RESEARCH REPORT: Central Bank Digital Currencies

RESEARCH REPORT: Central Bank Digital Currencies

Executive Summary

On March 9, 2022 President Biden issued Executive Order (EO) 14067 (Federal Register, 2022)— Ensuring Responsible Development of Digital Assets — which directed the United States Department of Treasury, the Federal Reserve, and other relevant agencies to begin exploring the adoption of a U.S. Central Bank Digital Currency (CBDC) (The White House, 2022). The executive order cites a litany of threats that would prompt the exploration of adopting a CBDC, including national security, economic risks, the stability and integrity of the financial system, illicit crime, and climate change. EO 14067 “places the highest urgency on research and development efforts into the potential design and deployment options of a United States CBDC…and the actions required to launch a United States CBDC if doing so is deemed to be in the national interest.”

This report outlines the role of money as a federal government tool and means of exchange. Analyzing the evolution of money in the modern world and examining how currency operates domestically and globally, this report examines how a shift to a CBDC would substantially alter the role and nature of money. In particular, the report assesses the extraordinary economic control, discrimination, and threats to data privacy that might result from the development of a CBDC. Additionally, given the extraordinary failures of the Federal Reserve recently, one must question whether they have the competency to replace the private sector banking system that has served our nation throughout its history. The fact is: The Federal Reserve cannot issue a CBDC without Congressional authority. Congress must make this clear by enacting legislation that restricts the creation and use of a CBDC. 

The Role of Money

At its foundation, money exists to perform three primary functions. First, money is used to facilitate the exchange of goods and services, operating as a medium through which economic activity can take place. Second, money operates as a store of value, providing users of that money with confidence that they will be able to make purchases in the future, rather than having to acquire goods and services contemporaneously with earning income. Third, money exists as a unit of measure, providing a baseline of worth for the buyer and seller of a particular good or service and facilitating government action such as the collection of income taxes.

The role of the dollar is especially significant as both a currency and a system of exchange. Nearly half of all global trade is invoiced through the dollar, even though the United States is responsible for only about 10 percent of global trade. As a result, the United States Dollar (USD) is the world’s reserve currency, meaning the currency is internationally recognized as the currency to be held in reserve by most national banks. As a system of settling payments, the dollar plays the most substantial role in determining the ebb and flow of the global economy of any currency in history. Its status as reserve currency facilitates implementation of our nation’s trade and sanctions policies. 

The Evolution of Payment Systems

The development of payment systems can be traced back to ancient Mesopotamia in 6000 B.C.E., where bartering was first introduced almost 2000 years before the first officially documented society of Sumer began (Butt et al., 2023). The first documented use of coins in the Western world originated in Lydia (modern-day western Turkey) around 650 B.C., the coins being a combination of gold and silver alloys (Middelkoop, 2016). Nearly 1,350 years would pass before paper currency would be invented in the 7th century A.D. during the Tang Dynasty in China (Collectibles & Currency, 2020). Paper currency was convertible into gold, but the fact that it is lighter to carry and can be printed in different denominations made it easier to engage in commerce. Roughly 600 years would pass before the check was developed in early Venice to operate as a legally binding promissory note in lieu of physical coins, allowing ships to carry fewer coins and more shipping products, thus establishing a system of commerce based upon fiat in the Western world (Barclays, 2016). Paper money can be damaged or stolen so checks may be a more secure form of payment for the purchaser.

The next major innovation in money would be the credit card in the 1920s, with the first universal credit card introduced by the Diners’ Club, Inc, in 1950 (Brittanica, 2023a). Credit card systems have evolved to provide nearly immediate authorization, improving the likelihood of payment for the merchant, whereas checks may be returned for insufficient funds. Expanding access to the ease of paying by plastic to those who did not have good credit, debit cards provided for funds to be immediately held at the customer’s bank, rather than charged against a line of credit. Today in the United States, debit cards are the most frequent form of payment (The Federal Reserve, 2023). The most recent major advancement in payment systems followed in the wake of a 2008 whitepaper entitled “Bitcoin: A Peer-to-Peer Electronic Cash System”, generating interest in the media and across markets. By 2009, a group known only as Satoshi Nakamoto invented Bitcoin, the world’s first completely digital currency, known as cryptocurrency (Britannica, 2023b). The advent of copy-and-pasteable cipher encrypted algorithms is revolutionizing the financial sector and digital payments, introducing a direct, easy, and transparent way to settle payments quickly. The first commercial transaction with Bitcoin was in 2010 for pizza, further validating the new use case and sparking the creation of new digital markets.

What is a Central Bank Digital Currency?

With improvements in technology and the rise of cryptocurrency over the last 14 years, the concept of completely digitizing currencies has emerged. In such a scenario, in addition to people having physical money in the form of paper currency, they could also have digital money issued directly by the central bank. This is an important distinction from digital currencies which are means of exchange issued by private entities and whose value are determined independent of the value of gold or the U.S. dollar.  What makes a CBDC unique and potentially problematic is that it is issued by and transacted through means established by a central bank, i.e. the federal government.

At least three versions of this scenario have been contemplated. In the first, only banks may hold CBDC, known as wholesale CBDC, effectively giving them an account with the Federal Reserve. Individuals would still have access only to paper money issued by the Federal Reserve, and their bank accounts would still be with private banks. To a great extent, this already exists because banks have accounts at the Federal Reserve, where they hold assets called “excess reserves.” In fact, a significant monetary policy tool of the Federal Reserve is the setting of the interest rate paid on excess reserves. Such deposit transactions between private banks and the Federal Reserve are already carried out electronically, so there is little innovation by creating a wholesale CBDC.

The second version is called “intermediated retail CBDC.” Individuals would hold CBDCs assigned to their name at the Federal Reserve, but they would have to transact through a private bank to access the funds. Presumably, in such a scenario, banks would offer lower interest rates on deposits that are held in CBDCs and higher interest rates on those that are held in normal deposits but that the bank can still lend out. This has the potential to be destabilizing to the banking sector because our financial system relies on deposits being used to fund commercial loans for small businesses, car purchases, and credit cards.

The third version is “direct retail CBDC.” In this case, everyone would have access to a bank account directly at the Federal Reserve. All transactions between buyers and sellers would be facilitated solely through the central bank, reducing the role of private banks in the economy. This new socialist model means that all individual and business bank accounts would be directly with the Federal Reserve, similar to the backward-looking postal banking system progressives have been advocating for years (Brown, 2018). It would be accompanied by the level of customer service, technological innovation, and gross inefficiency Americans have grown accustomed to with government-run systems, such as the U.S. Postal Service. In addition, direct retail CBDCs create concerns about funding the consumer and local small business lending activities currently done by community and regional banks and privacy issues we address below.

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