The Federal Reserve is set to release a much anticipated discussion paper on the prospect of a digital U.S. dollar. According to the Bank for International Settlements (BIS), over 86 percent of central banks are investigating the possibility of a digital currency. Although China began a trial for its digital yuan in four cities in 2020, the Commonwealth of the Bahamas was the first to formally issue a sovereign digital currency, known as the Sand Dollar. In our article, Sovereign Digital Currencies: Parachute Pants or the Continuing Evolution of Money, we explore the budding dynamic between cryptocurrencies, particularly stablecoins, and central banks that are now investigating the potential of the launch of their own digital currencies to fend off nascent competition from cryptocurrencies and to retain control over monetary policy and sovereignty. This contest is situated within the broader international quest to be the preeminent sovereign reserve currency (currently the U.S. dollar). We also investigate several implications of a digital U.S. dollar for the financial system, including possible bank disintermediation, loss of privacy, and increased cybersecurity risks. In this post, we focus on the disintermediation potential of a global stablecoin for national currencies and central bank digital currencies (CBDCs) for banks.
Stablecoins are asset-backed cryptocurrencies. They developed in response to the extreme volatility of cryptocurrencies that are not backed by any central authority or assets. For example, Bitcoin’s price dropped 30 percent in less than 24 hours on May 19, 2021.
Money has three generally accepted attributes. It functions as a medium of exchange, store of value, and unit of measure. The advantage of stablecoins is that, unlike most cryptocurrencies, they can retain their value and serve as an alternative to money. The four primary categories of stablecoins are those backed by 1) a national currency or basket of national currencies, 2) a commodity, 3) another cryptocurrency, or 4) smart contract algorithms designed to control supply and maintain the coin’s value. A global stablecoin would be available and acceptable across multiple jurisdictions.
Should a global stablecoin be issued, such as the Diem, it could pose significant risks to the international financial system. It might compete with and disintermediate national currencies domestically and internationally by serving as a money alternative for global payments. Indeed, just as the shadow-banking system, which relies on asset-backed money-like claims (repurchase agreements), coexists with the traditional banking system, a privately-created money-like stablecoin payment system might coexist with the traditional national currency-based global payment system.
At the very least, the future payments landscape is almost certain to include multiple CBDCs. The BIS has called for global cooperation by central banks on digital currency development, and CBDCs are a focus of its Innovation Hub. Along with the central banks of Australia, Malaysia, Singapore, and South Africa, it plans to test CBDCs in international settlements. While no single definition of a CBDC exists, a 2020 IMF Working Paper stated, a “CBDC is a digital representation of a sovereign currency issued by and as a liability of a jurisdiction’s central bank or other monetary authority.” There are numerous forms that a CBDC could take.
The current system of money creation in the U.S. has been termed a “franchise” arrangement. Money exists in physical (cash or currency) and digital (central bank money and commercial bank money) forms. Both the Federal Reserve and commercial banks create money via digital accounting entries, and each backs the money it creates. Most banks carry FDIC deposit insurance, guaranteeing that amounts of $250,000 or less “are as sound as a central bank liability.” Additionally, banks experiencing liquidity problems can turn to the Federal Reserve for last-resort lending assistance. However, only banks (and a few additional institutions) are currently permitted accounts at the Federal Reserve. These accounts provide access to central bank money.
As we discuss in our article, a number of design choices would need to be made prior to the Fed issuing a CBDC. For example, a one-tier direct CBDC could be provided directly by the central bank to customers in either a token or an account form. This design presents the greatest risk for the disintermediation of banks. The introduction of such a CBDC by the Federal Reserve potentially risks upending the current system of money creation in the U.S. as the central bank, a risk-free counterparty, would compete with commercial banks for deposits. The result would likely be bank disintermediation, new risks to financial stability, and an increased amount of credit allocation by the central bank. To attract deposits, banks would need to offer more lucrative terms to depositors than the central bank does. In times of crisis, deposits would almost certainly flee from risky banks to the Federal Reserve. This foreseeable dynamic would create a new source of bank runs and increase risks to financial market stability. As the Federal Reserve’s liabilities increased with CBDC deposits, there would be a corresponding increase in the asset side of its balance sheet. The central bank already holds a sizable amount of U.S. treasuries and agency mortgage-backed securities. Its notable footprint in these markets risks distorting prices and creating shortages of “safe collateral” in financial markets. Indeed, policymakers at the Federal Reserve anticipate tapering of asset purchases in the coming months. Yet, were the central bank to issue a CBDC, its balance sheet would inevitably and significantly increase. As a result, the Federal Reserve’s role in credit allocation would expand considerably.
The global landscape of payments and money is changing. The advent of cryptocurrencies such as stablecoins and the increasing interest in CBDCs are poised to challenge established arrangements in the financial system. The outcome of the coming clash is uncertain. Whether the foreseeable disintermediation potential of global stablecoins for national currencies and of central bank digital currencies (CBDCs) for banks ultimately results in the demise of systems, coexistence of parallel systems, or novel public-private payment or monetary partnerships (coalitions) remains to be seen.
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This post comes to us from professors Kimberly A. Houser at the University of North Texas and Colleen Baker at the University of Oklahoma. It is based on their recent article, “Sovereign Digital Currencies: Parachute Pants or the Continuing Evolution of Money,” forthcoming in the NYU Journal of Law and Business and available here.