We can do more than we think without a Fed digital dollar

Should the Federal Reserve issue a new central bank digital currency (CBDC)? 

A recent “white paper” issued by Rep. Jim Himes (D- Conn.) argues the answer is yes. It outlines the objectives and characteristics of the new Fed digital dollar Himes envisions authorizing in legislation yet to be introduced.

Without debating the merits of a new Fed CBDC, it is important to understand that all of Himes’s objectives can be achieved without a digital dollar. Insured depository institutions and state-licensed money transfer agents could create the tokenized dollars payments system envisioned by the white paper. Under this approach, the Federal Reserve need not issue CBDC; its only additional duty would be oversight of the new ledger-based payment system.

The Federal Reserve already issues digital currency in the form of reserve balances held in master accounts at Federal Reserve district banks. Reserve balances are backed by the full faith and credit of the U.S. government and are default risk-free. Only insured depository institutions and a limited number of specialized financial institutions are allowed to open Fed master accounts and own reserve balances.

While only a select few institutions can own reserves at the Fed, any consumer or business can own digital currency in the form of deposits at an insured depository institution. These deposits are backed by the full faith and credit of the U.S. government up to $250,000 per account — the FDIC deposit insurance limit. Deposits in excess of the insurance limit could, in theory, be exposed to losses should an insured depository institution fail. However, in most cases, all deposits of failing institutions are acquired by another bank without any loss to depositors. Moreover, a depositor can expand explicit FDIC insurance coverage by having accounts at multiple banks either directly or indirectly using deposit brokerage services.

The Himes white paper envisions that the Fed would issue a new CBDC that is tokenized, held by the public, and used in lieu of cash for retail transactions. Tokenized means that CBDC dollars are transferred between accounts (a.k.a. wallets) using some type of distributed ledger system. 

The paper suggests that the Fed CBDC “should be deployed using a permissioned semi-distributed architecture… [that] would permit only authorized participants to access the underlying payment database.” Financial regulators would decide which institutions have database access. The paper cautions that these new digital dollars must “be structured in a way that preserves commercial banking maturity transformation and does not reduce credit availability.”

Rep. Himes proposes that a Fed CBDC be intermediated, meaning that depositors would open wallets at approved financial institutions. These institutions would manage the customer interface activities currently associated with customer accounts at insured depository institutions. Approved institutions could include insured depository institutions and state-licensed money transfer agents including licensed stablecoin issuers. An approved financial intermediary would be responsible for fulfilling all anti-money laundering and know-your-customer protocols that currently apply to bank accounts and money transfer agents. These intermediaries would manage accounts and presumably compete to develop account services that attract customers’ Fed CBDC balances.    

According to the Himes paper, one clear benefit of a Fed-issued CBDC is that it is “backed by the full faith and credit of the U.S. government, like traditional cash, and would provide holders with a degree of safety that may not be offered by privately issued stablecoins…”  To mitigate the potential risk of a run on the banking system, the paper argues that there should be limits on balances that can be held in Fed CBDC wallets to attenuate the potential that “CBDC might also be regarded by consumers as a safe refuge in times of financial stress, leading to a countercyclical reduction in bank deposits.” The white paper also suggests that similar to cash, CBDC wallets should not pay interest.

The characteristics and objectives articulated in Himes’s white paper can be achieved without issuing a new Fed CBDC. If regulated depository institutions and money transfer agents were encouraged to work with the Fed to develop the “permissioned semi-distributed ledger” payments processing system envisioned by the white paper, they could offer tokenized deposit accounts to retail customers and businesses, just as they offer checking accounts today.  These new tokenized dollars would be federally insured up to the $250,000 FDIC limit if the wallet were held at an insured depository institution. 

Under this alternative approach of creating tokenized bank deposits accounts, unlike issuing a new Fed CBDC, there would be no risk of disintermediation or negative ramifications for the availability of bank credit as these balances would just be a new type of bank deposit account, not balances held by the Federal Reserve. Similarly, there is no risk that banking system deposits will run to Fed CBDC wallets in times of crisis because there would be no Fed CBDC issued.

Tokenized bank deposit accounts could pay interest just as checking accounts have been allowed to pay interest since the passage of the Dodd-Frank Act, but they need not do so if Congress prefers these deposits mimic paper currency. Depository institutions and state-chartered money transfer agents issuing these new accounts would be subject to all of the existing federal and state safety and soundness regulations and anti-money laundering “know your customer” rules they must comply with today. There is no need to revisit financial regulations because these accounts are just like existing accounts except they use a new type of payment system to clear and settle transactions.  

The focus on issuing Fed CBDC is misguided. The private sector financial system — insured depository institutions and state-licensed money transfer agents — in cooperation with the Federal Reserve system could develop the payments infrastructure needed to transfer tokenized dollar balances to facilitate consumer and business transactions. The Federal Reserve should be encouraged to help the private sector develop this system, but it need not issue the tokenized digital currency that is transferred over this system. Insured depositories and licensed money transfer agents can create and manage tokenized dollars in wallets that they service, and the Fed can exercise oversight powers over this next-generation payments system.

Paul Kupiec is a senior fellow at the American Enterprise Institute specializing in financial services issues.