The first heavyweight paper weighing the pros and cons of a digital currency is doing the rounds after release by the US Federal Reserve.
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Many governments, including Britain, are flirting with the idea of a central bank digital currency (CBDC) but have yet to go beyond the research stage.
The Fed does not recommend a CDBC strategy but wants stakeholders and the public to give their views about going digital.
A CDBC is the digital equivalent of the cash in your pocket but is tied to a blockchain like a cryptocurrency, but with some key differences.
For instance, a CBDC lets someone spend or transfer their cash without a bank account.
The US Federal Reserve study into the benefits and problems of a digital dollar is available at last but disappointingly does not consider if the idea of a CBDC is good or bad for the economy.
The Fed says the barebones report is the first step on the way to a digital currency but refuses to recommend a policy, instead inviting Congress and the President to make a decision.
“We look forward to engaging with the public, elected representatives, and a broad range of stakeholders as we examine the positives and negatives of a central bank digital currency in the United States,” Federal chair Jerome Powell said.
A CBDC is a million miles away from the wild frontier of unregulated cryptocurrencies.
The big difference between the two opposites is regulation.
A CBDC is a stable coin pegged to the value of a currency controlled by a government’s central bank.
The Fed has already committed to a FedNow service delivering an around-the-clock interbank payment system in real-time.
Technological advances in cryptocurrencies, digital wallets and smartphone apps have prompted the Fed to explore the risks and benefits of issuing a CBDC.
Policymakers want to know how a CBDC would work, asking questions about:
- The benefits and risks of a CBDC for households, businesses and the broader economy
- How a CBDC fits into the US financial system
- How to protect digital funds from fraud and theft
A CBDC is similar to other cryptocurrencies, like Bitcoin and Ethereum.
The principle is digital currencies are hosted on a blockchain. A blockchain is an online database hosted on a network that updates in real-time.
Each block on the chain contains the details of several transactions in the order they were called.
Each block has a unique hash that confirms the transaction as genuine.
The difference between the blockchain and a standard database is the blockchain has no administrators. This stops someone from altering the data because the blockchain automatically updates every computer on the network, and every user can see every transaction.
The Fed says the public could have the utmost trust in a Fed backed CBDC because it does not depend on underlying assets or insurance to maintain value.
The study sees to ways of running a CBDC:
- The Fed directly holding accounts and digital wallets taking on the role of a retail bank
- The Fed acting as an intermediary with retail banks managing accounts and digital wallets
Is a CDBC better than adopting a cryptocurrency as a payment system?
The answer depends on whether you are a crypto speculator or an ordinary joe.
Speculators love the unregulated crypto market because uncertainty triggers volatility in the value of crypto, leading to opportunities to make money.
Big business would prefer to force customers to play in a walled garden that they control, like the ill-starred Facebook LIbra, which comes with some onerous restrictions on where and how the stablecoin could be spent.
A CBDC is a stablecoin. A stablecoin has little fluctuation in value and presents speculators with little chance to profit in the margins. As a regulated financial service, a CDBC is beyond the control of any person, group or business.
For expats, a CBDC offers an opportunity to streamline cross-border payments.
People don’t like spending hard cash. Governments around the world are reporting money is going out of fashion, and the number of cash payments is diminishing, says the Fed, giving some examples:
- In the US, consumers only spent cash in one in five payment transactions
- Cash accounts for 10 per cent of payments in Sweden
- Half of all point-of-sale (POS) payments in China are electronic, while cash accounts for one in eight transactions
While the Fed report focuses on the benefits of introducing a new digital dollar, inevitably, the authors also examine the financial and economic risks of introducing a CBDC.
One concern is how a CBDC would impact the structure of the US financial system. For example, the Fed realises a CBDC neatly replaces commercial lending and could suck money out of the banking system if an interest-paying CBDC was available.
This could lead banks to introduce higher fees for services to make up for lost revenue. The Fed also points out a non-central bank digital currency could have the same impact on traditional banking services.
A CBDC would also become a reliable store of value for risk-averse consumers. However, the ability to quickly move money from hard cash to a digital format could trigger a run on a bank in times of financial stress.
The Fed study argues a CBDC would need to quell privacy and security concerns for consumers.
“Although securing CBDC would be challenging, a CBDC could enhance the operational resilience of the payment system if it were designed with offline capability, that is, if it allowed some payments to be made without internet access,” says the study.
“Many digital payments today cannot be executed during natural disasters or other large disruptions, and affected areas must rely on in-person cash transactions. Central banks are currently researching whether offline CBDC payment options would be feasible.”
The US Federal Reserve is not the only central bank exploring a digital payment system. It’s thought around 90 countries are developing their own CBDC.
The tiny Central American republic of El Salvador has already adopted bitcoin as a currency alongside the US dollar.
China, Japan and the UK are all following the same path, although they are at different stages along the route.
China has already outlawed trading in cryptocurrency and banned private exchanges in what is seen as preparatory steps for a CBDC.
The Bank of England is planning a similar consultation to the Fed later this year.
Japan has hinted a CBDC is on the way this year and is readying for a test project.
Alongside the consultation, the Fed is also running separate research investigating the technology aspects of running a CBDC.
THe FEd is moving ahead with CBDC plans for fear of being left behind by China and other countries that could weaken the US dollar’s position as the world’s de facto reserve currency.
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