The Ascension Of Cryptocurrencies And Prospect Of A Central Bank Digital Currency Requires Evolution Of The Existing Payment System

With cryptocurrencies becoming more a part of the existing financial system, the Federal Reserve has floated the idea of a Central Bank Digital Currency (CBDC).  In January 2022, the Fed published a paper entitled Money and Payments:  The U.S. Dollar in the Age of Digital Transformation. In that paper, the Fed addressed the benefits and pitfalls of a CBDC and sought input from stakeholders in the financial system.  Generally, a CBDC would be supported by the Fed and not subject to the credit and liquidity risks of money deposited in commercial banks.  A CBDC would be created and issued by the Fed in an effort to create more stability in a digital currency environment.  To that end, the Fed notes cryptocurrencies “remain subject to extreme price volatility, are difficult to use without service providers, and have severe limitations on transaction throughput.” The Fed expresses its preference for stablecoins – an emerging digital currency backed by the U.S. Dollar.

Of note, the Fed proposes implementation of a CBDC into the existing payment system through an “Intermediated” model.  Under this approach, “the private sector would offer accounts or digital wallets to facilitate the management of CBDC holdings and payments.”  The paper expresses the need for a CBDC to be supported by “the private sector’s existing privacy and identity-management frameworks.”

In response to the Fed’s request for input on a CBDC, the Electronic Transactions Association (ETA) expressed doubt that a CBDC is necessary because the current payments system is robust and efficient. Not surprisingly, the ETA lobbies the Fed to ensure private sector involvement in any CBDC, consistent with the Fed’s “Intermediated” model.  This model is likely the best approach to any CBDC because it is unlikely the Fed can support the facilitation of CBDC transfers in the manner which commercial banks, fintechs and electronic payment processors currently facilitate conventional currency transfers.  Nonetheless, the existing payment system must account for innovation and tailor its approach to a CBDC (or other non-Fed cryptocurrencies) in a manner that adopts evolving technologies.

A CBDC would be entirely digital and lacking a physical form.  Thus, all transactions would be P2P and need to be recorded on some form of a digital ledger.  Blockchain technology, which is currently operating in such fashion with existing cryptocurrencies, would be the means in which such recordation can be achieved.  As such, regardless of whether a CBDC is ultimately implemented by the Fed, the payments system needs to embrace blockchain technology to adapt its infrastructure in the digital age.  Fostering involvement in the transaction of digital currencies is an emerging market for payment companies and fintechs.  Many of the same principles employed in the conventional payment scheme will apply equally to cryptocurrencies.  It is just the means of payment and support system for the same which differs.  Therefore, expect to see heavy competition arise in the payment space surrounding the facilitation of digital currency transfers.