencies is definitely exciting and demonstrates the US’ commitment to technological innovations and digital advancements. The way to create and actually implement digital currencies in the real-world is quite long and requires sustained and meticulous efforts from the regulators. It is yet to be seen how people respond to the report and what changes are further implemented to move forward.
Ian Kane is the Co-Founder at Unbanked, a global fin-tech platform built on blockchain. Kane has worked in technology & digital media for over 10 years with a heavy focus on business development, sales, and strategy. His diverse professional background enables him to bring unique insight and experience to every challenge he takes on.