New Federal Reserve Papers on CBDC: Key Takeaways for Community Banks

The Federal Reserve Board recently released its long-anticipated report on how the U.S. might advance towards an “age of digital transformation” with a future central bank digital currency (CBDC).

With the separate Federal Reserve Bank of Boston and MIT Digital Currency Initiative following up with initial findings of their research on CBDC implementation, we’ve distilled the key takeaways of both efforts for community bankers.

Proceeding Cautiously

The Federal Reserve is cautious about a U.S. digital currency. In its paper, the Fed signaled that if the central bank were to issue a digital dollar, it would be intermediated by “commercial banks and regulated nonbank financial service providers.”

ICBA appreciates that the Federal Reserve recognizes the vital function of the existing financial structure and supports preserving the role of community banks as economic engines of the U.S. economy.

Operations and Security

As a liability of the central bank, a CBDC would work like bank-issued digital money Americans use today, with crucial differences:

• The digital cash would be stored akin to an electronic safety deposit box or a "digital wallet" on our phone, much like Venmo or Apple Pay.
• Banks would not hold CBDC on their balance sheets. They could only lend against it if the CBDC is deposited into a bank account, thereby converting it into commercial bank money and liability of the bank.

The report also stressed the need to safeguard consumers’ privacy rights while balancing the transparency necessary to deter criminal activity.

As the Fed contemplates a CBDC and design options, ICBA recommends a layered approach built on the traditional banking system, which could enhance privacy and data security.

Benefits of a Future U.S. CBDC

According to the report, a future U.S. CBDC would benefit the financial system by:

• Extending public access to central bank money that is free of credit and liquidity risk in a rapidly digitizing economy, including the proliferation of cryptocurrencies and stablecoins, while supporting monetary policy.
• Reducing friction and cost in payments, particularly for cross-border transactions.
• Promoting financial inclusion by extending financial access to the economically vulnerable in an increasingly cashless monetary system.
• Preserving the role of the U.S. dollar as the world’s reserve currency and its dominant position in international trade.

Risks of a Future U.S. CBDC

On the other hand, the Fed cited the following potential risks.

• A CBDC could affect the financial sector market structure, including by reducing credit availability and raising the costs for households and businesses.
• A widely accessible and attractive CBDC could lead to largescale bank disintermediation. In turn, a CBDC could negatively impact financial stability during periods of economic stress if not appropriately designed to mitigate these concerns.
• The introduction of CBDC could affect monetary policy implementation and interest rate control by altering the supply of reserves in the banking system.

Federal Reserve Bank of Boston-MIT Collaboration

To contribute to the debate on a future U.S. CBDC, the Federal Reserve Bank of Boston and MIT Digital Currency Initiative separately released a joint technical report and source codebase to investigate the risks and tradeoffs of various designs for digital currency.

In phase one of the multiyear research collaboration, known as Project Hamilton, the organizations tested two systems to mint a tokenized form of the dollar. They established the processor’s baseline criteria from existing cash and card volumes and expected growth rates. They also sought to surpass the existing transaction volume of interbank settlements.

The testing exceeded expectations, achieving 1.7 million transactions per second with 99% settlement finality under two seconds. However, the experiment found that distributed ledger technology would not achieve its stated objectives, because the project assumed the platform would be administered by a central actor.

The next phase will test different designs and features not included in phase one, including configurations for privacy and auditability, programmability, smart contracts, and offline capability.

Meanwhile, the open-source software (OpenCBDC) released by Project Hamilton is intended to support broader experimentation by industry experts to expand learning and sharing of a "theoretical" CBDC.

Ongoing Conversation and Our Opportunity for Input

The introduction of a CBDC would represent a significant shift in U.S. currency. However, future innovation in digitizing cash will not be without trade-offs.

Open questions on policy, technical, and currency design remain. As the first step in fostering dialogue, the Federal Reserve Board is soliciting input from a wide range of stakeholders on 22 questions through May 20, 2022.

ICBA welcomes this broad array of discourse, which includes the voice of community banks in the discussion. Community bankers who want to share views and engage in the conversation are welcome to email me directly.