13 Things Fed Should Mull Over Before a Digital Dollar Launch
The US Federal Reserve should look into more than a dozen major matters before launching its central bank digital currency (CBDC), a digital dollar, including safety, fairness, inclusion, interoperability, and resilience among others, found Global Digital Finance (GDF), an industry body working on the adoption of digital finance.
"There are a number of critical issues which [...] should be considered and addressed by policymakers
before a public digital currency is issued," said an October 2020 report developed by the GDF’s Digital Currency Working Group. One of the reasons is that "the widespread adoption and use of a CBDC would represent a monumental shift in how citizens, businesses, and governments fundamentally interact with fiat currencies and cash."
As to what these critical issues are, the report lists them as follows:
Security precautions will be necessary at every layer, said the report, including educating the users on safe fund management. In regards to the protocol, a digital dollar will need to have a formal specification with a well-designed system of roles and permissions, which will also be subjected to public review and testing. Multiple implementations could be beneficial, after the specification was determined to be valid by an expert. The network shouldn't have more than the minimum necessary functionality at its start, while a bounty program would be useful for reporting vulnerabilities.
Privacy concerns are heightened with digital currencies, said the report, because they could expose the user’s entire transaction history and net worth. To have the levels of consumer privacy as with cash, neither the central bank nor the government should have direct access to universal unshielding capability, meaning, there should be no backdoors. Transactions should only be unshielded by government authorities when the virtual assets are used for illicit purposes, as evidenced by blockchain analytics, and only when allowed through a court review and order. (Learn more: Don't Take Your Privacy For Granted As Regulators Get Anxious About Crypto)
3. Anti-money laundering (AML)
All CBDC payment systems should be compliant with AML and combating the financing of terrorism (CFT) regulatory requirements, but without compromising user privacy. Given that this is the virtual equivalent to fiat, it might be possible to replicate and tune the privacy aspects of cash, while maintaining compliance with AML/CFT regulations.
Institutional practices with an appropriate process for strengthening privacy must be followed in an institutional setting for wholesale CBDC, while smaller transactions may have a smaller quorum compared to larger ones. A multi-tier approach is possible; appropriate multi-party ceremonies would be used to access the segregated key, which never leaves the secure premises; and externally, an organizational wallet can link to the Legal Entity Identifier anchored in a registry. For a retail CBDC, multi-factor authentication, such as biometrics, strengthens the connection of user identity with the device identity, said the report, while small CBDC transactions should be allowed to happen in a true peer-to-peer manner.
5. Issuance / Governance
The province of the respective central bank or treasury department in most countries is the one to issue a CBDC, given that it is responsible for the issuance of paper currency. It would be distributed through the existing banking system. But in the US, new federal legislation will need to be enacted to authorize the development and use of a digital dollar.
The custodian needs to be a well-regulated entity to prohibit unilateral moving of funds. A digital dollar requires custody through a digital organizational wallet, while self-custody for smaller amounts and for retail spending could be accomplished through a personal wallet. When it comes to a token-based model, the tokens would follow current regulations and be held in a separate, custodial wallet. It's advisable to use a third party to maintain custody, while management of private keys could be implemented as well.
A digital dollar should be designed and implemented through:
a) transactional function - interoperability with the existing financial global system for payments, credit/lending, storing, insuring, and investments;
b) technical - interoperability with the standardized technical standards and protocols that support payments, credit/lending, storing, protecting (insuring), and investments of financial assets;
c) as a unit of exchange/value - interoperability and exchangeability with existing fiat currencies, CBDCs, and other officially government-regulated currencies, including other government currency backed digital currencies and stablecoins.
8. Role of banks
Commercial and central banks could be involved in either a retail CBDC or wholesale CBDC, which would determine the holder of the asset on the balance sheet, as well as affect the designator of the asset’s transfer execution. Either way, banks will face numerous challenges, such as heavy investment in new distributed ledger/blockchain technologies and in system resiliency and cyber-security, as well as a risk to lose privileged relationships with other financial institutions.
The central bank credit extension can be in the form of wholesale CBDC with special programmatic restrictions, argued the report. Short term CBDC lending is possible for momentary liquidity needs, which could result in the development of a repo market, which could then take off due to standing instructions to custodians from clients. Retail CBDC can also be used in credit markets, and it's possible for ordinary people and smaller businesses to lend retail CBDC seeking higher yield.
10. Monetary stability
"A tokenized dollar would propose an infrastructure upgrade that would continue to support and advance the global competitiveness and stability of the US dollar in light of technological trends that support broader market opportunities, wider accessibility and flexibility, cost reductions, and efficiency of transactions," said the report. The authors claim that the USD as a source of stability is especially relevant in the global economic context of high uncertainty, with consumers, businesses, and governments relying on it.
11. Resiliency, performance, and scalability
When it comes to resiliency, digital dollar must be available 24/7 to support usage and operations for digital financial services, and also should be fully resilient and “disaster-recoverable” in terms of all credit, market, and operational risk, including cybersecurity and environmental risks. For performance and scalability, it must perform and be supported by infrastructure at high levels of throughput, input/output, bandwidth, and latency, while it should also scale to the minimum performance levels of the highest benchmarked financial systems today for payments, credit/lending, deposits, insurance administration, and trading.
12. Consumer protection
Necessary consumer and investor protections include implementing safeguards in proportion to the additional risks that CBDCs may create; taking measures to ensure proper and secure conduct; adequately informing users about the risks; audits; systems and controls in place for wallets and custodians, IT systems, cybersecurity; measures to ensure users are made whole in the case of losses due to hacks, fraud, theft, or mistakes in sending funds to the wrong wallet, and others.
13. Financial inclusion and access
Digital currencies could address the issues that underbanked and unbanked communities experience by providing alternative access to financial services. For example, CBDCs can be integrated with private fintech providers to leverage a central bank-housed digital account, which would enable a more inclusive digital payment system to be established and financial data identities to be created, while users would build a credit history.
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