Amid increased interest from Congress in cryptocurrencies and stablecoins, in late January 2022, the U.S. Federal Reserve published its discussion paper on central bank digital currencies (CBDCs). Based on the paper, it appears that while the Fed recognizes the potential benefits CBDCs can have on payment systems—from financial inclusion to maintaining the dollar’s primacy in the global economy—it has more questions than answers regarding key policy concerns about monetary and financial stability risks, and the potential impacts a U.S.-issued CBDC would have on the global financial system.
Currently, 87 countries representing 90 percent of global GDP are exploring a CBDC. Of the four largest central banks in the world (the Euro Zone, Japan, the United Kingdom, and the United States), the United States is the furthest behind in CBDC developmentdue to privacy concerns, regulatory hurdles, and divisions within Congress on whether a U.S.-issued CBDC is necessary. While U.S. financial institutions understand the need to address gaps in the current financial system—as demonstrated by the Fed’s plans to launch its FedNow Service in 2023, which seeks to provide instant payment services for interbank settlements—heightened interest in CBDCs, particularly from China and Russia, is prompting the Fed and other central banks around the world to explore and evaluate their potential roles in the digital asset ecosystem.
In an effort to address these important issues, we tackle five key foreign policy questions posed by the Fed in its discussion paper and highlight related issues that warrant further attention.
Could some or all of the potential benefits of a CBDC be better achieved in a different way?
There are many payment technologies currently in use or under development that could replicate the benefits of a CBDC on a domestic level. For example, technologies such as real-time gross settlement, new forms of non-cash payments, and real-time payments can replicate some of the potential benefits of CBDCs or stablecoins in the payments space. From an inclusion perspective, globally, there are numerous fintech companies dedicated to expanding access to financial services around the world, such as Akaboxi in Uganda and Teknospire in India, in addition to numerous U.S. start-ups. These companies provide access to banking services in underserved communities and lower the costs of remittances potentially as effectively as a CBDC.
Internationally, there are potential benefits of a U.S. CBDC that may be harder to achieve via other means. The main benefits would come from the widespread use of a U.S. CBDC to maintain the dollar’s importance in the international payments system by securing a dominant position in the future of international payments architecture and countering foreign countries’ active attempts to gain influence. For example, the Society for Worldwide Interbank Financial Telecommunications (SWIFT), which is critical for conducting cross-border financial transactions, is already exploring working with China’s digital renminbi. This could facilitate China’s shift away from its reliance on the dollar and move it closer to eventually providing a viable alternative to the existing dollar-centric system. Such a shift would erode the United States’ global economic standing and limit its international influence by providing an alternative financial system beyond the reach of U.S. sanctions.
In the short term, it is highly unlikely that the dollar’s dominant international role will be usurped. At least 60 percent of exports are invoiced in dollars in Latin America, Sub-Saharan Africa, Central Asia, East and Southeast Asia, and the Pacific, according to the International Monetary Fund (IMF), with the remainder divided between local currencies and the euro. At present, the renminbi is not poised to challenge the dollar’s role as the world’s reserve currency, given that it is not freely exchangeable and Chinese capital account is closed.
The United States cannot take its primacy for granted, however, and must dedicate resources establish the necessary digital infrastructure to facilitate and meet the rising demand for faster, more secure, and cheaper electronic forms of payment, especially if the United States seeks to retain and incentivize consumers, businesses, and markets to function within a U.S.-led financial system. To date, nine countries have launched their own CBDC—the most recent being Nigeria’s eNaira in October 2021—and as China and Russia pilot their digital currencies and build alternative financial infrastructures, the United States must address the inefficiencies of the current payment systems, particularly for cross-border transactions in emerging market economies; otherwise, it risks losing its influence within the global financial system. Processes to watch in the coming months include the Central Bank of Russia’s test of digital ruble transactions across a dozen commercial banks, including ones located in the illegally annexed region of Crimea. China is similarly piloting its digital yuan at the Winter Olympics—the first time the e-CNY is being made available to foreigners.
The United States should bear in mind the varying reasons that other countries are issuing CBDCs and move forward with a clear understanding of the purpose(s) a digital dollar would aim to achieve. Some smaller countries have released CBDCs for consumer use, which has focused expressly on increasing financial inclusion, such as the Bahamas’ Sand Dollar. While this could be one benefit of a U.S. CBDC— 5 percent of U.S. households lack access to a bank account—most large-economy nations have focused on broader policy goals. China’s recently issued CBDC is being used to undercut the influence of private payment providers like Alipay, provide data on citizens’ economic activity, and potentially push forward the process of internationalizing the renminbi. A U.S. CBDC following this model would generate serious privacy concerns and raise questions about undercutting domestic private-sector innovation. Countries like Russia and Iran are using CBDCs as a way to evade U.S. sanctions and limit the use of native cryptocurrencies like Bitcoin. Using a U.S. CBDC to limit the effectiveness of sanctions-evasion efforts is possible, in theory, by working with existing international financial institutions to adopt a U.S. CBDC and limit the adoption of foreign alternatives. However, as things stand today, the United States is a ways away from both the technical capacity and the government consensus necessary to move forward with such a strategy.
While CBDCs are a significant development in international finance, the United States should not be looking at other nations issuing CBDCs in isolation. Both China and Russia have developed alternatives to the SWIFT system and are moving toward de-dollarizing their foreign exchange reserves in an effort to decrease their economic reliance on the dollar and weaken the impact of U.S. sanctions. In order to determine appropriate next steps, the U.S. should be closely watching not just CBDC development, but also efforts to internationalize their use and the impact that such efforts could have on governments’ influence abroad and on the global financial system. For example, China’s partnership with SWIFT to globalize its digital renminbi, or the potential issuance of loans denominated in digital renminbi to other countries, pose more significant challenges to U.S. interests internationally than the domestic launch of its digital currency alone.
Key considerations must also be given to how countries are designing their CBDCs and digitizing their financial services. As countries roll out their digital currencies, differing data, privacy, and messaging standards pose significant interoperability challenges, which could hinder funding flows among CBDC payment systems. The United States’ limited progress in its CBDC program may require it to adopt technical features from other countries so that it can be complementary to its allies who, in some cases, are already piloting their CBDCs. For example, South Korea finished its first test phase for a digital won in January 2022 and is now entering its second research phase. Japan similarly plans to distribute its digital currency called DCJPY, which seeks to improve large-scale fund transfers and settlements among companies in 2022. And while the European Central Bank’s (ECB) digital euro is in the early experimenting phases, the ECB plans to begin working on a prototype by the end of 2023. Further international collaboration on CBDC standards is needed to ensure interoperability and minimize disruptions in financial flows.
Could a CBDC adversely affect the financial sector? How might a CBDC’s effect on the financial sector differ from that of stablecoins or other non-bank money?
Early Design Considerations Will Determine the Ultimate Impacts of a U.S. CBDC. The impacts that a U.S. CBDC could have on the financial sector largely depend on the design ideas embedded into the technology. Absent from the Fed’s paper was a discussion of the differences inherent in retail versus wholesale CBDCs, and a clarification of which options are being considered. The risks, benefits, and design considerations will all vary, depending on whether the United States issues a retail CBDC, a wholesale CBDC, or both, and this should be one of the first decisions made before moving forward with developing a digital dollar. Based on the framing of the paper and previous congressional hearings, it appears that most of the debate is about issuing a retail CBDC, which would effectively act as a digital dollar that consumers could use for transactions, similar to the digital renminbi that China is now in the process of testing.
Many of the issues currently being debated by the Fed in relation to privacy, private-sector involvement, cybersecurity risks, and shocks to the financial system relate specifically to issuing a retail CBDC. If the United States were to pursue this route, it would add significantly higher stakes to design considerations. With a retail CBDC, it is possible the Fed could issue CBDC directly to consumers and risk disintermediating parts of the existing banking system while significantly expanding the role of the Fed. To avoid this risk, and to leave the existing financial structure in place, any retail CBDC issued by the Fed would need to leverage existing digital financial service providers and commercial banks for distribution.
In contrast to the retail approach, a wholesale CBDC would use blockchain to improve the efficiency of interbank transactions but would not be issued directly to individuals. A wholesale CBDC model would leave the existing banking system intact and is unlikely to pose serious financial stability risks. Many of the most advanced CBDC projects in developed countries, such as Project Jasper in Canada and Project Ubin in Singapore, have focused primarily on developing a wholesale CBDC model. The development of a wholesale CBDC would not have the same potential financial inclusion benefits, but it would be an effective approach for developing CBDC technology at lower risk and maintaining the existing importance of the dollar in international transactions.
Addressing Cybersecurity Concerns Must Also Be Prioritized. One of the top concerns briefly raised in the Fed’s report, which warrants further consideration, is cybersecurity. Cyberattacks are growing in frequency and sophistication, with experts noting that state-sponsored threat actors are adapting to more robust security in the critical infrastructure by looking for vulnerabilities among financial services, the defense industrial base, NGOs, critical manufacturing, and IT organizations. Indeed, Cybersecurity Ventures estimates that the cost of global cybercrime—which is driven largely by financial gain—will reach $10.5 trillion annually by 2025. In 2021, over $4 billion in cryptocurrencies were stolen by hackers. Depending on how a CBDC is designed and whether it is for retail or wholesale use, the cybersecurity risks will vary. However, as the digital asset ecosystem expands with more actors entering this space, the financial sector will face mounting challenges to address existing and emerging threats (such as those associated with quantum computing, which can compromise data encryption methods) to its security. Given the decentralized nature of the industry, it will likely be difficult to standardize data protection, privacy, and law enforcement data-sharing rules, particularly as countries in Europe and the United States are already struggling to harmonize their cybersecurity frameworks.
How might domestic and cross-border digital payments evolve in the absence of a U.S. CBDC?
In the absence of any U.S. action, it is likely that cross-border payment systems will continue to integrate more efficient technologies while simultaneously moving away from reliance on the U.S. dollar as their primary currency. The integration of new technologies into the digital payments space is currently driving a transition toward faster and cheaper cross-border payments. For example, SWIFT recently updated its messaging system while new services like Ripple aim to use blockchain for instantaneous international transactions. Alongside technological innovation, intense competition from China, Russia, and, to some extent, the EU and other states, is emerging in efforts to increase influence over international financial architecture. Developing a robust U.S. CBDC could help the United States set international standards, patent key technology, and ensure that the United States keeps pace with technological innovations in the payments space. The United States should not take for granted that the dollar will retain its primacy, particularly if other major geopolitical power shifts continue or if new blockchain-based technologies begin replacing existing cross-border payment systems.
Meanwhile, as the Fed and other central banks around the world explore the possibility of a CBDC, it is highly likely that existing stablecoin issuers and other private-sector entities will seek to expand the adoption of their digital currencies and push for regulations that support the stablecoin sector’s long-term growth. Currently, the top stablecoins by market capitalization are backed by the dollar, with companies’ projects such as Circle’s USD Coin and JP Morgan’s JPM Coin looking to provide the speed and convenience of a digital currency with the strength and utility of fiat currencies. Industry leaders have advocated that given the nascent stages of U.S. CBDC development, dollar-backed stablecoins could provide a way for the dollar to maintain its leadership in the global financial system while providing the same benefits as CBDCs. However, stablecoins have their own challenges, namely that they are predominantly used to allow consumers to participate in other digital asset platforms for speculative trading rather than for retail use. As a result, there are still lingering questions about the roles stablecoins should play in the financial system and whether they would truly serve as an adequate replacement for a U.S. CBDC.
How could a CBDC provide privacy to consumers without providing complete anonymity and facilitating illicit financial activity?
The discussion paper suggests that the Fed may be looking to design a CBDC with the following features: 1) pseudonymity to protect user’s privacy but not provide anonymous use that could allow for illicit financial activities to occur; 2) intermediation, or hosting, by private banks and financial service providers; and 3) transferability, meaning its value can easily be shared among various intermediaries.
Given the investments in R&D and technology needed, as well as current divisions in the federal government, it is highly unlikely that the United States will issue a digital dollar within the next five years. Depending on how the United States issues its CBDC, should it ultimately do so, there are different approaches to privacy that could be pursued. If the United States decides to issue a retail CBDC, it will need to decide first whether it will use blockchain-based technology or other means. The decision to use blockchain could help address privacy concerns but would invite a slew of additional design considerations. It would need to be decided whether the central bank should be responsible for hosting the underlying physical blockchain infrastructure or whether to run the CBDC on an existing blockchain such as the Ethereum network. In theory, running a CBDC on a decentralized platform, like Ethereum, would provide the highest degree of privacy but would also move some aspects of control over the currency away from the central bank. Considering the issues with hacks, transaction prices, and scalability that have plagued Ethereum and other blockchain networks to date, pursuing this option for a digital dollar would bear considerable risk.
If the United States does ultimately choose to pursue this route and use a public blockchain, it would still need to make upfront decisions about the degree of privacy embedded into its CBDC design. Transactions could be made nearly untraceable and anonymous, or more accessible and transparent than they are today. The United States could also take a middle-of-the-road approach by making commercial banks and private companies responsible for onboarding consumers and handling privacy elements, such as know your customer (KYC) requirements. This approach would come closest to replicating how the financial system handles consumer privacy today, making government access to personal financial data subject to the existing rules outlined in the Right to Financial Privacy Act. The issue of privacy is likely to continue to be contentious, as China’s CBDC has been criticized by some as a tool for the government to surveil its population. Legislation has already been introduced in Congress to curb government oversight of a potential U.S. CBDC largely based on privacy concerns.
During the House Committee on Financial Services hearing in December 2021 regarding stablecoins and cryptocurrencies, industry leaders agreed that all digital currency transactions must be associated with a legally traceable identity in order to prevent and address criminal transactions. In addition to adopting best industry practices, if a U.S.-issued CBDC is pursued, one relatively simple solution that has been proposed is the creation of pseudonymous identification numbers for users, which could be de-anonymized by a federal agency pursuant to a court order. One example would be a randomized tax identification number that would be anonymous to market participants, but their real identities could be stored and managed by a federal agency that would be able to identify who that individual or organization is, if necessary. However, as discussed previously, this brings many data governance questions in addition to privacy issues, especially as differences among China, the European Union, and the United States challenge how businesses and consumers approach international data flows and storage.
For a deeper dive into the new technologies and geopolitical tensions driving transformations in the international financial system, FP Analytics’ Future of Money Power Map breaks down how the varying systems operate and forces influencing change, and the Global Data Governance Power Map walks through evolving national frameworks focused on managing cross-border data flows and the ongoing challenges to doing business in an increasingly complex regulatory environment.
Christian Perez is a Senior Policy & Quantitative Analyst with FP Analytics, Foreign Policy’s independent research and analysis division. His work focuses on trade and investment, emerging technologies, sustainability, and impact analysis. He is a graduate of the Johns Hopkins School of Advanced International Studies.
Gahyun Helen You is a Policy Analyst with FP Analytics. Her research focuses on international security, economics, cybersecurity, technology policy, and governance. She is a graduate of New York University.