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US CBDCs: An Analysis of the January 2022 Fed Report
How did they do? Pretty ok. Do they say anything of note? Yes!
“A CBDC could spur innovation by banks and other actors and would be a safer deposit substitute than many other products, including stablecoins and other types of nonbank money.”
So the Fed finally released their exploratory report on Central Bank Digital Currencies which was talked about and discussed and promised and delayed throughout last year. This paper (and papers like it) are critical because thoughts laid out here get translated into policy which has impacts across literally the entire future of US economic strategy, the international financial system, and (selfishly most important for me) the trajectory of US Fintechs! So the stakes are real.
Be warned, dear reader. I love this stuff so this one might be a bit more for me than for you. I’ll try to aim for brevity…
At it’s core the Fed released basically a Pro’s and Con’s paper. Here’s the full text for those interested.
Bottom line…the paper is basically fine.
By the numbers:
There are 22 uses of the word “might”, as in “we might have an opinion at some point in the future”
There are 34 uses of the word “may”, as in “we may at some point write more papers”
There are 66 uses of the word “could”, as in “we could only think of so many ways to not commit to an opinion”
It took over a year to write 40 pages - so about 10% of a page per day (less than a paragraph) - but really the last 13 pages are definitions and appendices about how money works and there are 8 pages of blank or “structure” pages like the Table of Contents so there are actually like 19 pages of content. So really about 5% of a page per day. Generously spaced. Wide margins.
I could’ve knocked this out in a weekend tbh
But, to be fair, I’m impatient.
That’s what makes me want to be an entrepreneur.
Entrepreneurship is basically just being at Point A, seeing where Point B could be, and then doing your damnedest to get a team from A to B as fast and effectively as possible.
Because anything else is just the offensive to your soul.
Anyway, government is designed to optimize for other things (which is usually the right answer) like good stewardship of resources, high confidence in maximum net value decision making, and reversion to the status quo (not an insult, status quo’s are very stable which is why they’re a good spot for governments to spend most of their time in).
All of these emphatically optimize against speed.
So I wanted more from this paper, but it’s fine. I’m not that disappointed. Also - I live in Boston now so if anyone reading this knows anyone at the Fed (or if any of you government types ever read this) - I’d love to connect with them (you!) to talk about this stuff and help where I can.
For the record, I’m not antigovernment (unlike a lot of Crypto people). I started my career in the “legitimate use of force” department of the government and I enjoyed most of that part of my life. I truly believe that government can be an effective tool for prosocial behavior and is a good mechanism for aggregating capital (through taxation) to invest in public goods (like national defense and bridges and basic research and UBI’s gasp) that society needs to function. If that sentence didn’t give you a heart attack to read, then you might enjoy We the Possibility, which is a book about getting more high quality innovation out of government entities. Cool stuff. Hard to do.
Also just checking in - Not sure what I’m talking about right now?
Read this report on stablecoins by Messari (which is one of the few solid information sources on crypto imo). Stablecoins are essentially digital tokens that attempt to stay pegged to a fiat currency like the dollar. There are a lot of other kinds, but that’s the kind the Fed is referring to throughout this report. It’s super important to note that ALL of Messari’s reports are funded by a company (in this case Celo) which means the report is going to shill that company throughout, but the explanation of the different types of stablecoin peg methods (algorithmic vs fiat backed vs crypto backed) is still pretty good. A perfect, theoretical stablecoin can sort of be thought of as traditional money, but better/faster/easier to send than your bank wire and ACH transfers but without some sort of a government guarantee.
Back to business (with the intro).
I’ll just go through the baseline highlights.
The report starts with a classic affirmation of the Dual Mandate of the Fed. It’s a good reminder and then they dive straight into that this is NOT an opinion statement on CBDCs (see my counting of weasel words above). Got it. They do waffle a bit on “studying these topics for several years” but also this is the “first step” in researching CBDCs, but I’ll allow it.
The first big point though is
"The Federal Reserve does not intend to proceed with issuance of a CBDC without clear support from the executive branch and from Congress, ideally in the form of a specific authorizing law"
Which is a bit rough. It’s gonna take years to get this done. Ah. Impatience.
The next few pages goes into how central banks work, how money works, and reasserts that the "Central bank money carries neither credit nor liquidity risk, and is therefore considered the safest form of money. " which kind of glosses over inflation risk but here we are.
They also talk about existing payment system improvement efforts which could preclude the issuance of a CBDC. Specifically Fednow is supposed to debut in 2023 as an instant payment processor. It was started in 2019 and man a 4 year product cycle is way too slow. That’s just a game we can’t afford to play anymore. Also, we’re lying to ourselves in the 2023 rollout goes without a hitch. That’s just not how product launches work even in the best of circumstances.
There’s also some mentions of committees for financial inclusion (awesome!), but man the Fed moves so slow. Just give someone a budget and the authority to try to make an Atlanta’s neighborhood collective financial life better and keep what works and scale it. Yea this can go wrong, but money printers go BRRRRRRR anyway so why not try to help faster?
What about Stablecoins? Don’t worry! The Fed is confident that they do some good things and have some risks. Also they point out another government report also says stablecoins do some good things and they also have some risks and they conclude that some laws should exist to regulate them in some way. Helpful. AHHHHH.
Moving on to actual CBDC’s
"A CBDC would be the safest digital asset available to the general public, with no associated credit or liquidity risk." ← Pointing this out is huge so I’m really happen they included this. A CBDC is fundamentally a technology that does risk-free (again aside from inflationary risk) storing of value, unit(ing?) of account, and medium(ing??) of exchange just better than other money like things. I appreciate that they explicitly mentioned this.
Then they talk about what would make a good CBDC. (deep breath)
Note - I will call a CBDC with these characteristics “FedCoin” throughout the rest of the essay.
The ideal FedCoin described in the report has 4 main characteristics. They believe it should be privacy-protected, intermediated, widely transferable, and identity-verified. Let’s break down what those each mean.
Privacy-Protected - They assert that consumer privacy is critical (I agree), but also we need to be able to see deep enough to spot criminals (I also agree with this for a FedCoin specifically - not all tokens, but that’s for another time). It doesn’t get any deeper than this, but this is a good start.
Intermediated - Fedcoin will be a Central Bank liability, which is a pretty big change from the current market structure where commercial banks hold the lions share of user facing liabilities. The Fed wants (NEEDS) users to be managed by intermediaries because oh my god can you imagine if the Fed had to manage an account for every person that ever wanted a FedCoin? Sheeeeesh. But seriously good call out, Jerome.
Transferable - tbh it seems like they were running out of words to fill out this section and they just picked "money needs to be able to be spent or its not good at being money". Moving on.
Identity-Verified - This is basically part 2 of the privacy protected condition. They don't want anons to just start loading up FedCoin into their wallets, which I get. If the Fed is directly on the hook for these liabilities, it would be pretty embarrassing if ISIS could just start an account and be liquid instantly.
These characteristics feel pretty reasonable to me. I think they’re pretty bland, but fundamentally appropriate (which screams government haha). They were clearly thought through and I don’t see any major holes, but of course the internet…uh finds a way. We’ll see how further research here goes and if the messaging changes as the MIT DCI folks dig their teeth into it.
The report goes a step further and states that "CBDC transactions would need to be final" which feels a bit like a way to skirt around actually saying that irreversible transactions on the blockchain might be ok? and I respect that clever phrasing.
Benefits and Risks
Here’s where we get to the good stuff. This section starts strong with this callback zinger to the earlier section about comparing assets.
“A U.S. CBDC would offer the general public broad access to digital money that is free from credit risk and liquidity risk”
again whoa! Yes it would!! Again inflation risk (money printers and all that), but seriously this is an honest take and someone in Boston is doing their research. I’m encouraged already. Then they do a clever little spiel about how a FedCoin could preserve the dollar’s supremacy in the international economy as the global reserve currency and they gently suggest that if there is no FedCoin, another CBDC might appear that does everything the dollar currently does, but better and then American households would lose that exorbitant privilege to buy everything super duper cheap. Great addition.
Next, they dive into another relatively honest take that a true risk-free CBDC removes the need for…commercial bank money because of course it does. Why would you deposit money into a bank that everyone can cause a run on when the Fed (or rather intermediaries on behalf of the Fed) could instead keep a digital record of your FedCoin balance and whenever you get a bit nervous and start asking about your FedCoin Jerome can just give you a thumbs up that you’re still cool to withdraw an actual dollar if you ever want it. Way better outcome than 1929. There’s a bit of an open question about the mechanics of this though with custodial intermediaries rather than the Fed directly holding the FedCoins, but probably solvable.
They also point out that this kind of would ruin how commercial banks work and increase the cost of credit (which is basically true if we don’t come up with other alternative ways of lending capital and creating credit). So they gently suggest that the FedCoin should be designed a way that it doesn’t totally eat commercial bank money’s lunch (like making it ultra low or no interest bearing). I’m torn on this because I like innovation, but also there’s probably not an immediate need to destroy a part of the American economy that is inextricably linked to who knows where? Decisions decisions.
Rounding out that thought though is a solid take that we’re already on the path to change and that’s not going to stop.
“A CBDC could spur innovation by banks and other actors and would be a safer deposit substitute than many other products, including stablecoins and other types of nonbank money. These forms of nonbank money could cause a shift in deposits away from banks even without a CBDC.”
Finally, the next section goes on to briefly mention that there are ways to reduce the potential instability that the terminator FedCoin might cause (to be clear can you imagine how fast a bank run (excuse me an intermediary run lol) COULD occur when all the institutions have a panic button programmed into their money? And then imagine if someone builds a startup that gives that same feature set to every individual FedCoin account holder in the US? big yikes if we’re not thinking about this stuff!), but this part is a bit weak I think. It half heartedly mentions programming in withdrawal limits or something like that, but can you imagine how upset that would make people haha - still plenty of work to do here.
ok finally! The section I was waiting for -
Efficacy of Monetary Policy Implementation
This is basically where we can see if the Fed has cold feet.
Let’s be real. The Fed straight can't give up much of their control over monetary policy mechanisms because they are their primary tool (besides like public statements) to manage inflation vs unemployment (remember the dual mandate mentioned above).
Overall, they show a pretty solid grasp of (in my opinion) what the real tradeoffs on monetary policy and scenarios are for how a FedCoin could be implemented.
The quick version is that if a FedCoin is ultra low or no interest bearing, then it probably doesn't do that much harm to the existing tools in the Fed's toolkit (specifically adjusting the Federal Funding rate which is the rate the Fed lends at to commercial banks <- this makes your interest rate go up and down and makes investors invest more or less).
In this scenario, FedCoin basically turns into another blunt monetary policy tool likely via open market operations - this is a plus for the Fed for sure. Remember that inside the Beltway, more budget/tools/power = more longevity for your organization and more credence given to you and your interests.
However, if the FedCoin bears interest comparable to other assets (like treasury bonds or whatever people consider "safe") then the Fed is worried about everyone dumping everything else and just grabbing FedCoin because they're a fundamentally better financial instrument. Barring any shenanigans with arbitrary transaction limitations and restrictions, a computer state token 100% guaranteed by the Fed that is programmed to spit out money at a code-defined rate at a code-defined interval to achieve a return equivalent to other “safe” but, older, less liquid, harder to transact, longer to reconcile, and oh by the way did I mention this is the website where a retail investor can buy treasury bonds? Screw that, give me robot money.
When you get the exact same thing without any of the downsides, you'll make the change once you figure out how to deal with the frictional costs of transitioning.
Hear that gold bugs? Bitcoin is calling.
So anyway if it is an equivalent return with a better instrument, the Fed acknowledges that the other stuff might go away (or more worrisome for them go away all at once unexpectedly and violently because everyone wants that sweet, sweet Fedcoin). This means volatility (like a lot of it). And they basically shrug because its a hard problem to solve and say like "we're not sure what will happen if the market changes and we try to adjust interest rates to compensate for that". Fun!
And then they leave with on a classic government note.
“These and related topics are active areas of research that will no doubt yield additional insights over time.”
Privacy, Prevention of Crimes, and Cybersecurity
This section is great. They basically just say - institutions that are the intermediaries for FedCoin should have to comply with the same consumer privacy and financial crime prevention standards as commercial banks. Yea - makes sense. I'd argue for a thoughtful grace period for startups so you don't choke out innovation before it can start growing (because we know many of the banks are going to need to be dragged kicking and screaming into this new FedCoin world).
They also thoughtfully acknowledge that the internet is hard and FedCoin intermediaries will be easier to attack than banks currently because digital money is digital and digital is hard. Also, they mention offline payments, which is interesting considering 19 million americans still don't have usable internet.
Finally, they leave with an open solicitation for comments from the public on a set of 22 questions (which I support).
Honestly, these questions are basically all of the things that I just made fun of them for not addressing during this essay. So I guess I should probably put together a response for these in order to not be the guy who just complains on the internet...
This is how government should work. I wish we didn't have to wait 120 days for them to close the questions (impatience), but again here we are.
I'm just a guy that enjoys economics and thinking about monetary policy so take this with a grain of salt.
I think someone at the Fed likes the idea of some form of a CBDC, they’re desperate to have private market champions (specifically I think Fintechs) say that they can handle being the intermediary at scale for them, and I think they want the CBDC to be extremely low or zero interest bearing so they don’t have to worry about commercial banks getting too mad at them for ruining their stranglehold on lending.
Personally, I think a FedCoin should have a yield and that interest yield should be pegged to some short term (3 month ish) trailing inflation metric that you only receive if you stake it for some period of time so it can be a “safe haven” net zero return asset, but acts as a natural inflation reducing sponge (ie. people convert to FedCoin because they’re scared of runaway inflation eroding the value of their cash & deposits then lock it up to earn the inflation rate yield which slows down money velocity and consequently slows inflation a la MV = PY). This is what programmable money let’s us do, folks! Super cool.
tldr; We’ve made some progress. FedCoin could happen, but only if Congress makes it happen. Oof.
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