Apr 1, 2022 3 min read Crypto

The Fed on the Blockchain

The Federal Reserve is about to restructure the American financial system. And not because it wants to. With the possibility of a recession looming and inflation surging, the Fed has its hands full. If it had its choice, the creation of a Central Bank Digital Currency (CBDC) would not make the bottom of the “to do” list.

But the opportunities of a central bank coin on the blockchain are obvious, no matter how well the Fed and the banks believe the current payment system works. CBDC is a work in progress but the blockchain in various forms is up to the task.

Blockchains

Blockchains are an established technology which promise many functional roles in finance beyond coins and currencies. The idea of the blockchain is bigger than its applications. The mathematical algorithms allowing for distributed ledgers offer both private and public applications. On the private side, bitcoins, altcoins, and smart contracts are the subject of constant debate about their disruption. But it is on the public side that the blockchain promises to be the most disruptive.

Blockchains are not the only technology under consideration to build distributed ledgers or support a CBDC. And several technical variations and combinations are in use. The potential disruption of most of these technologies, however, is the same. They arise because financial markets are by their very nature intermediaries and the blockchain eliminates the need for intermediaries.

Non-blockchain approaches like the digital dollar are in the works. The digital dollar is token-based i.e., electronically communicated with anonymous transactions, which are not government guaranteed.

But for this and all the possible technologies in the electronic dollar space, it is the blockchain which is central to achieving the goals of CBDC. Tests of CBDC blockchain transactions appear to clearly outperform cryptocurrencies. And it is the blockchain’s distributive technology which, fully implemented, would obviate the need for third parties like banks. The central banks and the commercial banks have not missed this point.

Slow implementation may not be possible

A recent study by seven central banks and the Bank for International Settlements laid out the case for a go-slow approach to allow the entire banking system to adjust to a new network of national CBDCs. Indeed, the central banks are intending just that - a slow level of implementation. One important concern is whether the CBDC pays interest. To the degree that it does, CBDC threatens to draw assets from and potentially destabilize banks.

CBDS going into use anyway

Despite the recognized need to slowly adopt CBDCs, the technology is almost universally under consideration. The countries which have adopted CBDCs, or close to adopting it, were included in a recent IMF study. They include: the Bahamas, Canada, China, the Eastern Caribbean Currency Union, Sweden, and Uruguay.

Driving the adoption were several policy issues. These included expanding the financial inclusion of the citizens and improving access to financial resources. Of course, restricting the illicit use of money was high on the list of goals. Resilience for several countries was important because of the frequent natural disasters limiting the financial system. Maintaining the sovereignty of their systems and improving financial competition were also on the list of goals. In the end, though, it is unlikely that these policy items listed here will be the motivation for the US implementing a Federal Reserve CBDC.

Central banks have been exploring the benefits of a CBDC for decades. The Fed itself summarizes studies on the issue going back to 1960. The studies document the potential increase in public welfare from the adoption of a CBDC but warn of the problems with the bank profitability.

These studies do not capture what should be the largest current motivators for Fed action: the growth and instability of the crypto market and the Chinese multilateral banking challenge. The size of the cryptocurrency market is large enough to be a concern to Fed officials. The stability and predictability of the crypto market is a growing concern. While theft and lack of transparency of cryptocurrency continue to challenge regulators, implementation of an international CBDC by the Chinese is one element of the country’s pursuit of digital dominance. This requires that the Fed take rapid decisive action which the Administration indicates that it is willing to support.