North America April 29, 2021 / 02:42 pm UTC

The Digital USD

By Mike Gallagher

Bottom line: Fed Chair Jerome Powell noted Wednesday that the Fed is researching the idea of a digital USD. A number of hurdles exist, both to ensure it does not undermine the existing financial system and also to avoid digital dollarization in weak countries overseas given the USD’s global role. Central Bank Digital Currencies (CDBCs) have the scope to act as a medium of exchange more than cryptocurrencies such as Bitcoin and are an area of innovation that needs to be watched in the coming years.

Figure 1: Retail Fast Payment Systems and CBDC 

Source: BIS 

Hurdles for a Digital USD

The Fed is undertaking research into a digital currency (a digital USD), Powell said during the April 28 FOMC press conference, while China already examining the idea of a digital yuan. Will these CBDCs help or hurt existing cryptocurrencies such as Bitcoin? 

The proposed design of CBDCs makes them superior to Bitcoin as a medium of exchange, as the design of Bitcoin effectively slows transactions and makes it more costly than CBDCs or existing retail fast payment systems (FPS) such as Visa/PayPal/Apple Pay. The initial idea of cryptocurrencies as medium of exchange has evolved into the likes of Bitcoin now serving more as digital gold and a store of value (due to the code restraining production to 21m and decreasing mining rewards increasing the marginal cost of production) or a speculative investment.

CDBCs including a digital USD would likely follow the principles outlined by the Bank for International Settlements (BIS) in a recent speech to ensure it can enhance the existing financial system as a medium of exchange. A digital USD would not be a new currency to compete with existing currencies, but rather denominated in the USD (the unit of account) and an extra central bank liability. The latter is a key feature, as existing cryptocurrencies are not backed by central bank payment infrastructure. A central bank liability also means that it could reduce transaction fees, as transactions could occur without intermediaries and only a change of digital USD ownership at the Fed. Bitcoin anonymity would contrast with a digital USD or other CDBCs, as a digital USD would require know-your-client and anti-money laundering checks before setting up a digital warrant — the vast majority of economic players would be comforted by this feature. However, the reality is that Bitcoin transactions can be traced and the use in illegal activity has been exaggerated. Overall, CDBCs including a digital USD or yuan would likely be superior to cryptocurrencies as a medium of exchange.

Even so, three major hurdles exist:

  • CDBCs including a digital USD should not undermine the existing financial system. The BIS and central bank view is that the existing commercial bank and payment systems are necessary to ensure the proper functioning of payments, deposits, investment and lending are not undermined. Thus CDBCs, like cash, would not be interest-bearing, unlike digital deposits at commercial banks. Additionally, thought needs to be given to how a digital USD would work in times of banking stress, when people would prefer to hold USD in digital form with the Fed rather than checking account USD balances with weaker banks. 
  • CDBCs could impact the transmission mechanism of monetary policy. Central banks want CDBCs to be an enhanced part of the existing system that is additive and allows innovation without major dislocation, which may change the way monetary policy works. Research is underway to review this issue.
  • Digital USD in weak economies. CBDCs such as a digital USD could also help to reduce transaction costs and settlement risks across borders, where stable coins had been designed to challenge existing units of account for international transactions (e.g. commodities in USD). For weak economies, this could be a threat that sees a digital USD crowd out weaker currencies. To avoid this risk CBDCs or digital USD would not be legal tender in countries with weak currencies, and global central banks are also looking at mechanisms (mCDBCs) for cooperation if a system evolves of multiple CBDCs. 

Overall, it will likely take some time before a CBDC is established, and the Fed may want to see another G10 currency move ahead first to understand the issues in practice rather than in theory. This could take years. Conceptually CBDCs would seem to help cryptocurrencies, but as a medium of exchange CBDCs would work better than cryptocurrencies with lower transaction costs. Bitcoin is likely to lose out to CBDCs as a medium of exchange. Additionally, crypto assets need to be seen in a wider context, with the idea of Bitcoin as digital gold (a subject for a separate article) and Ethereum providing the base for smart contracts

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Analyst Certification
I, Mike Gallagher, the lead analyst certify that the views expressed herein are mine and are clear, fair and not misleading at the time of publication. They have not been influenced by any relationship, either a personal relationship of mine or a relationship of the firm, to any entity described or referred to herein nor to any client of Continuum Economics nor has any inducement been received in relation to those views. I further certify that in the preparation and publication of this report I have at all times followed all relevant Continuum Economics compliance protocols including those reasonably seeking to prevent the receipt or misuse of material non-public information.