Do you ever wonder why we still have paper money in a world that continues to become more digital? Maybe it is because of the anonymity or the cost associated with using financial institutions to store and transfer a dollar. It could also be that there is not a viable substitute in the market. For whatever reason, consumers still like cash. It is not only consumers who like cash, though; for the most part, so do merchants. Cash settles at par, meaning if someone pays you a dollar you receive the whole dollar. It is also settled instantaneously and once received it can be spent seconds later. In addition, cash is irrevocable. Once you receive it no one can take it back from you. You own it. Now imagine a world where this is all done digitally versus physically.
The discussion of creating a digital dollar or a Central Bank Digital Currency (CBDC) could lead to a new era of payments in which a digital dollar can fulfill the purpose of a physical dollar and create additional benefits. Before explaining some of the additional benefits of CBDC, let's first talk about other forms of digital currency in the market and their differences. The digital currency most people are familiar with is bitcoin. Bitcoin represents a value in the marketplace that traders decide based on their willingness to pay for it. Like other commodities, the market sets the price, and the price fluctuates based on market conditions. People hold bitcoin for various reasons, but it basically acts as a storage of value. Because of the fluctuation, it is difficult for bitcoin to become a widely used form of tender.
Another type of digital currency in the market is stablecoin. Stablecoin is still based on the same blockchain technology as bitcoin; however, instead of the market setting the price, the price is backed by a reserve asset such as a fiat currency. A fiat currency is a form of money not backed by a physical commodity but rather the governing body that issued it. Other reserve assets that back stablecoin could include a commodity like gold or even other cryptocurrencies. The fiat currency could be a single currency like the U.S. dollar or a basket of currencies. The theory is that a stablecoin will fluctuate with the cost of the reserve asset which provides greater stability. The goal of stablecoin is to provide a blockchain-based currency whose stability makes it more suitable for payments. The potential downside of stablecoin is there is no set standard to ensure it has the asset reserves needed if there were to be a run on moving the currency back to the reserve asset. Not all stablecoins are created equal, and consumers could find themselves in a situation where the value of the coin diminishes due to lack of appropriate reserves.
Digital currency such as CBDC is created by a central bank. A CBDC can have the functionality of a stablecoin and comes with the added benefit of being backed by the government. CBDC differs from other stablecoins because others have no requirement of their backing and can be in default with just the entity failing and not a government default. As with a physical dollar, the government guarantees the value of the money for a CBDC. Different than a physical dollar, however, the CBDC has increased flexibility in usage because a payor and payee are able to electronically transport electronically the digital currency. The limitation of the physical dollar is that its value must be transferred manually and cannot be used in a digital world. While many systems have been created to transfer the represented value of a dollar within a commercial bank account, this comes with a cost, as well as complications. Complications include the possibility of the currency being revoked after merchandise has left a merchant’s possession or waiting several days for the actual transfer to occur in order for the value to be used again.
The Federal Reserve has recently started to evaluate whether the creation of a U.S. digital dollar makes sense. Their recent paper Money and Payments: The U.S.Dollar in the Age of Digital Transformation outlines the differences between digital currencies and poses many policy questions on how a digital dollar should work. The MAG recently issued a white paper titled Best Practices: Central Bank Digital Currency Development Principles. In this paper, the MAG outlines basic principles that should be considered in the development of a digital dollar, including the following:
- CBDC deployment must enable competition and innovation
- Flexibility is needed to meet both the business and consumer needs
- Fraud liability and authentication requirements need to be clearly defined
- Regulations must be framed to the specific risk which is presented to the payments ecosystem
- Functionality needs to align with paper currency
- Input and buy-in from all parties will be critical to success when building a CBDC
We agree with the Federal Reserve’s basic premise that CBDC must provide benefits to households, businesses, and the overall economy that exceed any cost and risk of holding or using a CBDC. The current payments system in the U.S. was developed decades ago and requires the involvement of several parties to move value from one person to the next. It also allows for billions of dollars of fraud annually. If created and implemented correctly, CBDC can create efficiencies in the system while decreasing the amount of fraud that currently prevails. The Federal Reserve is also the only entity that can bring the backing of the government to the creation of digital currency.
The merchant community needs innovation like CBDC to bring greater competition and innovation to the payments industry. We encourage the merchant community to become familiar with the Federal Reserve paper regarding the creation of a CBDC, as well as to get involved and weigh in on why the creation of a CBDC could bring significant benefits to the consumer. We look forward to engaging with the Federal Reserve to collaborate and ensure that CBDC will create a benefit to the consumers we all serve.