Digital Dollar Design Specifics Community Bankers Should Know

By Nasreen Quibria

As the globe focuses on the rise of digital assets, the Federal Reserve is cautiously weighing whether to build a central bank digital currency (CBDC), which raises complex policy and technical considerations.

Legal Framework

Any decision to move forward with a national digital currency will first require a solid legal framework.

Federal Reserve Chairman Jerome Powell has said the Fed “would not proceed without support from Congress, and I think that would ideally come in the form of an authorizing law, rather than us trying to interpret our law to enable this.”

Beyond congressional support, a key foundational design element of a future digital dollar will be its architecture, as discussed in last month’s blog post. The Fed's operational role and the interplay with private intermediaries could have far-reaching ramifications for community banks.

Infrastructure Considerations

Infrastructure and access considerations are also design details that can profoundly affect community banks.

Central banks are deliberating between a conventional database or distributed ledger technology (DLT), a decentralized database using cryptography that would underpin the CBDC’s digital infrastructure. The technical design choice can offer varying benefits and downstream implications.

Although DLT can reduce friction in payments systems and improve the transparency of financial transactions, no central bank is likely to rely on a permissionless DLT because:

  • “Public blockchains” are entirely open to anyone joining and participating and cannot be directed by a central authority.
  • The Federal Reserve will want control over its currency, just like the fiat dollar in circulation today.
  • No community financial institution will accept a public blockchain that underlies technology used for Bitcoin and other private cryptocurrencies with full transaction viewability that can also be vulnerable to market manipulation.

Conversely, the draw of a closed or “permissioned” distributed ledger technology is programmable money, or digital currency programed with logic so it can be spent only for designated purposes. But a DLT-based CBDC that can store business logic would sacrifice anonymity.

Privacy and Transparency

Balancing the privacy and transparency of financial transactions is a crucial concern of central banks considering a CBDC.

Full surveillance and traceability will impede privacy and inhibit adoption.

On the other hand, with the heavy burden of compliance—such as “Know Your Customer” and anti-money-laundering checks—regulators and financial institutions may welcome a national digital currency that can improve visibility into the shadow economy to reduce the costs of financial crimes and national security concerns.

An added benefit of a permissioned DLT-based system is that it can preserve privacy via “controllable anonymity”—meaning small transactions can be held in private, and payment and encrypted personal data may not be disclosed to a monetary authority or other entity.

Integrating Payment Systems

Even so, the downside of DLT is it would require developing a costly transactional infrastructure.

There is already an array of efficient Federal Reserve and private-sector interbank payment systems available, including the upcoming introduction of FedNow instant payment services. Policymakers will need to consider connecting this existing safe and secure infrastructure with DLT to avoid building an entirely new payment rail.

Integrating distributed ledgers could also maintain banks as intermediaries with a decentralized two-tier model while leveraging the unique advantages of the transformational technology.

Consumer Access

Another design choice is how consumers access the CBDC.

An account-based model is tied to an identity scheme with verification linked to the account holder’s identity, such as today’s bank accounts. However, reaching demographics such as the 7 million unbanked U.S. households can be difficult.

For a CBDC to achieve its financial inclusion goals, an alternative option is a token-based (or value-based) system with dual offline capability. A token-based system combines cash-like properties with verification that relies on the sender's ability to authenticate the object's validity (the token) used to pay.

An offline-capable digital currency can create secure point-to-point transactions through the use of authorized hardware that would help ensure underserved communities, such as the 18 million Americans without access to any broadband network, are not left behind.

An added benefit of a token-based distributed ledger system is better insights and reach into the informal economic sector. With this technology, the Federal Reserve could deliver monetary or fiscal support for targeted stimulus payments during difficult times.

A two-tier hierarchical infrastructure in which community banks partner with fintech solution providers could bring significant value to promote trust and access to a digital dollar network while incorporating disadvantaged communities into the banking mainstream.

Looking Ahead

With the growing movement among major economic powers to rethink how money will be exchanged in the future and the Fed’s evaluation of a U.S. CBDC, a digital dollar may be an inevitable part of the world’s financial future.

A critical consideration will be designing a future-proof digital dollar that maintains the vital role of community banks, expands access to financial services with consideration of regional needs, and promotes resilience for all U.S. consumers.

Nasreen Quibria is ICBA vice president of emerging payments and technology policy.

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