That is the question du jour.

Opposition to a Fed-issued Central Bank Digital Currency (CBDC) has grown in recent times with lawmakers and privacy advocates coming out against the idea.

Last week, Florida governor Ron DeSantis introduced a bill in his state seeking to ban its use in his state. Senator Ted Cruz went a step further and sought to prohibit the Federal Reserve from issuing one at the federal level.

Both bills play on prevalent fears of government surveillance i.e., the idea that authorities will monitor citizen bank accounts by issuing digital money. But the pandemic stimulus payments already proved that the government, and the Federal Reserve, already exert significant control over individual accounts and the banking system.

This is not to say that privacy is not a matter of concern in digital money. But there are also other considerations, related to policy and infrastructure, that complicate the case for CBDCs in the United States.

Why Implement a CBDC?

To understand why the case for and against CBDCs is not as cut-and-dried as it seems, it is important to identify the motivations for introducing one. Broadly, there are three reasons why governments might consider a CBDC for their economy.

First, a CBDC can bring unbanked populations into the mainstream economy. This use case for a central bank currency is especially strong in poor countries in Africa and Asia, where large percentages of the population are unbanked. The logistics and costs of operating a bank branch in rural or poor areas is expensive and alternate options to integrate such regions into the mainstream economy are few and limited.

A second possible reason to consider CBDCs is to streamline the implementation of monetary policy. Currently, central banks work through a network of commercial banks to disseminate cash to the public. For economies like the United States, that process can be a complicated one because there are thousands of financial institutions, of various hues and varieties like credit unions and regional banks, in its ecosystem.

A third possible reason to investigate CBDC implementation is to streamline payments and transfers between parties. Instant transfers have long been the holy grail for payment services.

But services that promise instant transfers, like Venmo, actually work off the rails of legacy financial infrastructure. With its promise of a digital equivalent of paper money, a CBDC infrastructure can make instant payments possible.  

A Complicated Case for CBDCs

The benefits of a CBDC almost make the decision of implementing one a no-brainer. The operative word here is “almost” because the effects of CBDCs differ between economies. The United States’ financial infrastructure – although sophisticated and broad – is complex. And that means the decision to implement CBDCs will require a careful consideration of tradeoffs between benefits and losses.

An Unbanked Dilemma

The most obvious benefit of CBDCs is to bank those whose do not have access to financial services and bring them into the mainstream economy. According to the Federal Deposit Insurance Corporation (FDIC), 4.5% of the US population, or approximately 5.9 million people, remained unbanked in 2021.

Poverty was not the overriding factor contributing to their unbanked status. Only 21.7% of respondents to the FDIC’s survey said they did not have sufficient money to maintain minimum balance at banks while 21.6% said they chose to remain unbanked due to privacy concerns and mistrust of banks.

Being cut off from the country’s financial infrastructure did not hamper the ability of those who are unbanked to interact with the mainstream economy, the survey noted. They had alternatives in the form of prepaid cards and services like Venmo to conduct commerce with others. What this means is that an unbanked population, at least in the US, is not necessarily disconnected from the mainstream economy.

Doing Away Banks Through CBDCs

A retail CBDC, or one that establishes a direct connection between the Federal Reserve and U.S. citizens through virtual bank accounts, has the potential to simplify the U.S. economy. It can disintermediate the current process of spreading money into the economy through banks because it allows for direct implementation of monetary policy.

The pandemic provided a glimpse of this with with stimulus payments that magically appeared in our accounts. In the context of CBDCs, the alternate to that scenario is that of a Fed interest-bearing account sucking money out of the economy through rates that encourage saving and less spending.   

A 2022 Fed paper hypothesized that banks could rapidly lose a significant share of their deposit base, if retail CBDCs become a high demand asset. “While the exchange of Federal Reserve notes for retail CBDC may not have a direct effect on the supply of aggregate reserves, the exchange of deposits for retail CBDCs would lead to a decrease in the supply of supply of aggregate reserves,” the paper’s authors wrote. Translated this means that deposits at retail banks will suffer because people will prefer to keep their cash in accounts with the Federal Reserve rather than at banks that are susceptible to runs.

These losses will be reflected in bank balance sheets and a sectoral crisis that could ripple out into the broader economy. A more streamlined banking structure – one in which there are few large well-capitalized banks that can withstand competition or coexist with a CBDC – is an option. But the current situation in the U.S., with its plethora of banks, is not fit for that structure. [That it is heading towards just such a formation due to recent developments is another matter].

The Transfers and Payment Puzzle      

Instant transfers and payments are endeavors worthy of pursuit and CBDCs could make them possible. The problem, here, is that the Federal Reserve has already achieved that goal with the launch of Fed Now – a payment service that promises instant transfers – making the case for a retail CBDC a moot cause.

While the case for a retail CBDC remains murky, a wholesale CBDC, however, might come sooner. This form of CBDC will enable quick foreign exchange transfers and service FX trade markets – the largest wholesale markets in the world.

Project Cedar at the Federal Reserve Bank of New York recently developed a prototype for a wholesale central bank digital currency issued by the Fed. The project’s aim was to expedite foreign exchange transactions. It uses the same technology – blockchain and a UTXO data model – as that used by blockchain.