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Navigating the ABCs of CBDCs—Central Bank Digital Currencies

Wednesday, June 30, 2021

By Laura Taylor, Manager

To make a central bank digital currency, or not to make one…this is the question.

You’ve likely heard of Bitcoin, Ethereum, or even Dogecoin, but you may not have heard of “Fedcoin,” an informal name some have used for the idea of a digital currency tied to a central bank, namely the Federal Reserve.

Chances are you’ve got central bank currency in your pocket or wallet now—like a five-dollar bill. But what about a central bank digital currency? How would that work?

“Depending on its design, a CBDC [central bank digital currency] could be a substitute for cash for the first time in history and could directly compete with bank deposits, though central banks worldwide are adamant these are not their intentions,” St. Louis Fed Senior Economist Amalia Estenssoro wrote in an April 30, 2021, Regional Economist article.

CBDCs could decrease the time it takes to settle payments and increase the efficiency of domestic and international financial markets, according to the article. That would be a win-win for people looking to receive money more quickly and businesses looking to settle payment systems in real time.

Let’s take a deeper dive into the ABCs of CBDCs with our resident digital currency expert David Andolfatto. Andolfatto, a senior vice president and economist in the St. Louis Fed’s Research Division, recently hosted a Twitter Q&A Editor's note added after publication: The Q&A was April 12, 2021. via @stlouisfed to answer questions about central banks and digital currencies. Below is some of what he had to say. Questions and responses have been lightly edited for clarity and length.

Q: What impact would CBDCs have on bank lending?

Andolfatto: That’s a very interesting question. The short answer is, we don’t know for sure because CBDC hasn’t been tried extensively. There’s a number of things in the past that would lead us to suggest that the impact might be minimal, in my view. I’ve recently written a paper on the subject that’s been published in The Economic Journal if people are interested to go and read that. And what I discovered, at least theoretically, is that as long as the central bank digital currency is earning less than the interest on reservesInterest on reserves is interest paid on money that banks hold in their reserve accounts with the Fed. that probably the primary impact that a CBDC would have on commercial banks is that it would actually lead them to compete a little bit more aggressively to retain deposits…because deposits are a relatively cheap source of funding for banks. That’s good for us, right? It increases the deposit rates and maybe it provides other free services as well. 

Certainly, it’s likely to have an impact on profit margins for banks. But in terms of the effect on bank lending, bank lending depends more on, say, the interest on reserves, or the opportunity cost of making loans. And so, to the extent that a CBDC doesn’t affect the interest rate at which banks can borrow, for example, or attract funding from other sources, I doubt very much that the CBDC would have a material impact on bank lending.

Q: How would a CBDC help the unbanked—people who don’t have bank accounts—or level the playing field for low-income people?

Andolfatto: Yeah, that’s a great question. I think the answer to that question depends a lot on how the CBDC is designed. In one version of the CBDC that some proponents are putting forth, the CBDC would be provided free of charge for, say, all U.S. persons. Imagine being able to access an account with the Federal Reserve for free and to be able to make payments on that account for free to anybody in the United States or possibly elsewhere.

That version of CBDC would obviously certainly not discourage less well-off people from accessing the banking sector. So, I think that type of public service would go some way, in fact, to promoting financial inclusion in the United States and in providing a free public service. The analog I have for that is that it’s very much like providing any public infrastructure, like the interstate highway system. We could apply tolls, I suppose, but it would be greatly inconvenient. Why not just provide a basic public service? And I do think it would help promote financial inclusion.

Q: Should the Fed speed up its adoption of digital currency now that China has launched its own digital yuan?

Andolfatto: This is an area where I’m pretty agnostic about what the Fed should actually do in terms of providing a universally accessible digital currency. I can see different models where the Fed actually provides it directly, where people can open bank accounts directly with the Fed. I can see intermediate versions of it, synthetic versions, if you like, where the accounts are intermediated by the U.S. banking system. Whether or not the United States should proceed in this manner is to my mind a little bit independent of what the Chinese are doing. I think China’s going to do what it’s going to do, and what we should be doing is what should be good for American citizens. I’ve been largely a proponent of the idea, but on the other hand, I can see how the private sector itself is actually moving pretty rapidly in this space as well and providing low-cost payments or alternatives for the U.S. consumer as well. So, it’s not clear.

Q: Can you assure us that these digital currencies won't ever be used to tell us when, how or where our money can be spent?

Andolfatto: In life one can’t give absolute assurances of anything. But if I understand the question correctly, I think the caller [questioner] is concerned about the potential of privacy that would be associated, say, with a government sort of digital currency. This is an ongoing debate that we have all the time about how much privacy is desirable. Obviously, in the United States we value personal privacy a lot, and we let our representatives in Congress know that. And by and large it’s respected along many dimensions.

But there’s a bit of a trade-off here as well because we don’t know, for example, what sort of entities might make use of these central bank digital currencies for nefarious purposes, say, to finance terrorist activities.  We might want the government to monitor certain types of transactions as well. And we see this in the anti-money laundering laws and the KYC laws.KYC, or “know your customer,” regulations outline the identifying information financial institutions must have on their clients. So, there’s a trade-off. One can’t give assurances, but I think what we can be assured of is that Congress will respond to the electorate’s concerns and this is kind of the best we can hope for.

*Editor's note added after publication: The Q&A was April 12, 2021.


1 Interest on reserves is interest paid on money that banks hold in their reserve accounts with the Fed.

2 KYC, or “know your customer,” regulations outline the identifying information financial institutions must have on their clients.

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Laura Taylor 

Laura Taylor is a manager with the St. Louis Fed External Engagement and Corporate Communications Division.

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