Why the Fed Is Considering a Digital Dollar

The Federal Reserve might want to fix your wallet by turning it phone beeping. Though your wallet is still designed for dollar bills, Americans have been using cash to buy things less and less over the years. That's part of why the Fed is considering digitizing the US dollar, giving people money they can access on their phone and bypassing electronic payments that can be slow and costly for businesses. Some see this as a necessary upgrade to the US financial system but others worry it could potentially upend commercial banking.

A central bank digital currency, or CBDC, is exactly what it sounds like, a purely digital form of a country's money issued by its central bank that people can use just like cash. It's true that cards and apps already allow for electronic payment but behind the scenes, these financial transactions involve several steps, settling payments over a patchwork of systems. The plumbing of the system is still based on a cash system. Josh Lipsky is the director of the Atlantic Council's Geoeconomics Center and says the US financial system is still pretty old school when it comes to moving money around. It's based on banks talking to banks, saying hey, I need you to transfer this to me. We've updated some of that over the years but actually, if you were to look back, a lot of it dates back to the 1950s and before. And that's not a great way to run a modern global economy.

After a debit card is swiped, the transaction can flow through several entities, including point-of-sale systems, payment networks like Visa and Mastercard, your bank and the merchant's bank. The system can take up to three days to move money between accounts and often comes with transaction fees that can weigh heavily on small businesses, who experts say may have to pass the cost onto customers or put restrictions on card usage. These extra costs can limit their revenues and customer base. CBDCs could bypass this system, allowing digital money to flow directly between two people, in the same way you hand over cash at the register. One method the Fed is considering is issuing digital wallets to Americans directly or through commercial banks or other financial service providers.

The digital dollars themselves would be no more than computer code, possibly stored on a central ledger at the Fed or on a distributed ledger, like many cryptocurrencies. When you use your wallet to pay for something, the Fed would take the digital cash out of your wallet and deposit it into the merchant's, simplifying the process and doing it without fees. These could be done through an app on a phone or for those without smartphones, an SMS text message or debit card. Besides frictionless payments, a digital dollar could help the 8.4 million unbanked households who don't have a debit or credit card and can get left behind in a cashless world. For example, instead of mailing checks, the government can deposit your tax refund or stimulus payments directly into your Fed wallet, making the money available immediately.

Proponents also say CBDCs offer a much more effective tool for central banks to enact monetary policy. Right now, the Fed influences interest rates across the entire economy by setting borrowing rates between banks, known as the Federal Funds Rate. But this is often a fraught process that doesn't always produce the desired results. - The Fed sets this benchmark rate and other private banks are supposed to cue off it and then your mortgage is supposed to cue off it. Does that really work? How much time does it take? And the answer that economists will tell you is it works but there're probably more efficient ways to transfer monetary policy.

Economists believe that if the Federal Reserve were to assign interest rates to the money stored in digital wallets, it would be much more effective at influencing economic decision making at the household level. According to a January survey, 60% of central banks around the world are currently experimenting with CBDCs. The Bahamas was the first country to release a digital currency, called the Sand Dollar in October 2020. And China has been developing and testing a digital version of the yuan but there are questions about how a digital currency would work in the US. Legitimate digital public money could help drive out bogus digital private money. It could help improve financial inclusion, efficiency and the safety of our financial system if that digital public money is well designed and efficiently executed, which are two very big ifs.

The recent rise of cryptocurrencies like Bitcoin and private currencies like Facebook's Diem have spurred central banks to explore CBDCs in an effort to keep pace. Experts say these alternative currencies expose the risk of money and payments circulating outside the watchful eyes of central banks. - This is a blind spot for them because when they're setting monetary policy, they like to know how much money is in circulation, broadly how that money is being used and so that helps them understand the macroeconomics and the fundamentals of the economy at any given time. But by keeping up with new competitors, CBDCs could threaten to leave traditional banking behind. So, if the Fed were to become a bank in the traditional sense, and actually issue people money and hold people's money directly, then you might hold less money in your Bank of America app and that would cut into their business model. So, they have to think about how digital currencies affect their business.

Because of these issues, the Federal Reserve is still studying the scope and structure of how a digital dollar would work and how it could be integrated into the current banking system. The Fed does not want to start dealing with 300 million customers overnight. They're not equipped to do that. So, you don't want to call up the Fed at midnight and say I forget my password. This is not something the Fed wants to be doing or can do. So, they need to think about who to work with to deliver digital dollars.

The Fed would also have to tackle privacy concerns over how anonymous digital dollar payments should be and whether the money should be restricted to specific transactions or programmed to expire after a certain time period to encourage spending. It plans to release a discussion paper on the benefits and risks of a dollar this summer and has said it would move forward without support from Congress. Many experts say the Fed will need to figure out a digital dollar to keep up with the pace of a rapidly changing global economy. What that looks like remains to be seen but it could mean using this a lot less.