Federal Reserve studies digital dollar: Will CBDC affect the dollar's status? What makes a successful CBDC?

In an era where technology is reshaping our financial landscape, the concept of a US Central Bank Digital Currency (CBDC) has sparked intense discussions among financial experts and policymakers. Scholars Jean Flemming and Ruth Judson from the Federal Reserve Board have delved into how a US CBDC could potentially enter the international payment system, intertwining with the long-standing dominance of the US dollar.

According to the Bank for International Settlements (BIS), over 90% of central banks worldwide are exploring the CBDC space, with the Federal Reserve also evaluating how a digital dollar could either revolutionize or merely create ripples in the global financial arena.

FED Explores the Potential of Digital Dollar

Challenges in Cross-Border Payments Not Technological Barriers

Scholars from the Federal Reserve (FED) stated that the value of cross-border payments in 2022 is estimated to be $156 trillion, more than five times the value of global trade in goods and services.

The U.S. dollar and the U.S. payment system play a key role in many cross-border payments. However, due to various friction costs, including within the U.S., cross-border payment systems are more expensive and slower compared to domestic payments, with many of these frictions being the result of policy choices rather than technological barriers.

The high cost and slow speed of cross-border payments currently stem from two sets of interrelated factors: first, a lack of accessibility or seamless interoperability between payment systems, and second, the need for manual intervention at various stages of the payment process. In this digital age, a U.S. Central Bank Digital Currency (CBDC) may have the potential to streamline these processes.

Digital Dollar Can Continue to Strengthen Currency Dominance

FED scholars stated that the U.S. dollar, as a giant in the global financial realm, serves as the cornerstone for transactions, reserves, and invoicing worldwide, a position attributed to the stable governance of the U.S., economic resilience, and the attractiveness of its capital markets. Introducing a digital dollar may further consolidate or subtly shift this dominant position, depending on the design and policy choices accompanying its issuance.

Key to Design: Shaping the Impact of CBDC

Accessibility Policy

FED scholars believe that the emergence of friction in cross-border payments is due to the fact that payment systems settled in central bank currencies are typically limited to domestic financial institutions. Accessibility policies address who can hold, use, and transfer central bank funds, especially whether non-residents and their financial institutions can use central bank funds and under what conditions.

In the U.S., expanding direct access to central bank funds would require legislative reform, particularly for non-bank institutions, and this policy choice is not exclusive to issuing a CBDC. Additionally, careful decisions need to be made regarding the regulation of foreign banks or non-bank Payment System Providers (PSPs) to reduce risks while maintaining a fair competitive environment. A well-designed U.S. CBDC, the more widespread it is, the greater the potential for the dollar to be favored as a medium of exchange, unit of account, and store of value.

Interoperability

FED scholars stated that another way to enhance the availability of CBDC is to improve efficiency by establishing interoperability between payment systems across jurisdictions. As opposed to accessibility policies, choices regarding interoperability may require technical coordination with foreign jurisdictions.

Privacy, Anti-Money Laundering, and Restrictions

Finding a balance between protecting privacy, implementing Anti-Money Laundering (AML) measures, and account restrictions may affect the global attractiveness of the digital dollar, which may attract or deter international users based on varying preferences for anonymity and security.

Interest Rate Returns

FED scholars stated that as long as the U.S. CBDC is perceived as more attractive than foreign legal tender, it is an attractive store of value for foreigners.

Under similar conditions, the higher the expected return on assets, the higher the demand. The higher the interest rates offered by a CBDC, the more attractive it is. Positive interest payments, if allowed, can enhance the attractiveness of the U.S. CBDC, thereby strengthening the use of the dollar, but negative interest rates may have the opposite effect.

International CBDC Competition, Private Stablecoin Issuers Threaten Dollar Dominance?

FED scholars stated that as countries worldwide contemplate their digital currency developments, the future role of the dollar is delicately balanced. The emergence of foreign CBDCs and private company innovations like stablecoins may disrupt current dynamics, but without an equally attractive U.S. counterpart, it may not necessarily weaken the dollar's dominance in certain aspects.

FED scholars believe that the mainstream status of U.S. dollar assets as a store of value is based on the ample supply and liquidity of U.S. Treasury and other debts, as well as the long-term stability of the U.S. economy and political system.

If other jurisdictions offer similar conditions, the dollar may lose to these currencies. However, these trends are progressing slowly. Furthermore, CBDCs themselves or their functionalities will not change the above conditions. Therefore, even though these trends may be beyond the control of U.S. policymakers, the issuance of a CBDC by one or a few countries is unlikely to significantly alter the current demand for dollar assets.

Improving Cross-Border Payments, CBDCs Not Necessarily Required

FED scholars stated that while CBDCs are unlikely to undermine the international role of the dollar or have a negative impact on cross-border payments, the enhancement of CBDCs can also be achieved by improving existing non-CBDC payment systems.

Lastly, FED scholars believe that the dollar's international role as a unit of account, especially as a store of value, is unlikely to be affected by the introduction of CBDCs, even stable and large non-U.S. currencies.