Should the Federal Reserve create a digital dollar?
Contributors: Joseph T. Abate, Zoso Davies & Michael Gapen
19 Nov 2021
Central banks are investigating whether they should launch digital currencies. But why? Barclays Research analysts dug deep into this emerging area, with specific focus on the US Federal Reserve’s initial exploration of its own digital currency, often referred to as ‘Fedcoin’.
Contributors: Joseph T. Abate, Zoso Davies & Michael Gapen
19 Nov 2021
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Digital money is booming
Governments have never had a monopoly on the provision of money. Private systems – unbacked by the government or deposit insurance – regularly sprang up in the past, often to service discrete communities. In the US in the 1800s, for example, railroad and canal companies paid workers in paper “scrip,” redeemable for goods at sponsored stores. More commonly, banks issued their own currency that circulated as money. In theory, this paper could be redeemed in gold and silver. By the time of the Civil War, there was a mass of private issue paper in circulation and analysts published books to identify counterfeits and to assess the discount to face value on each issuer's notes.
Private money before crypto: Chesapeake and Ohio Canal Company note (1841)
Source: Joseph Abate
Although this type of private money largely disappeared by the 20th century, it is making a comeback in a modern, non-bank, digital form. The most prominent of these systems are the Bitcoin and Ethereum “blockchains,” which record transactions in blocks and connect one block to the next, creating a transparent and consensus-based immutable ledger. Yet there are plenty of other private rivals. One is Facebook’s project to create Diem: a medium of exchange for the platform’s 2.4bn members, that could be used around the world in place of local, fiat currencies. Others include stablecoins that are pegged to a basket of assets or fixed to a fiat currency like the dollar. The outstanding amount of stablecoins has increased more than 10-fold in the past year.
But is there a role here for the Fed, or indeed, any central bank? Payments and settlements can be faster and cheaper, particularly across borders. Digital money can also foster greater financial inclusion, as people can transact in it without needing to rely on an intermediary like a bank. That could represent an advantage for households that do not have bank accounts and depend instead on cheque cashing, money orders and cash. This lack of intermediaries makes digital money well suited for transactions in low-trust environments, or in areas where legal enforcement of contracts is limited. But, as our analysts note, these are fairly weak arguments for creating Fedcoin.
Private platforms can be risky
When transactions move outside of the highly regulated financial system and onto alternative platforms, they enter regulatory and legal grey areas where normal standards of consumer protection do not apply. An online venue that lets users exchange private money with each other, or pay for goods and services, is effectively a shadow economy with a shadow financial system.
Such systems can be fragile. History suggests that private money is vulnerable to collapses in confidence, when holders of the currency come to believe that the issuer cannot, or will not, adhere to its pledge to redeem it at par for cash, assets, or goods and services. That often triggers a rush for withdrawals that the issuer is unable to meet. A second, related problem is that private issuers lack access to backstop liquidity providers – like a central bank – which can be important in forestalling panics or, at least minimising their spill over effects.
Our analysts note that cryptocurrencies pose more of a threat to the stability of financial systems than previous versions of private money, which were usually local and of limited application. New digital currencies bundled with different services and features could continue to crop up anywhere across the globe, growing to significant size. In theory, sovereigns and central banks could regulate, tax or even ban private digital money and payment systems.
But in practice, this is particularly difficult with crypto. As these units are created with a global audience in mind, they are frequently outside regulatory jurisdictions. Or they are so decentralised that explicit governance is impossible. Regulators risk adopting “whack-a-mole” strategies, designing policy rules that react to the latest craze. Consumer protections would be spotty.
The primary threats cryptocurrencies pose to financial system stability
Source: Barclays Research
Another way to address the problem: for central banks to create their own digital currencies, offering the same attractive features but with the added benefit of a government backstop. In doing so, they could look to squeeze out riskier, private sector alternatives. The US Federal Reserve has launched a review of the potential benefits and risks of issuing a Central Bank Digital Currency (CBDC). CBDCs have already been deployed in pilot form by China (DCEP or the e-CNY), Sweden (the e-Krona), The Eastern Caribbean Central Bank (DXCD), and the Central Bank of Bahamas (Sand Dollar).
So how might ‘Fedcoin’ work?
But designing a Fedcoin is tricky – it needs to be “good, but not too good”. That is, it needs to be good enough to crowd out destabilising forms of private money, but not so good that it crowds out bank deposits. After all, if the Fed were to offer personal accounts on its balance sheet, people might be tempted to take all of their money out of commercial banks and deposit it with the ultra-safe central bank. In this manner, the Fed would be threatening the foundations of the financial system by draining banks of retail deposits, which they need to finance lending. This would increase the cost of bank loans to households and businesses as banks were forced to compete with the Fed for deposits. The Fed could avoid this by lending directly to households and businesses. But no central bank wants to be in the retail banking business or to choose winners and losers by allocating credit to the private sector.
Instead, the Fed could design a hybrid system. Retail accounts would be managed and operated by licensed financial services providers such as commercial banks, and the account balances – but not the transactions – would be reported to the central bank periodically. Such a system would blend the anonymity of a digital currency with the anti-money laundering and “know your customer” requirements associated with regulated bank deposits. The structure would not disintermediate commercial banks, and the Fed itself would not morph into a retail bank. From the perspective of a CBDC user, very little would change. Their accounts would still sit with banks and payments processors, who would provide familiar services.
Could CBDCs be successful?
Our analysts think so. Of course, the Fed and other central banks would need to reassure households and companies that their privacy would be appropriately and rigorously protected. But when it comes to legality, stability and trust – the three main advantages of public-sector systems –the Fed and the dollar score highly. As a result, it is our analysts’ view that the US central bank should have few problems in achieving widespread use of a CBDC, at least domestically, if it determined that there was a need for one.
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About the experts
Joseph T. Abate
Managing Director, Fixed Income Research
Joseph T. Abate is a senior member of the Barclays Fixed Income Research team based in New York, focusing on short-term dollar funding and money markets. In this role, he writes extensively on fed funds, Libor, regulation and liquidity. Prior to joining Barclays in 2008, he was a Senior Economist at Lehman Brothers. Before he joined Lehman, Mr. Abate worked at the Federal Reserve Bank of New York in the Domestic Research Division. Mr. Abate is a Phi Beta Kappa graduate from Vassar College and has an MBA from New York University.
Director, European Credit Strategy
Zoso Davies is a Director in the European Credit Strategy team at Barclays, covering Investment Grade and Macro Credit. As part of his role, Dr. Davies regularly contributes to cross-asset and thematic research. In particular, he has worked extensively on central bank corporate bond purchases and the impact of monetary policy on the European banking system. Dr. Davies was also a key contributor to the development of Fundamental ESG Research and contributed to Barclays BlueTrack™, Barclays methodology for measuring our portfolio emissions. Dr. Davies joined Barclays in 2010, prior to which he was awarded a PhD in Physical Chemistry by University College London.
Managing Director, US Economics Research
Michael Gapen is Head of US Economics Research at Barclays. Based in New York, he is responsible for the firm's outlook for the US economy, in particular, US monetary policy and the effect of financial markets on the economy. Prior to taking on this role, Mr. Gapen was a Senior US Economist and, following his appointment as Asset Allocation Strategist in January 2012, he took on additional responsibility for forming the firm's asset allocation views. Mr. Gapen holds a PhD in Economics from Indiana University.