How’s the Great CBDC Experiment Going?

In March 2022, Joe Biden officially asked the Federal Reserve (FED) to urgently begin developing plans for a U.S. Central Bank Digital Currency (CBDC), or a so-called ‘digital dollar’. The US government is now starting to recognize the latent possibilities of the burgeoning digital asset market and hopes to use this technology to create a CBDC that will  “preserve the dominant role of the U.S. dollar.” But what is a CBDC? How does it relate to cryptocurrency, and what are the latest developments in the great CBDC experiment?

The FED defines a CBDC as “a digital liability of a central bank that is widely available to the general public.” The ‘digital’ part is not so innovative insofar as most people these days already hold money in a digital form one way or another, such as commercial bank accounts. The uniqueness of a CBDC primarily lies in the fact that it is a central bank liability rather than a classic commercial bank liability.

When a person holds money at a commercial bank, the commercial bank itself has an obligation to ‘pay out’ upon request and exchange the digital record of money for physical cash. However, in a fractional reserve banking system like ours today, banks have a limited asset pool with which to fulfill these obligations and they must rely on mechanisms like deposit insurance to maintain consumer confidence and avoid bank runs. Hence, the ‘digital money that is the liability of a commercial bank comes with a great deal of systemic instability. At any moment, an event could cause consumers to get spooked.

For a CBDC, the issuing central bank is the institution with an obligation. Unlike commercial banks, a central bank possesses a monopoly on increasing the monetary base, and thus holding a CBDC entails far fewer confidence-related vulnerabilities and no obligation to maintain an underlying asset pool since the central bank could always just issue more CBDCs. A CBDC is, therefore “analogous to a digital form of paper money” as it can be used without a “credit or liquidity risk.”

While acknowledging the huge successes and “explosive growth” of digital currencies like Bitcoin, the President expressed concern about the risks of unregulated cryptoassets for “consumer protection, financial stability, national security, and [the] climate.” In the hope of mitigating these risks, as well as “harnessing the potential benefits” in order to “reinforce American leadership in the global financial system,” Biden asked federal agencies to explore the creation of a US CBDC.

Despite these recent announcements from the U.S. administration, the FED is late to the CBDC party. In a BIS Paper, released in January 2021, 56 of the 65 central banks surveyed were engaged in some kind of CBDC development. One of the major motivations spurring central banks to continue research in this area are the “cross-border [payment] implications” of CBDCs. The FED recognized that current cross-border payments “remain slow and costly.” Improving cross-border payments relies on fully utilizing “new technologies,” which is where private crypto firms come into the picture.

The development of a CBDC is not the only form of payment modernization that could bring about improvements. A white paper written by an Arab Monetary Fund advisory group listed 3 alternatives including improvements to messaging protocols, coordination of existing RTP (Real Time Payment) systems, and the use of cryptocurrencies. 

Messaging protocols include providers like SWIFT, Revolut, and RippleNet that essentially increase the efficiency of the old-style correspondent banking model where banks use their deposits in different countries to pass-along funds through a chain of intermediaries to the final recipient. 

‘Coordinating RTP systems’ is the approach taken by providers like The Clearing House and is based upon promoting cross-border interoperability between instantaneous, domestic payment systems. 

Finally, although usually used more often as a speculative investment, specialist cryptocurrencies designed as a payment solution, like Ripple XRP, have the potential to bypass the entire legacy payment system. They operate as standalone currencies that can be instantly passed between digital wallets across national borders.

These potential solutions are important to note because, to put it simply, CBDCs may well become redundant if one of these alternative forms of payment modernization is adopted by mainstream financial institutions. For example, major banks like Wells Fargo and J.P. Morgan are already adopting new RTP systems and the FED’s white paper even named The Clearing House’s RTP network a successful “real-time interbank payment system.” Likewise, if the court rules in favor of Ripple in a now infamous SEC lawsuit, then XRP could face fewer impediments to widespread adoption.

CBDCs are by no means faltering despite having plenty of competition in the FinTech arms race. Perhaps the most promising recent development for future CBDCs is the Project Dunbar paper, titled ‘International settlements using multi-CBDCs’, published by the Bank for International Settlements in March 2022. In this paper, BIS presents its latest project that aims to create a digital currency platform that would “facilitate cross-border transactions between financial institutions.” They have already successfully developed 2 working prototypes, including Patior.

I’m very optimistic on this matter if you dig into my paper exploring the uses of blockchain technology in the modern monetary policy you can probably find:

Although the potential of CBDCs is debatable, it is worth considering whether we should be skeptical about the idea of government-supported CBDCs and question whether they would be aligned with the general ethos of cryptocurrency.