The Federal Reserve Board (Fed) recently released a highly-anticipated report examining the benefits and risks of establishing a U.S. Central Bank Digital Currency (CBDC[1]). Establishing a CBDC would be a major shift from the Fed’s traditional approach to the financial system, which is focused on the “safety and soundness” of financial markets. The Fed’s review and request for public comment is motivated in large part by the growth of digital assets (a.k.a. cryptocurrencies) with money-like characteristics and the underlying blockchain technology that supports those digital assets.

However, the Fed’s report on CBDCs does not take a position or make any recommendations or conclusions, other than to indicate that new legislation would likely be necessary to provide the Fed with a mandate under a “specific authorizing law.” 

As indicated by the Fed, today’s financial market allows for different amounts of credit and liquidity risk. Central banks, such as the Fed, serve as a foundation to the system and their assets carry no credit or liquidity risk, such as with physical currency issued by the Fed. Commercial banks money, alternatively, is distributed in digital form, and poses little risk due to federal deposit insurance, regulatory supervision and access to the central bank’s liquidity. Non-bank money is also processed digitally, but does not have the range of consumer and financial protections of a commercial bank and carries the most risk.

As the world gets smaller and access to digital currency increases, there are certain identified shortcomings that the current financial system has not adequately addressed. In particular, the Fed acknowledges (1) that nearly 25% of the U.S. population either does not have a bank account or relies on more costly financial services like money orders; and (2) that cross-border payments are slow to process, with high fees and limited accessibility, and are further complicated by intermediaries, regulatory requirements and exchange rates. The Fed is now looking to see whether a CBDC may prove superior to other methods in addressing shortcomings of the financial system.

The Fed outlined the following successful features of a CBDC:

1. Privacy Protection: Protecting the privacy of consumers has been and will be crucial when implementing a new financial service.
2. Intermediaries: As it would be prohibitively burdensome and disruptive for the Fed to create and manage accounts for individuals, the most efficient way to provide access to a CBDC would be to employ the already-existing and tried-and-true infrastructure of the private sector that addresses privacy, consumer identity verification, and innovation.
3. Transferability: Should the CBDC be issued through intermediaries, these intermediaries should be able to transact between themselves seamlessly to promote an efficient economy.
4. Identity Verification Capabilities: Although consumer privacy is critical, privacy must be balanced with the importance of combating potential criminal activity, an area regulated heavily by robust rules. This balance has historically been achieved by requiring banks to verify the identity of their customers. Therefore a CBDC would need to implement a system in which it is possible to conduct the appropriate Know Your Customer diligence to remain compliant with current regulations.

In short, the benefits and risks of a CBDC are as follows:

• Benefits: The unique benefits of a CBDC include (1) access for the public to digital assets that have zero credit or liquidity risk, (2) increased innovation to meet current and future needs and demands for payment services, (3) reduction in common barriers to financial inclusion and transaction costs, (4) decreased cross-border transaction burdens, and (5) the sustained power of the U.S. dollar internationally as the desirability of digital assets continue to rise.
• Risks: The potential risks of a CBDC include (1) possible policy and market disruptions such as threats to the popularity of current low-risk assets (e.g., money-market mutual funds and Treasury bills), (2) a shift away from depositing funds in banks, which would harm the economy by reducing credit availability and raising credit costs for consumers, (3) the possibility that the CBDC would be used to fund terrorist organizations or to launder money, and (4) the uncertainty in determining the appropriate amount of reserves the Fed would need to put on its balance sheet, as the demand for CBDC may fluctuate in unforeseeable ways.

Whether the Fed continues developing steps towards a CBDC is dependent on whether the research points to benefits for households, businesses and the economy overall – exceeding downside risks – i.e., indications that a CBDC would be a superior alternative method to our current system. The Fed’s report encourages comments from companies that are actively innovating in this space and that understand the benefits and risks the technology may provide.

There is a 120-day comment period for market participants or any member of the public. Comments are due by May 20, 2022. If you would like our assistance in preparing a comment letter on this issue please contact any of the Dentons professionals listed in this client alert. 

[1] All references to “CBDC” in this alert contemplate a CBDC issued by the U.S. Federal Reserve.