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Last week, the Digital Dollar Project announced it will launch five U.S. digital currency pilots over the next 12 months, making it the largest effort of its kind in the country. The project is a partnership between the consulting firm Accenture and the Digital Dollar Foundation.
Why this matters: A digital dollar, issued by the Federal Reserve (the central bank of the U.S.), would be a big deal. It would make it easier for dollars to circulate at home and abroad, but it would also give the government unprecedented insight into financial data. It could also disrupt a class of cryptocurrencies called stablecoins, which are a vital part of the crypto ecosystem.
Digital currency vs. cryptocurrency: Bitcoin, a popular cryptocurrency, has snagged headlines in the past few years and governments have noticed. Central banks around the world realize that they need to get onboard the digital trend or risk becoming obsolete. Their answer to the crypto craze? Central Bank Digital Currency (CBDC), a new type of digital currency that governments are exploring.
While cryptocurrencies like Bitcoin are decentralized, peer-to-peer currencies — meaning, no central authority controls them — CBDC is a government-issued digital currency.
The government-issued bit is key here. The digital currency you often interact with (i.e., credit cards, Venmo) are just promises to pay dollars, vouched for by private banks. Basically the “money” they’re letting you move around is actually just hypothetical numbers that represent money until it culminates in an actual bank transaction.
CBDCs, on the other hand, are issued by a government’s central bank, meaning the government takes on the liability for this money. CBDCs never take physical form, instead, they’re basically a digital version of actual cash.
“If I gave you CBDC, it’s as if I’m handing you physical money, like a $100 bill. You’d have that money in your account and it’s yours. I couldn’t take it back,” Jim Cunha, senior vice president at the Federal Reserve Bank of Boston, told Forbes. This is different from electronic forms of payment that we use today.
“If I send you money through PayPal, it’s just a promise that money is coming. Your balance may show the funds, but money hasn’t actually moved between banks yet.”
This means that money transfers could take place 24/7, instead of being reliant on banking hours.
Growing in popularity: In April 2020, China became the first major economy to launch a CBDC pilot, and the digital yuan is now the most advanced CBDC project in the world. By Nov. 2020, the People’s Bank of China (PBoC) had processed the equivalent of $300M.
Other central banks are looking to get in on the action too: Ecuador, Japan, Sweden, Ukraine and Uruguay are among the other countries that are actively pursuing CBDCs.
The prospect of a digital dollar: The United States getting into CBDCs is notable because the dollar is the world’s currency. It’s the most widely used currency on Earth, and since the end of World War II, has functioned as the world’s reserve currency. 40% of the world’s debt is denominated in dollars, and as of the end of 2019, the dollar made up over 60% of all known central bank foreign exchange reserves (which are used to determine the value of a given currency).
There’s a lot the Federal Reserve stands to gain by rolling out a CBDC, such as a “Fedcoin,” but there’s a ton of risk involved too — domestically and globally — if things go sideways. In Feb. 2021, Fed Chair Jerome Powell made it clear that a digital dollar is indeed a “high-priority project” but that they’re “looking carefully, very carefully, at the question of whether we should issue a digital dollar.”
The fine print: Currently, digital transactions are overseen by private entities, so central banks don’t have direct control over them. With an official CBDC, central banks could position themselves to have far more control over cashless transactions.
This would make the process of payments more efficient, and proponents argue that they could do even more to improve social good. If treated as a public utility, CBDCs could make it easier for governments to disburse aid and improve financial access for the unbanked. Advocates were quick to point out how a CBDC could have benefited Covid-19 relief. A digital dollar would have allowed the Federal Reserve to immediately disburse funds to individuals and businesses, rather than the slow and arcane distribution process that left many Americans confused and, in some cases, at extreme financial risk.
However, many proponents of cryptocurrency say that the innovative aspect of Bitcoin (along with other blockchain-based cryptocurrencies) is that it’s decentralized. CBDCs are basically digital fiat, and crypto-advocates worry that CBDCs give governments unprecedented insight into how money is being spent by those who use it.
Meet in the middle: For the past few years, stablecoins have provided a middle path between traditional cryptocurrency and CBDCs. In fact, the research and development that went into making stablecoins work is functionally the foundation and market validation for CBDCs.
Facebook made waves in 2019 when it announced it was developing a digital currency called Libra, which has since been renamed Diem. Diem is what’s known as a “stablecoin.”
Stablecoins are a class of cryptocurrency that could give CBDCs, ahem, a run for their money.
Theoretically, CBDCs and stablecoins can coexist and in some ways help each other … The reality will likely be trickier.
Unlike the prices of typical cryptocurrencies, like Bitcoin, which are established by the open market and tend to fluctuate wildly, stablecoins are backed by a reserve asset — things like the dollar — which pins their value to something stable. Stablecoins offer a stable alternative to the volatile price movements seen in other cryptocurrencies (looking at you, Dogecoin).
In this way, stablecoins can mimic fiat currency, but differ from CBDCs in a few key ways.
The first is that they are not issued by central banks, they are issued by non-profit and commercial enterprises and are typically distributed through crypto exchanges. This also means that users have to trust that these issuers have sufficient reserves to maintain the peg (i.e. to the dollar). No such trust is required with central banks. The Fed, for example, is responsible for printing dollars, so it can never run out of them.
The second is that stablecoins — unlike CBDCs — are cryptocurrencies. But, because they require that a specific entity actually holds the reserve asset, they’re not as decentralized as other cryptocurrencies. Still, the majority are blockchain-based and accepted on many crypto exchanges worldwide, so they offer more of the benefits of decentralization than we’d ever expect of a CBDC.
Competition: Unfortunately, it’s possible that central banks will see stablecoins as competition — something Facebook learned the hard way in 2019.
When it was first announced, Diem (then Libra) prompted concerns among central bankers and regulators that the currency could threaten monetary stability by competing with the dollar and the euro. Outcry ensued, prompting a handful of major companies to pull out of the Libra Association.
Diem has since scaled down its ambitions considerably but a small pilot is expected to launch later this year.
Facebook aside, crypto advocates are more favorable toward stablecoins, arguing that they offer the same core functionality as CBDCs while increasing users’ privacy, security, and anonymity — as well as easy access to the global cryptocurrency market.
Can we all just get along? Theoretically, CBDCs and stablecoins can coexist and in some ways help each other. The former brings fiat currency to the digital realm, while the latter lets people reliably participate in an otherwise volatile crypto market. In an ideal world, advocates of both would find ways for them to work together.
The reality will likely be trickier.
The looming question mark on this front, of course, is the US dollar. If the Fed does ultimately roll out a CBDC, will it view the many stablecoins pegged to the dollar as a threat to adoption, or validation of the dollar’s status? Only time will tell. For now, we’ll be keeping our eyes on what the Digital Dollar Project’s efforts reveal — and how the Fed responds to them.