As countries around the world launch research into the potential benefits and operational mechanisms of central bank digital currencies (CBDCs), Greg Baer, CEO of the Bank Policy Institute (BPI), pointed out that numerous unresolved questions remain regarding the policy implications of such currencies.

"A central bank digital currency is not a simple digital form of paper currency: its implementation will have profound impacts on the U.S. financial system and economy," Baer wrote in aworking paperpublished this month. "It could change the position of the central bank, and even of government as a whole, in society."

Baer's paper comes as the Federal Reserve Bank of Boston, which is developing digital dollar transfer, storage, and settlement software in collaboration with researchers at the Massachusetts Institute of Technology (MIT), said it may release some of its work as early asJulyThe Boston Fed's collaboration with MIT focuses on the technical question of "whether it can be done," rather than the policy question of "whether it should be done." Baer's industry group represents the largest U.S. banks, including JPMorgan Chase, Bank of America, and Wells Fargo.

In his paper, Baer explores the costs, benefits, and significant implications of issuing a CBDC. He argues that discussions around the technical aspects of CBDCs have been fairly thorough, but lack a comprehensive and in-depth exploration of policy issues. "Existing discussions often list a bunch of potential benefits and some costs, then wrap up hastily," he said. "You have to examine each issue one by one like whack-a-mole—both in isolation and in relation to other issues."

However, growing global interest in CBDC research and development is creating urgency for those who believe the policy debate can wait. James Cunha, senior vice president at the Boston Fed responsible for prototype development, toldBloomberg: "We don't think we can wait for the policy debate to conclude, or we'll be about a year behind."

U.S. lawmakers are closely watching China's progress with the digital yuan and remain vigilant about the potential economic impact of China becoming a global financial leader. According to Bloomberg, Senator Sherrod Brown, an Ohio Democrat who chairs the Senate Banking Committee, wrote to Powell last month urging him to accelerate CBDC research, writing: "We cannot be left behind."

According toCNBCChina, which has been researching the digital yuan since 2014 and conducting pilot programs nationwide, plans to allow foreign athletes and visitors to use the digital currency during the 2022 Beijing Winter Olympics. Josh Lipsky, director of the Atlantic Council think tank, toldThe Wall Street Journalthat China's push for a CBDC poses a threat to the dollar's dominance on the global stage, thereby creating security risks for the United States. "Anything that threatens the dollar is a national security issue. In the long run, this does threaten the dollar," said Lipsky, a former International Monetary Fund official.

China is not the only country with CBDC ambitions. Sweden's central bank has said the country could launch an "e-krona" within five years; the European Central Bank plans to publish a CBDC analysis report this summer and has said it could launch its own digital currency within the next four years. "This is a technology project, but it's also a fundamental change," ECB President Christine Lagarde toldBloomberg Television"We need to make sure we don't disrupt any system, but rather enhance the system." The UK became the latest country to join the CBDC exploration ranks on Monday, when Chancellor of the Exchequer Rishi Sunak said at a conference that Britain isforming a CBDC exploration taskforce between the Treasury and the Bank of England。

Powell's stance

Amid surging global interest in CBDCs, Federal Reserve Chair Jerome Powell has said the U.S. central bank intends to proceed prudently and does not need to be first. "We have an obligation to be at the forefront of understanding the technical challenges and the potential costs and benefits of issuing a central bank digital currency," Powell said last month during a virtual panel hosted by the Bank for International Settlements (BIS). "Because we are the world's primary reserve currency, we don't need to rush this project, and we don't need to be the first to market." In an episode aired last week, Powell toldCBS's "60 Minutes"that public and congressional input must be sought before taking action on a CBDC. "We haven't decided whether to do this, because the question is: Would this benefit the people we serve?" Powell said. "We need to answer that question well. We need to deeply engage the public and Congress in this process, because if we're really going to do this, it would be a significant step."

Model choices

Baer said it remains to be seen which model the Fed would choose to issue a CBDC. The direct model he outlines in his paper would mean the Fed holds consumer accounts and provides all payment services involved in the commercial circulation of the CBDC. "An inevitable consequence of this model is that bank deposits would decline as funds shift into CBDCs," he wrote. The direct model also requires the central bank to take on account management responsibilities such as account services, anti-money laundering and know-your-customer monitoring, transaction verification, dispute resolution, and providing mobile banking applications. Baer noted that for this reason, most central bank officials consider the direct model "infeasible and a dead end."

For example, the European Central Bank has acknowledged it lacks both the capacity and resources to interact directly with potentially hundreds of millions of digital euro users, and plans to use financial intermediaries such as banks to provide front-end services, ECB Executive Board member Fabio Panetta said inFebruaryBaer wrote that an indirect model using intermediaries would mean consumers hold CBDCs in bank accounts or digital wallets of fintech companies, with the obligation to provide CBDCs on demand falling on intermediaries rather than the central bank. "However, what remains unexplained is why or how banks would continue to perform those extremely costly and burdensome agency functions when intermediaries no longer receive the low-cost funding benefits of holding deposits," he wrote. Intermediaries would also lose revenue from interchange fees, which are a core part of fintech companies' business models—these companies typically partner with banks that are not subject to interchange fee price caps.

The financial inclusion argument

Treasury Secretary Janet Yellen—Powell's predecessor at the Fed—said at a virtual conference last month that central bank research into issuing a CBDC ""makes sense". "Too many Americans lack access to convenient payment systems and bank accounts, and I think a digital dollar, a central bank digital currency, could potentially help with that," she said. "It could bring faster, safer, and cheaper payments, and I think those are important goals." The Atlantic Council argued in its2020 analysisthat in countries that decide to issue a CBDC, retail CBDC accounts should be treated as "a national right."

However, Baer said he is not convinced that CBDCs can achieve the financial inclusion goals their proponents claim—at least in the United States. A2019 studyby the Federal Deposit Insurance Corporation (FDIC) found that 5.4% of U.S. households are unbanked. In the FDIC survey, 6% of unbanked respondents cited lack of convenient branch locations, business hours, or desired products and services as a primary reason. Baer argues that CBDCs cannot solve these problems. "Because a CBDC comes with fewer services than a traditional bank account and has no branches, it seems completely unattractive to the 6% of respondents who want more services or branches," he wrote. Baer also noted that many unbanked individuals are wary of engaging with the banking system due to illegal immigration status or cash income, fearing banks will report their identity or transactions to the government. "These people may be even more concerned about dealing with the government, since the government is an additional party," he wrote.

But CBDC supporters argue that rapidly transferring CBDCs into accounts via direct deposit would be significant for people who live paycheck to paycheck. ACH transactions can take days to settle, and for lower-income individuals, faster access to their next paycheck could help avoid overdraft fees or late rent. The Fed is also developing a real-time payment system, with the system expected to be called FedNow andoperational by 2023。

Impact on lending

Baer said the core issue with CBDCs is the potential negative impact on lending. "I think there's a general consensus, at least among analysts, that a CBDC will inevitably lead to funds flowing from bank deposits into cash—here meaning digital cash—which is not only bad for banks, but also bad for people who like to borrow from banks, because those loans are funded by bank deposits," Baer said. He wrote that as banks raise interest rates to persuade businesses and consumers to hold deposits rather than CBDCs, loan supply would decrease and costs would rise, and the impact would affect all banks, not just large institutions. "That's the core issue with all of this—you can't design a truly comprehensive CBDC without disintermediating the banking system and making loans more expensive and scarcer," he said.