The concept of “central bank digital currency” is open to all sorts of interpretations, most of which are unrealistic.

To some, it looks like the Federal Reserve is competing with Bitcoin, or the Fed is going to create accounts for individuals. These steps will not occur. The Federal Reserve takes a first step in setting expectations, without actually committing to policy choices, in a working paper titled “Money and Payments: The US Dollar in the Age of Digital Transformation” (January 2022; if you wish to submit comments, you can go to the link). Near the beginning of the report, the Fed writes:

For the purposes of this document, a CBDC is defined as a digital liability of a central bank that is widely available to the general public. In this respect, it is analogous to a digital form of paper money. The document was designed to foster broad and transparent public dialogue about CBDCs in general, and the potential benefits and risks of a US CBDC. The document is not intended to advance any specific policy outcome, nor to signal that the Federal Reserve will be making any imminent decisions on whether to issue a US CBDC.

The definition of a CBDC alludes to the issues involved. How exactly would a “digital form of paper money” work? Perhaps the key point now is that when you get paid or buy something or make a payment with a check or a credit card or an electronic payment, the payments usually go from one bank to another. But when you use foreign currencies, no individual bank guarantees your payment. Thus, a CBDC opens up the idea of ​​a payment mechanism that takes place outside of the banking system and where the underlying value is backed by the Fed rather than a bank.

In thinking about this, I found helpful some meditations by Raphael Auer, Jon Frost, Michael Lee, Antoine Martin, and Neha Narula of the New York Fed. In a blog post titled “Why Central Bank Digital Currencies?” (December 2021), they point out that when it comes to facilitating payments, there are four objectives:

Payment Fees. It costs money to pay money. Payment costs have generally come down over time, but surprisingly not by much – credit card networks still routinely charge merchants a 3% service fee, and card revenues represent more than 1% of GDP in United States and much of Latin America. …

Financial inclusion. Universal access to payment services has been a long-standing policy goal…Inclusion is a major societal concern in developing economies and in some developed economies with large unbanked populations (the United States and the Eurozone, for example). …

Consumer Privacy. … Digital payments, including bank accounts, payment cards and digital wallets, create a data trail. Private consumer information is aggregated and distributed for monetization. Recent research suggests that there are public good aspects to privacy; individuals may share too much data because they do not bear the full cost of not protecting their privacy when choosing their payment instrument. …

Promote innovation. New, more convenient and secure payment methods not only benefit consumers, but can also spur innovative business opportunities. New technologies also offer the possibility of potentially automating certain financial practices through “smart contracts”, thereby improving efficiency.

The recent Fed report also lays out the problems along these dimensions. As the Fed writes: “A crucial test for a potential CBDC is whether it would prove superior to other methods that
could solve the problems raised in this document. … The Federal Reserve will continue to explore a wide range of design options for a CBDC. While no decision has been made on whether to pursue a CBDC, analysis to date suggests that a potential U.S. CBDC, if created, would better meet U.S. needs by being protected. through confidentiality, intermediary, widely transferable and identity -verified.

Even in boilerplate writing like this, you can see the issues bubbling beneath the surface. A CBDC is meant to be both “privacy protected” and also “identity verified.” Hmm.

A CBDC is likely to be “intermediated,” which refers to the idea that it would operate through outside financial institutions, which need not necessarily be banks. Individuals or companies can have a “digital wallet” in these companies to hold their digital currency from the central bank. But once you add additional external financial institutions, with their own costs and profit margins, are payment costs really likely to drop? And are “unbanked” people who currently have no connection to the financial system more likely to establish such a connection with “digital wallets”?

As far as financial innovation creating different types of payments, it seems to me that there are already a lot of companies trying this, and it’s not clear to me that a CBDC would increase innovation or reduce costs (and therefore lower prices) for this industry.

Right now, the case for a CBDC seems to rest on a lot of “potentially could” statements. The Fed report writes:

A CBDC could potentially offer a range of benefits. For example, it could provide households and businesses with a convenient electronic form of central bank money, with the security and liquidity that would entail; give entrepreneurs a platform on which to create new financial products and services; support faster and cheaper payments (including cross-border payments); and expanding consumer access to the financial system.

On the one hand, the practical problems here are considerable. If the Fed decides to regulate CBDC-based payment networks as if they were banks, all the benefits of such a mechanism largely disappear. On the other hand, if these payment networks are regulated differently than banks, then what risks will accumulate in the CBDC payment system? For example, how do concerns about cybersecurity or resiliency differ between the two systems? And if the monetary value of CBDB digital wallets can be quickly transferred back and forth, to and from ordinary bank accounts, how could these risks spread throughout the financial system? My bias for now would be to focus on other methods of reducing payment costs, improving privacy, and helping the unbanked, and let the idea of ​​a CBDC simmer on the bank burner a bit longer.

For those interested in more detail on the subject, Dirk Niepelt has edited a book of 19 short, readable essays on the subject, Central Bank Digital Currency: Considerations, Projects, Perspectives (CEPR, November 2021). Some of the essays focus on general conceptual issues; others provide details of what CBDCs are already experimenting with that some central banks around the world are conducting.