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Should the Issue a Central Digital ? By Paul H. Kupiec August 2021

During Federal Reserve Chairman Jerome Powell’s July 2021 congressional testimony, several elected members encouraged Powell to fast-track the issuance of a Federal Reserve digital cur- rency. Chairman Powell indicated he is not convinced there is a need for a Fed . But he also indicated that Fed staff are actively studying the issue and that his opinion could change based on their findings and recommendations. In this report, I explain how a new Fed- eral Reserve digital currency would interface with the existing system and review the policy issues associated with introducing a Fed digital currency.

The Bank for International Settlements defines Governors of the Federal Reserve System 2021b). “ digital currency” as “a digital payment Digital deposits are recorded in (electronic) instrument, denominated in the national unit of entries with no physical form. Digital Fed- account, that is a direct liability of the central eral Reserve deposits can only be held by financial bank” (BIS 2020). In his semiannual appearance institutions (primarily ) eligible for master before Congress, Federal Reserve Chairman Jerome accounts at a Federal Reserve bank. Powell indicated that the Fed was studying the idea Most businesses and consumers are not eligible of creating a new dollar-based central bank digital to own Federal Reserve master accounts, so they currency (USCBDC) (Lee 2021). The design of cannot own Federal Reserve digital deposits under USCBDC has important implications for the US finan- current arrangements. They can own central bank cial system. To facilitate the policy discussion, I money in the form of paper Federal Reserve notes discuss how a US digital currency relates to existing or hold “bank money”—US dollar-denominated forms of dollar-based money, the sys- digital currency in the form of bank deposits that tem, competing privately issued , and are exchangeable at par into paper Federal Reserve the policy issues associated with USCBDC design. notes. Unlike central bank digital money, bank- issued digital deposits can be subject to default Central Bank Money, Digital Money, losses if the bank issuing deposits fails. However, and Efficiency of Payments Systems bank deposits to $250,000 per depositor are fully insured by the Federal Insurance At present, the Federal Reserve issues two types of Corporation (FDIC), and the maximum effective central bank money—paper Federal Reserve notes and digital Federal Reserve deposits (Board of

AMERICAN ENTERPRISE INSTITUTE 1 Terminology

A short description of some industry-specific terminology is below.

Stablecoins. Stablecoins are a class of that attempts to maintain a fixed exchange rate with a designated fiat currency or basket of fiat by holding reserve assets that can be used to buy and sell on exchanges to maintain the target exchange rate peg.

Federal Reserve Master Account. Eligible institutions may have one master account at a designated Federal Reserve bank that is both a record of financial transactions that reflects the financial rights and obligations of an account holder and of the Federal Reserve bank with respect to each other and the place where opening and closing balances are deter- mined (Board of Governors of the Federal Reserve System 2021c).

Automated Clearing House (ACH). The ACH is an electronic funds transfer system run by NACHA, formerly called the National Association, since 1974. This provides ACH transactions for use with payroll, direct deposit, tax refunds, consumer bills, tax payments, and many more payment services in the US.

Blockchain. is a decentralized, distributed, public digital ledger consisting of historical transactions processed and recorded in uniform sequential groups of transac- tions called blocks. Each block of transactions is processed across many computers using cryptographic methods that make it difficult to falsify a record or alter records retroactively.

Permissioned Blockchain. This blockchain network has limited to a shared dis- tributed ledger. Controlling access to ledger transaction processing and record verifica- tion allows ledger security to be maintained with more efficient cryptographic methods.

insurance coverage on bank deposits can be increased The transfer of digital bank money is the primary simply by keeping deposit accounts in multiple banks. mechanism used to settle retail transactions in the The infrastructure for settling domestic trans- US. Transfers of bank retail digital deposits are actions between financial institutions using cen- inexpensive but historically have taken longer to tral bank digital deposits is well-developed, fast, settle than central bank digital deposit transfers. reliable, and inexpensive. 1 Domestic transfers of Table 1 provides the fees and settlement times central bank digital deposits can settle in real time associated with Automated Clearing House (ACH) or end of day depending on the settlement system domestic deposit transfers for a sample of US used.2 Settlement systems for international trans- banks. New real-time processing systems are now fers of central bank deposits are reliable if more available (Clearing House 2021) for settling bank expensive than domestic transfers. However, efforts retail digital transactions (Zelle 2021). In addition, are underway to reduce international transactions popular online money transfer services3 linked to costs (FSB 2020b). bank accounts offer, for a fee, a faster settlement

1 For example, Fedwire, the Federal Reserve System for transferring bank master account balances, charges institutions a monthly fee for access and transactions fees that depend on the volume of transactions. The FRB (2021) details the current Fedwire ACH fee schedule. 2 Board of Governors of the Federal Reserve System (2021a) explains the Federal Reserve’s Fedwire Fund Services. 3 is an example of a state-licensed money transfer that offers settlement times faster than standard ACH transactions do.

AMERICAN ENTERPRISE INSTITUTE 2 Table 1. Electronic Bank Deposit Transfer Fees and Settlement Times at Selected Banks

Financial Institution Cost (Both Directions Unless Specified) Approximate Delivery Times* Transfer Fee Alliant $0 One business day

Ally Bank $0 Three business days

American Express National One to three business days; three or more $0 business days for transfers initiated at the Bank bank where the funds should arrive

Axos Bank $0 Three to five business days To Bank of America account: $0 From Bank of America account (three busi- Three business days; option for next-day Bank of America ness days): $3 delivery From Bank of America account (next day): $10 To Bank5 Connect account: $0 From Bank5 Connect account (standard de- Up to three business days; option for next- Bank5 Connect livery): $0 day delivery From Bank5 Connect account (next day): $3

Barclays $0 Two to three business days

Boeing Employees Credit $0 Two to three business days; option for free Union next-day delivery

Capital One 360 Bank $0 Two business days

Chase $0 One to two business days Three business days; option for free next- Citibank $0 day delivery

Discover Bank $0 Up to four business days

Navy Federal Credit Union $0 Two to three business days

PNC Bank $0 Three business days

Synchrony Bank $0 Up to three business days

TD Bank $0 One to three business days To US : $0 Three business days; option for free next- US Bank From US Bank account: Up to $3 day delivery (incoming transfers only) To Wells Fargo account: Three business days

Wells Fargo $0 From Wells Fargo account: Two business days Note: * These are typical outgoing and incoming transfer times when initiated through , according to each ’s disclosures and general policies. Delays can occur due to holding periods, sending after daily cutoff times, initial service setup, and other reasons. This list includes only personal accounts, not business accounts. Source: Burnette and Tierney (2021).

time than standard ACH transfers (Venmo 2021). electricity consumption (McDonald 2021), and trans- The volume of transactions settled in real time will actions fees and settlement timing vary according undoubtedly increase over time. to the volume of transactions and the public In contrast, the processing of cryptocurrency computing resources processing the distributed transactions is costly in computing resources and ledger. Figure 1 shows the average daily cost of pro-

AMERICAN ENTERPRISE INSTITUTE 3 Figure 1. Average Daily Cost to Process a Transaction on the -Distributed Blockchain Ledger

Source: YCharts (2021).

cessing a stablecoin transaction on the Ethereum- USCBDC transactions processing. This presumes distributed blockchain ledger over the past year. of course that international ownership of USCBDC These costs, while much higher on average than would be legal and widely used. the costs of domestically transferring bank deposit Proponents of private stablecoin cryptocurren- balances, are mostly lower than the cost of trans- cies and USCBDC argue that both would provide ferring bank deposits internationally. the unbanked with a new, more affordable way to access to the banking and payment system. As dis- USCBDC, Stablecoins, and Competing cussed below, unless USCBDC pays , Digital Currencies USCBDC account holders will likely face costs to maintain USCBDC accounts and transfer balances One rationale for so-called stablecoin cryptocur- to reimburse the costs intermediaries must expend rencies like Facebook’s proposed is the claim to maintain and transfer USCBDC balances. While that they will bring down the cost of processing USCBDC payments processing will likely be less transactions, especially when transactions are inter- expensive than the cost of maintaining and trans- national and involve countries with less-developed acting in private stablecoins, the unbanked would financial infrastructures (Libra Association Mem- still face costs unless subsidy programs were cre- bers 2020). Reportedly, Diem balances will be ated to defray the costs for targeted individuals. maintained and transactions processed using some Similar subsidy programs could be used to alleviate type of “permissioned” that the “unbanked problem” (FDIC 2012) using digital could make transactions processing more efficient bank deposit accounts, so it is unclear why a than ’s blockchain process (Auer, Monnet, and USCBDC is a better solution for giving the unbanked Shin 2021). Diem’s transactions processing system access to the payment system. is still being developed, so Diem transactions costs In sum, there is not a strong case for creating are yet to be determined. USCBDC based on the cost and efficiency of domes- Notwithstanding Diem representations regarding tic payment transaction processing, especially con- transactions costs, any transaction cost reductions sidering the efficiency improvements that will achieved by privately issued stablecoins settled using come with expanded real-time processing systems distributed ledger systems would likely be under- for digital bank deposits. Moreover, the allure of the cut by the cost savings achievable with centralized anonymity once associated with privately issued

AMERICAN ENTERPRISE INSTITUTE 4 cryptocurrencies such as bitcoin and Ethereum is A third source of potential USCBDC demand is being eroded as private cryptocurrency users are international investors. Currently, deposit insur- increasingly required to comply with anti–money ance protections for digital bank money only apply laundering and terrorist finance laws in the US and to deposits in domestically chartered and insured other developed countries. depository institutions and a few domestic The Financial Stability Board has opined that, branches of foreign banks with “grandfathered” unless they are properly regulated, privately issued insurance coverage. Dollar deposits in foreign stablecoins can threaten financial stability (FSB banks are not protected by FDIC insurance and are 2020a). One argument favoring USCBDC is that it subject to loss should the foreign bank fail. would prevent privately issued stablecoins from becoming systemically important pseudo-currencies. USCBDC Design When recently questioned about the Fed’s plans regarding a USCBDC, Fed Chairman Powell The framers of the Federal Reserve Act never envi- responded, “You wouldn’t need stablecoins, you sioned USCBDC, so it is an open issue whether the wouldn’t need cryptocurrencies, if you had a digital Fed has the legal authority to issue a new Fed digi- US currency. I think that’s one of the stronger tal currency. In response to members of Congress’ arguments in its favor” (US House Committee on questions about the need for explicit authorizing 2021). Others (Adler and Pollock legislation, the chairman admitted he was unsure 2021) focus on digital currency competition among of the Fed’s legal standing regarding USCBDC but central banks, arguing that the Fed will be forced further stated that, under his chairmanship, the to issue its own digital currency to prevent China’s Fed would not undertake such a step without strong digital currency from undermining the US dollar’s congressional support, even if the Fed’s legal staff international reserve currency status. Rightly or could justify USCBDC based on existing authorities. wrongly, senior Fed officials (Quarles 2021) are, Two designs could be used to issue USCBDC. In however, skeptical of this argument. one, the Fed would accept dollars and issue a digi- tal dollar token with a unique digital identifier. The USCBDC Demand digital token would then and settle using some type of distributed public ledger technology. If the Fed were to issue USCBDC, current features The integrity of this type of digital currency relies of our monetary system will likely generate demand on a large number of independent processors to for this new digital currency. Many businesses verify the authenticity of a transaction and ensure must maintain large uninsured bank deposit bal- that token owners cannot spend the same token twice. ances to meet payroll and other expenses. These Digital currencies of this design are not well suited for bank deposits are exposed to losses should the retail transactions because transactions are expen- bank holding the deposits fail. USCBDC may be an sive to process in volume using a public distributed attractive alternative for some uninsured deposi- ledger and payees may face significant delays and tors because USCBDC eliminates the risk of loss uncertain fees to verify the transfer of funds. due to bank failure. An alternative USCBDC design is more suitable Money market mutual funds (MMFs) are another for processing retail transactions. It uses a single potential source of USCBDC demand. On behalf of private ledger controlled by the Fed to process and their account holders, MMFs invest large amounts record USCBDC transactions. Under this approach, in short-term debt instruments such as Treasury USCBDC purchasers could have their own individ- bills, commercial paper, and repurchase agreements. ual deposit accounts at a Federal Reserve bank, or, Depending on MMF investments, account holders more likely, USCBDC accounts would be issued by can be exposed to losses from defaults or prema- financial intermediaries who would in turn have a ture investment liquidations. During periods of USCBDC account at the Fed. Retail accounts financial stress and elevated default risk, MMF would be established and managed by qualified account holders will likely prefer the certainty of a financial intermediaries who would be required to USCBDC deposit over an investment in a MMF.

AMERICAN ENTERPRISE INSTITUTE 5 back each dollar of USCBDC they issue with a dol- way, the cost of bank credit could substantially lar deposit in the intermediary’s Federal Reserve increase should USCBDC prove popular with bank USCBDC account. In other words, USCBDC inter- depositors. mediaries would have to back their USCBDC accounts Similarly, MMF account holders may withdraw with a 100 percent investment in Federal Reserve balances to purchase USCBDC. Withdrawals will master account balances. affect MMFs’ ability to purchase commercial paper If individuals were allowed to open USCBDC and other short-term liabilities that are an important accounts held directly at a Federal Reserve bank, source of funding for many large business and cor- the Fed would be responsible for complying with porations. Should a significant volume of USCBDC all the regulations associated with retail deposit purchases come at the expense of MMF account accounts, such as meeting know-your-customer balances, interest rates could increase on short-term anti– and terrorism finance marketable paper issued by private-sector firms. requirements and maintaining an portal in One of the most important issues surrounding which perhaps millions of customers could view USCBDC design is the payment of interest. Should their account balances and transfer funds. If, alter- the Fed be permitted to pay interest on USCBDC, natively, USCBDC is issued using intermediaries, and, if so, at what rate? the intermediary will interface with the retail cus- One option is to prohibit USCBDC from paying tomer and be responsible for enforcing all regula- interest. Paper money—Federal Reserve notes— tions associated with deposit intermediaries, pro- pays no interest, and before the passage of the cessing transactions, and maintaining customer Dodd-Frank Act, bank transaction account balances balance information while only reporting the inter- were prohibited from paying interest. At present, mediaries’ net USCBDC transactions to the Fed for only depository institutions are allowed to earn processing. Financial intermediaries will almost interest on balances held in Federal Reserve mas- certainly be involved should the Fed decide to issue ter accounts. Government-sponsored enterprises USCBDC. and primary dealers can have Fed master accounts Every dollar of USCBDC created is a liability of but do not earn interest on these account balances. the Fed and must be matched by assets of equiva- If USCBDC intermediaries were given the same lent value on the Federal Reserve’s balance sheet. status as other non-depository master account In the case of Federal Reserve notes and central holders, the no-interest convention would be con- bank reserve balances, the offsetting liabilities are sistent with current practice. However, prohibiting US Treasury securities, agency mortgage-backed interest would limit the retail demand for securities, collateralized to depository insti- USCBDC, as USCBDC account holders would tutions, and loans to other financial intermediaries likely be required to pay intermediaries to main- made through crisis-related special purpose lend- tain USCBDC accounts and process transactions. ing programs. The proceeds of USCBDC deposits The Federal Reserve may prefer paying interest could be used to purchase similar assets unless on USCBDC balances if the Fed is allowed to vary Congress intervenes to restrict or expand the assets the interest rate on these balances and the rate is the Fed is allowed to purchase using USCBDC allowed to differ from the rate the Fed pays on receipts. depository institution master account balances. USCBDC issuance will directly affect banks and Under this design, the Fed would acquire a new MMFs. The bulk of the dollar balances used to pur- instrument that could be used to control MMF bal- chase USCBDC will come directly from bank deposit ances and bank reserves. This additional instru- accounts and MMF accounts. Deposits are typically ment could enhance the Fed’s ability to attain its a bank’s cheapest source of funding and the pri- monetary targets, but it would also disrupt the tra- mary instrument banks use to fund loans and other ditional business models of banks and MMFs. investments. If USCBDC are purchased using bank The interest rate earned on USCBDC will likely deposits, banks will have to contract their loans be an important factor that determines institutional and security investments or replace lost deposits investor interest in USCBDC under normal condi- with a more expensive source of funding. Either tions. If USCBDC pays no interest, institutional

AMERICAN ENTERPRISE INSTITUTE 6 balances will likely remain bifurcated between unin- reasons to believe that USCBDC would increase sured bank deposits and MMF accounts because it the speed and reduce the cost of domestic transac- will be costly to maintain USCBDC balances and tions processing relative to the systems used to process transactions, whereas uninsured bank process bank digital deposits. deposits typically generate nonpecuniary benefits for account holders and MMF balances generate marginal account holder returns. Other things equal, higher USCBDC interest rates will draw The design of a USCBDC has larger balances from MMFs and uninsured bank important implications for the finan- deposits into USCBDC. Suppose the Fed were to issue USCBDC and set cial system and private-sector credit the interest rate above the overnight reverse repur- availability. chase rate (0.05 percent as of July 30, 2021, according to the Federal Reserve Bank of St. Louis) but below The international availability of a USCBDC the interest rate it pays banks on bank reserves would undermine the competitiveness of privately held at the Fed (currently 0.15 percent). This issued stablecoins and likely prevent them from USCBDC interest rate would likely attract some becoming a financial stability threat. Federal Reserve institutional money and drain account balances officials discount arguments that a USCBDC is from both MMFs and large uninsured bank depos- necessary to defend the reserve currency status of its. This in turn would reduce the volume of Fed the US dollar, but competition among central bank overnight reverse repurchase agreements and digital currencies could become an important con- reduce bank reserves, reducing banks’ and MMFs’ sideration in the future. capacity to fund private-sector credit. Conversely, The design of a USCBDC has important impli- negative USCBDC interest rates or any rate below cations for the financial system and private-sector the overnight reverse repurchase rate would signif- credit availability. If issued, USCBDC almost cer- icantly diminish the appeal of USCBDC. tainly will use a private central ledger controlled by On issues of financial stability, the availability of the Fed and employ regulated intermediaries to USCBDC could cause panicked uncontrolled disin- interact with USCBDC retail accounts. termediation in a financial crisis. Facing an elevated Decisions regarding USCBDC interest payments risk of default losses, uninsured bank depositors are a crucial design issue. Prohibiting USCBDC and MMF account holders would likely pull their from paying interest, while consistent with the lack balances from banks and MMFs to purchase of interest earned on paper currency, will limit the USCBDC regardless of interest rates because appeal of USCBDC under normal conditions. USCBDC has no default risk. In a financial crisis, USCBDC balances will entail transactions fees that private-sector financial institutions would likely may make USCBDC appear to be the most expen- hemorrhage funds as investors ran to the safety of sive form of dollar-denominated “money.” If USCBDC. USCBDC is allowed to earn interest, the USCBDC interest rate will be a new monetary policy instru- Conclusion ment that the Fed can use to regulate the level of reserves in the financial system. Regardless, the The dominant form of money in the US is digital availability of USCBDC will introduce a new finan- money in the form of bank deposits. Fast, reliable, cial stability concern: In a financial crisis, the finan- and inexpensive systems are in place to process cial disintermediation caused by an uncontrolled domestic digital bank deposit transactions. Inter- run into USCBDC will severely disrupt the availa- national digital deposit transfers are more expen- bility of private-sector credit. sive, but plans are underway to improve the effi- ciency of these systems. There are no compelling

AMERICAN ENTERPRISE INSTITUTE 7 About the Author

Paul H. Kupiec is a senior fellow at the American Enterprise Institute, where he studies economic issues related to banking and financial services.

References

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Auer, Raphael, Cyril Monnet, and Hyun Song Shin. 2021. “Permissioned Distributed Ledgers and the Governance of Money.” Working Paper. Bank for International Settlements. January 27. https://www.bis.org/publ/work924.htm.

BIS (Bank for International Settlements). 2020. “Central Bank Digital Currencies: Foundational Principles and Core Features.” October 9. https://www.bis.org/publ/othp33.pdf.

Board of Governors of the Federal Reserve System. 2021a. “Fedwire Funds Services.” May 7. https://www.federalreserve.gov/ paymentsystems/fedfunds_about.htm.

———. 2021b. “Financial Manual for Federal Reserve Banks. July 2021.” July. https://www.federalreserve. gov/aboutthefed/files/BSTfinaccountingmanual.pdf.

———. 2021c. https://www.federalreserve.gov/.

Burnette, Margarette, and Spencer Tierney. 2021. “What It Costs to Transfer Money Between Banks.” NerdWallet. June 10. https://www.nerdwallet.com/article/banking/ach-transfer-costs.

Clearing House. 2021. “The RTP Network: For All Financial Institutions.” https://www.theclearinghouse.org/payment- systems/rtp/institution.

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FDIC (Federal Deposit Insurance Corporation). 2012. “2011 FDIC National Survey of Unbanked and Underbanked Households.” September. https://www.fdic.gov/householdsurvey/2012_unbankedreport.pdf.

FRB (Federal Reserve Banks). 2021. “FedACH Services 2021 Fee Schedule.” https://www.frbservices.org/resources/fees/ach-2021.html.

FSB (Financial Stability Board). 2020a. “Addressing the Regulatory, Supervisory and Oversight Challenges Raised by ‘Global Stablecoin’ Arrangements.” April 14. https://www.fsb.org/wp-content/uploads/P140420-1.pdf.

———. 2020b. “FSB Delivers a Roadmap to Enhance Cross-Border Payments.” Press Release. October 13. https://www.fsb.org/ 2020/10/fsb-delivers-a-roadmap-to-enhance-cross-border-payments/.

Khatwani, Sudhir. 2020. “Bitcoin Transaction Fees: A Beginner’s Guide for 2020.” Money Mongers. May 30. https://themoney- mongers.com/bitcoin-transaction-fees/.

Lee, Isabelle. 2021. “Fed Chair Jerome Powell Says Cryptocurrencies and Stablecoins Won’t Be Needed Once the US Has a Digital Currency.” Business Insider. July 14. https://www.msn.com/en-us/money/markets/fed-chair-jerome-powell-says-cryptocurrencies- and-stablecoins-wont-be-needed-once-the-us-has-a-digital-currency/ar-AAM9YJ7.

McDonald, Oonagh. 2021. Cryptocurrencies: Money, Trust and Regulation. Newcastle upon Tyne, UK: Agenda Publishing. October 7. Quarles, Randal K. 2021. “Parachute Pants and Central Bank Money.” Utah Bankers Association Convention. Sun Valley, Utah. June 28. https://www.federalreserve.gov/newsevents/speech/quarles20210628a.htm

US House Committee on Financial Services. 2021. “Virtual Hearing: Monetary Policy and the State of the Economy.” YouTube. July 14. https://www.youtube.com/watch?v=gj9ygZHNemY.

AMERICAN ENTERPRISE INSTITUTE 8 Venmo. 2021. “Fees.” https://venmo.com/about/fees/.

YCharts. 2021. “Ethereum Average Transaction Fee.” https://ycharts.com/indicators/ethereum_average_transaction_fee.

Zelle. 2021. “What Is Zelle?” https://www.zellepay.com/support/what-is-zelle.

Robert Doar, President; Michael R. Strain, Director of Economic Policy Studies; Stan Veuger, Editor, AEI Economic Perspectives

AEI Economic Perspectives is a publication of the American Enterprise Institute (AEI), a nonpartisan, not-for-profit, 501(c)(3) educational organization. The views expressed in AEI publications are those of the authors. AEI does not take institutional positions on any issues.

© 2021 by the American Enterprise Institute for Public Policy Research. All rights reserved. For more information on AEI Economic Perspectives, please visit www.aei.org/feature/aei-economic-perspectives/.

AMERICAN ENTERPRISE INSTITUTE 9