Options for a Digital Dollar: Central Bank Digital Currency and Stablecoins
These are innovative times for currencies and payments. Digital currencies are all the rage among technology and financial firms. Central banks, regulators, and legislatures in many countries are debating how to support innovation in digital currencies while mitigating their risks. Many cryptocurrencies are traded as speculative assets, in addition to their growing use in blockchain applications, such as non-fungible tokens for digital art. However, many of these crypto assets are unlikely to play a major role in payments because their values fluctuate wildly. The future of finance and payments is likely to include two other kinds of digital currencies: central bank digital currencies (CBDCs) and stablecoins.
Q1: What are CBDCs and stablecoins?
A1: CBDCs are digital tokens issued by central banks essentially as the digital version of their fiat banknotes. Most central banks are considering CBDCs of at least one of two varieties: retail or wholesale. Retail CBDCs would be used by individuals to pay businesses or each other, while wholesale CBDCs would be used between financial institutions. The popular discourse focuses on retail CBDCs, as these would be what the public would use. About 50 central banks are researching or developing retail CBDCs, including 10 with pilot programs. Three retail CBDCs—in the Bahamas, eastern Caribbean, and Nigeria—have already launched. In a recent report, the International Monetary Fund (IMF) noted that among six jurisdictions with advanced retail CBDC projects, the most common policy goals for a CBDC are improved financial inclusion, access to payments, payment efficiency and resilience, and payment competition.
Stablecoins are privately issued digital currencies with an exchange value pegged to currencies or other assets. Fiat stablecoins, as the name suggests, are pegged to fiat currencies like the U.S. dollar and backed by assets denominated in that currency. The stablecoin market is rapidly expanding, from a total market capitalization of $30 billion in early 2021 to more than $175 billion today. Fiat stablecoins account for more than 80 percent of that value. The market is currently concentrated among three dollar stablecoins: Tether’s USDT ($79 billion), Centre’s USDC ($53 billion), and Binance’s BUSD ($18 billion). Today these stablecoins are used primarily for trading or purchasing digital assets, but they can also be used for peer-to-peer transfers and are likely to be used as a means of payment for retail goods and services including through partnerships with widely used payment networks like Visa and if payment companies like PayPal develop their own stablecoins.
Q2: What might a digital dollar look like?
A2: The United States needs to decide whether and how to issue a digital dollar. Last month, the U.S. Federal Reserve published a long-awaited discussion paper on the pros and cons of a potential CBDC available to the general public, suggesting a focus on retail applications. The Fed has been careful to note it has not decided on whether to create a digital dollar and will not do so without clear guidance from the executive branch and Congress.
There are many design and technical issues to resolve with digital currencies. Many of these issues are already subject to experimentation, either by technology firms, foreign central banks, or the Boston Fed’s collaboration with the Massachusetts Institute of Technology, called Project Hamilton. Fundamentally, however, if the United States is going to pursue a CBDC, policymakers need to decide on the respective roles for the Fed and the private sector in the overall structure that determines how the CBDC would be issued and used. The IMF refers to this as the “operating model” and offers three options:
- a unilateral CBDC, where the central bank directly issues and manages the CBDC with accounts at the central bank for retail customers;
- an intermediated CBDC, where the central bank issues the CBDC but delegates interface functions to private firms; and
- a synthetic CBDC, where private firms issue and manage the CBDC, but the digital currency is backed by central bank liabilities.
The first option, a unilateral CBDC, would be a radical departure from the Fed’s current model—and legal authority—of only granting accounts to certain financial institutions and the U.S. Treasury Department. In essence, the Fed would become a retail financial institution, with households having accounts and directly interfacing with Fed services. The Fed’s discussion paper, while otherwise cautious, makes clear that it does not want this operating model. This is probably due to legal limitations, a desire not to manage retail services beyond the Fed’s core competency, expected pushback on privacy grounds, and concerns about the potential disintermediation of banks. This latter issue refers to the potential for users to pull money out of their bank deposits and move it to their digital wallets, which in this scenario would be at the Fed. This would harm banks and could pose risks to financial stability. Thus, the United States is unlikely to pursue this operating model.
The second option, an intermediated CBDC, is the model most central banks are considering for CBDCs, including China’s e-CNY. The CBDC would be a liability of the Fed, similar to cash, but banks or other financial institutions would manage users’ digital wallets, essentially serving as custodians for the CBDC and probably having “know your customer” and anti-money laundering duties. Competition among the firms offering wallets would increase service quality and support innovation. The risk of disintermediation would be lower than under the unilateral CBDC model, in part because banks would be offering related services and especially if the CBDC did not pay interest. If the United States wants a CBDC, this could be a sensible model.
The third option, a synthetic CBDC, is not really a CBDC at all, because the central bank would not be issuing the digital currency. A synthetic CBDC is a stablecoin with a twist: the issuing financial institution would back its stablecoin with reserves at the Fed. In effect, this would be the digital currency version of the currency board regime used by central banks wanting to maintain a fixed exchange rate with currency nearly or fully backed by foreign exchange, such as in Hong Kong. If a synthetic CBDC were 100 percent backed by reserves at the Fed, it would be a form of so-called narrow banking, in contrast with fractional reserve banking, which is why some proponents call this a “narrow stablecoin.” A synthetic CBDC, or a system permitting the issuance of multiple fully backed dollar stablecoins, would be as safe as a CBDC while offering more private-sector competition and innovation.
Q3: What model should the United States choose?
A3: The United States need not choose a single model for a digital dollar. As such, it might make more sense to think of digital dollars in the plural. Of the models described above, an intermediated CBDC and a synthetic CBDC would not be mutually exclusive, at least in theory. More generally, a U.S. CBDC and dollar stablecoins could coexist.
The United States is behind some other major economies in CBDC development, most notably China, but it is ahead in stablecoins. Because of the dollar’s global status, the centrality of the U.S. technology ecosystem, and Washington’s so-far comparatively permissive attitude, the dollar is already the peg of choice for stablecoins.
Dollar stablecoins have at least one major advantage over a potential U.S. CBDC: they already exist. Even if Congress were to decide the Fed should create a CBDC, the process of development, experimentation, and deployment would probably take at least a few years. While China’s e-CNY is not on its own a major threat to the dollar’s global status, its lead among major CBDCs raises the likelihood of the underlying technology and standards proliferating globally. The United States should not delay in establishing a regulatory framework to enable safe but speedy development of dollar stablecoins to gain a first-mover advantage in related payments and technologies.
Q4: What should policymakers consider for what comes next?
A4: A new prudential regulatory framework is clearly needed for digital currencies in the United States. Congress is working to develop one and has held several hearings on stablecoins since late last year. In December, Senator Patrick Toomey (R-PA) outlined principles for stablecoin legislation, and this month, Representative Josh Gottheimer (NJ-05) released a discussion draft of stablecoin legislation. This discussion has been shaped by the November report from the President’s Working Group on Financial Markets, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency.
The report identified the key risks for stablecoins as potential runs on them if their redemption value were in doubt, payment system risks, and risks from potential concentration of market power. U.S. regulators have already acted in response to such risks. Last year, regulators fined Tether, issuer of USDT, for misleading investors about its dollar holdings. Concerns about market concentration contributed to regulators’ disapproval of Meta’s (Facebook’s) Diem stablecoin project, which it abandoned and sold to a bank holding company in January. Regulations should require disclosure of assets backing stablecoins, set liquidity and asset quality standards, and establish which entities can issue stablecoins.
The dollar’s preeminent global status gives the United States more responsibility and more options than other economies developing a digital fiat currency. The United States has an opportunity to foster innovation in digital finance and affirm the dollar’s role in the evolving digital ecosystem. Digital dollars, whether a CBDC or dollar stablecoins, could help preserve the dollar’s role as the preferred unit of account and medium of exchange in emerging digital markets and payment systems. This could also encourage “digital dollarization” in some economies. Traditional dollar assets like U.S. Treasury Department securities or bank deposits, however, are likely to remain the preferred store of value for investors given their enormous markets.
Policymakers should consider the options for a U.S. CBDC and dollar stablecoins as part of the same discussion over whether and how to develop digital dollars, with a menu of operating models that could exist in tandem. Washington should favor competition and encourage domestic innovation by allowing appropriately regulated nonbank financial institutions to issue stablecoins and by allowing some issuers direct access to Fed accounts to enable synthetic CBDCs. Even if each stablecoin were backed by similar assets, the underlying technologies and associated platforms and services for each could differ. Competition across stablecoins and even across operating models would test which offers the best features, including the lowest transaction costs for users. As the market develops and needs become clearer, Washington could decide whether to pursue an intermediated CBDC in the future. The options are more sequential than binary.
Gerard DiPippo is a senior fellow with the Economics Program at the Center for Strategic and International Studies (CSIS) in Washington, D.C.
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