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I read the Fed Report on CBDCs so you don't have to.

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by COINS NEWS 161 Views

TLDR;

I’ve read the new Fed study so you don’t have to. These were my key takeaways:

  • The Fed does not currently plan to issue a CBDC but they are strongly considering it.
  • They would not move forward without legislation directing them to do so and there is a clear benefit to the US consumers and economy that outweighs the benefits as compared to the risks.
  • A US CBDC would give people direct access to digital currency issued by the government – existing digital currencies are controlled exclusively by banks.
  • A US CBDC could help the unbanked and underbanked gain access to their money without the paying exorbitant fees like they currently do through check cashing services, payday loans, wire transfers, etc.
  • KYC would be an absolute requirement (despite allusions to privacy in the paper).
  • A US CBDC would be free of credit and liquidity risk (unlike existing stablecoins).
  • They would potentially consider limiting the amount of a CBDC that an individual or entity may hold or accumulate in a short amount of time.
  • Lastly – my impression is that one of their biggest concerns is how an interest bearing CBDC would impact existing financial instruments like T-bills and other bonds although they acknowledge that the cat may already be out of the bag on that one.

I was inspired by u/Nostalg33k’s nice write up of the congressional hearing and wanted to read the Fed report on a CBDC anyway so I decided to summarize it. I’m a bit long winded, so it turned out to be a bit longer than I expected but it’s still considerably shorter than the actual report. Hopefully it’s helpful to some people.

EXECUTIVE SUMMARY

The Executive Summary identifies the purpose of the paper as “a first step in a public discussion”. It is intended to be a starting point in a public dialog and questions are welcome by clicking here: https://www.federalreserve.gov/apps/forms/CBDC. They point out specifically that it is not meant to signal that the Fed will specifically move to create a CBDC, simply that it is being discussed and considered.

The Background section explains that the Fed has evolved payment technologies over time as the world has evolved starting with a check clearing system, then the ACH system currently used by banks for processing electronic funds transfers and a new system the Fed committed to creating in 2019 called FedNow which is meant to provide 24/7/365 interbank payments.

Due to recent developments they are now considering a US CBDC. According to the document they have been studying this for several years and are continuing to solicit reviews, including from the public as they explore whether or not this makes sense.

The Key Topics covered in the paper are:

  • Discussions on the existing forms of money
  • The current state of the US payment system
    • Strengths
    • Challenges
  • Various digital assets that have emerged in recent years
    • Stablecoins
    • Other cryptocurrencies
  • CBDCs
    • Uses and functions
    • Potential benefits and risks
    • Related policy considerations

INTRODUCTION

Mostly rehashes the previous information and adds one very key item that is one of the biggest takeaways from the paper. That is: The Fed does not plan to move forward in issuing a CBDC without support from Congress and the executive branch in the form of specific law authorizing the issuance of a US CBDC.

THE EXISTING FORMS OF MONEY

They identify the following forms of money and detail the risks and benefits associated with these:

  • Central bank money – physical currency issued by the Fed
  • Commercial bank money – digital form of money most commonly used by the public
  • Nonbank money – digital money held at nonbank financial providers (specifically highlight mobile apps)

THE PAYMENT SYSTEM

Most US based payments rely on the ACH system or wire transfers to move money around. There is little to no risk in the settlement of these funds because they are either central bank or commercial bank moneys which promotes stability.

Recent Improvements to the Payment System

They discuss improvements in making payments faster, cheaper, more convenient and accessible. Here they reference the RTP interbank network and the FedNow Service which is scheduled to debut in 2023.

With regard to nonbank money they highlight potential risk and instability to users due to a “lack of equivalent protections” although they do not highlight what specific risks they are concerned about.

Remaining Challenges for the Payment System

They highlight that many Americans lack access to digital banking and payment services and that some forms of payment (especially cross-border payments) remain slow and costly. They cite figures stating >5% of US households remain unbanked and an additional ~20% more rely on costly nonbanking services like money orders, check cashing services and payday loans.

They suggest that the fact the traditional banking system does not offer a truly competitive solution to some of these services limits competition and therefore drives prices for these services quite high and that reducing these costs would benefit economic growth and reduce inequality.

DIGITAL ASSETS

They reference cryptocurrencies directly for the first time here and mention that they are not used widely as payment while specifically highlighting limitations on transaction throughput, energy consumption and fraud as potential concerns for existing currencies.

They mention that stablecoins have emerged and are generally used for trading of other digital assets while firms are also exploring ways to use them as a form of payment.

They state that this report will not dive deeply into stable coins but reference the paper put out by the President’s Working Group on Financial Markets (available here: https://home.treasury.gov/system/files/136/StableCoinReport\_Nov1\_508.pdf - not sure if a link to a pdf is a good idea, so I removed the link but you can copy/paste) specifically noting that concerns about the increasing use of stable coins could lead to issues such as:

  • Destabilizing runs on the stable coin
  • Disruptions in the payment system
  • Concentration of economic power

The report mentions that there are gaps in regulatory authority that currently limit the government’s ability to reduce this risk and mention that the above linked report from the PWG recommends Congress act to promote legislation which would allow regulation of these markets.

CENTRAL BANK DIGITAL CURRENCY

Here they highlight that they are considering issuance of a CBDC if and only if it can address the issues of concern previously outlined in the paper. Currently physical currency is the only central bank money that is accessible directly by consumers, however a CBDC would also be directly accessible and therefore provide the general public with a second form of currency that is directly accessible.

My editorial note here: This is simply my interpretation of what that last paragraph means. The important part that they are trying to contrast here is that existing digital moneys are exclusively controlled by the banks. You cannot initiate an ACH transfer without the bank actually moving the money for you. The distinction made in the previous paragraphs makes it clear that a US CBDC would be outside of the traditional banking system, ie exist on a blockchain.

They go on to state that they will continue to consider a wide range of options for a CBDC although they are not 100% committed to creating one. These are the key points any US CBDC would need to meet:

  • Privacy-protected – need to strike an appropriate balance between safeguarding privacy and transparency needed to deter criminal activity (My note: existing physical currency technically does this in the form of serialized bills, however in any practical sense it is completely fungible and non-traceable, I would be very interested to hear how they plan to maintain privacy while also accomplishing this transparency, later in the report there are indications that this allusion to privacy is not sincere – I will be submitting a question on this topic and advise all of you to do the same)
  • Intermediated – The Fed would hold the liability of the CBDC itself, however individuals would use banks and nonbank service providers through the use of digital wallets.
  • Transferable – This simply notes that it would have to be readily transferable to be effective.
  • Identity-verified – KYC clearly defined (My note: so much for the privacy they outlined earlier in this section.)

Uses and Functions of a CBDC

This simply states that transactions could amount to almost anything but require real-time finality in a risk free manner. They also discuss smart contract functionality although don’t call it out by name by saying “Additionally, a CBDC could potentially be programmed to, for example, deliver payments at certain times.”

Potential Benefits of a CBDC

They highlight CBDCs as a new foundation and bridge between payment services in a safe centralized manner. They highlight again that this would be a direct access to digital money that is free from credit and liquidity risk (My note: I think this is actually a valid point. None of us truly trust Tether to be doing what they say they’re doing. Of course the US dollar is going to devalue over time through issuance of new dollars, but so would existing stable coins and a USD CBDC will always be worth the same as a physical USD and therefore will never completely fail unless the USD does. I don’t trust that a USDT will never crash relative to USD.)

They mention that while existing digital moneys have their own forms of protection, none of these are perfect and US CBDC would specifically manage risk better. This in turn would level the playing field for companies interested in dealing with digital payments and allow innovation in other areas while not having to worry about the risk of accepting digital currencies as they currently exist while allowing for the before mentioned smart contract capability and also making micro-transactions possible on a large scale which isn’t currently feasible with bank moneys.

Improvements to Cross-Border Payments

Like the title says, a US CBDC would potentially be able to make cross-border payments more readily available to the general public.

Support the Dollar’s International Role

They discuss the benefits of having the dollar be the world reserve currency of choice and how modernizing access to it would help to maintain that obviously beneficial position.

Financial inclusion

CBDCs could help economically vulnerable households get access to the financial system due to the speed, security and low cost of these types of transactions. They highlight this particular thing as a high priority for the Fed.

Extend Public Access to Safe Central Bank Money

Here they highlight the fact that while physical cash is the only form of money that consumers have direct access to, very little of the modern world relies on physical currencies which means the banking system is inserted (unnecessarily it is implied) into every transaction. They also note that it would be meant to work along side physical cash, not in place of it.

Potential Risks and Policy Considerations for a CBDC

Changes to Financial-Sector and Market Structure

  • Could fundamentally change the system
    • A fully functional CBDC could reduce deposits in central banks leading to higher overhead and impact to credit availability to households and business.
    • Interest bearing CBDC accounts could replace T-bills and other short-term low risk investments which would impact credit availability for business and governments.
  • Design could mitigate these impacts including making it non-interest bearing (My note: not sure how they would stop others that they identify as nonbanking financial providers from offering interest)
  • They also note that many of these changes may happen even without a US CBDC

Safety and Stability of the Financial System

CBDCs would be particularly attractive to risk-averse users. One concern, however is that the quick-conversion ability of CBDCs could actually make runs on financial firms more likely or more severe and traditional measures may not prevent such an occurrence.

Design could potentially mitigate this through features such as limiting the total amount of CBDC that can be held or accumulated over short periods.

My note: This seems like a tricky one, on one hand I get the idea that a run on the banking system is limited today by transaction speed and throughput and the fact that the instantaneous finality of a good CBDC could exacerbate things, limiting the amount that one entity can hold or accumulate in a short period of time seems like a kludgy fix that would do more harm than good. I think I will craft a question on this topic as well to submit.

Efficacy of Monetary Policy Implementation

The design of any CBDC would be important. The existing system relies mostly on interest rates to drive policy. Controlling the supply of a CBDC will be fundamentally different than it is with the reserves the Fed currently holds. For example, a surge in demand could deplete the reserves enough to put upward pressure on interest rates. The effect is exacerbated if the CBDC is interest bearing itself and will impact other markets.

The Fed is doing a large amount of research specifically in the area of how to properly manage a CBDC to reach their macroeconomic objectives and this is an area that they expect a lot of new information over time.

Privacy and Data Protection and the Prevention of Financial Crimes

On consumer privacy they just state that intermediaries would be left to address privacy concerns using existing tools. (My note: It does not sound like they really care about privacy in that case) On prevention of financial crimes they note existing reporting requirements (KYC) and will offer the advantage of these existing programs.

Operational Resilience and Cybersecurity

Securing the network is a difficult but important goal. They note the key concern of additional entry points to the system making it potentially more vulnerable than the existing central bank system. They also address a desire to explore the feasibility of an “offline” payment system.

SEEKING COMMENTS AND NEXT STEPS

They reiterate here that there is not a current effort to create a CBDC but will only work towards that goal if it will provide a benefit to the US economy that exceeds the downsides and again, only with support from the executive and legislative branches.

There is a list of questions that they are asking for public comment on as well. You can provide answers to their questions at the same web address linked above for asking questions: https://www.federalreserve.gov/apps/forms/cbdc. Here are the questions:

CBDC Benefits, Risks, and Policy Considerations

  1. What additional potential benefits, policy considerations, or risks of a CBDC may exist that have not been raised in this paper?

  2. Could some or all of the potential benefits of a CBDC be better achieved in a different way?

  3. Could a CBDC affect financial inclusion? Would the net effect be positive or negative for inclusion?

  4. How might a U.S. CBDC affect the Federal Reserve’s ability to effectively implement monetary policy in the pursuit of its maximum-employment and price-stability goals?

  5. How could a CBDC affect financial stability? Would the net effect be positive or negative for stability?

  6. Could a CBDC adversely affect the financial sector? How might a CBDC affect the financial sector differently from stablecoins or other nonbank money?

  7. What tools could be considered to mitigate any adverse impact of CBDC on the financial sector? Would some of these tools diminish the potential benefits of a CBDC?

  8. If cash usage declines, is it important to preserve the general public’s access to a form of central bank money that can be used widely for payments?

  9. How might domestic and cross-border digital payments evolve in the absence of a U.S. CBDC?

  10. How should decisions by other large economy nations to issue CBDCs influence the decision whether the United States should do so?

  11. Are there additional ways to manage potential risks associated with CBDC that were not raised in this paper?

  12. How could a CBDC provide privacy to consumers without providing complete anonymity and facilitating illicit financial activity?

  13. How could a CBDC be designed to foster operational and cyber resiliency? What operational or cyber risks might be unavoidable?

  14. Should a CBDC be legal tender?

CBDC Design

  1. Should a CBDC pay interest? If so, why and how? If not, why not?

  2. Should the amount of CBDC held by a single end user be subject to quantity limits?

  3. What types of firms should serve as intermediaries for CBDC? What should be the role and regulatory structure for these intermediaries?

  4. Should a CBDC have “offline” capabilities? If so, how might that be achieved?

  5. Should a CBDC be designed to maximize ease of use and acceptance at the point of sale? If so, how?

  6. How could a CBDC be designed to achieve transferability across multiple payment platforms? Would new technology or technical standards be needed?

  7. How might future technological innovations affect design and policy choices related to CBDC?

  8. Are there additional design principles that should be considered? Are there tradeoffs around any of the identified design principles, especially in trying to achieve the potential benefits of a CBDC?

submitted by /u/Pokoire
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