U.S. Central Bank Digital Currency: Balancing Opportunity and Risk

The Bank of International Settlement (BIS), essentially the “central bank of central banks,” is reporting that 90% of monetary authorities around the world are currently working towards a central bank digital currency (CBDC).¹ The current chair of the Group of Seven (G7), Japan, emphasized that the coalition, which includes the U.S., EU, and other highly developed economies, considers the introduction of CBDCs a primary policy focus.² Some nations, such as China, India, and Nigeria, have already launched digital currencies of their own. These developments, combined with the potential risks of any large-scale policy shift, have unsurprisingly led to a broad debate, filled with plenty of misconceptions over what CBDCs represent for the future of money and banking.

What is a CBDC?
“A CBDC could potentially serve as a new foundation for the payment system….[and] could also maintain the centrality of safe and trusted central bank money in a rapidly digitizing economy.” –  Federal Reserve Board of Governors

In the simplest form, a CBDC is a digital currency provided by a central bank, as opposed to being privately managed like Bitcoin and other “cryptocurrencies.” In the U.S., this would obviously be a digital form of the dollar. Conceptually, digital payments are already broadly used by consumers that rarely carry paper money each day, instead relying on debit or credit cards, payment platforms (Paypal, Venmo), or banking apps for transfers and check deposits.

However, there is a major difference between all of the above digital systems and CBDCs. When you deposit money into your bank account, it creates a liability on that bank’s ledger system - they owe you the money you deposited and are held responsible for transferring it back to you on demand. With a CBDC, the duty to maintain, transfer, or return those funds to you now falls on the central bank, which is a key point. Like paper money, a CBDC is a liability of the central bank. Unlike paper money, however, a CBDC has none of the finality and privacy associated with paper transactions. These are the reasons that some presidential candidates and pundits strongly oppose the idea,³ while proponents, conversely, see enough potential benefits to outweigh any perceived risks.  

Potential Benefits   

The Federal Reserve (Fed) asserts that “the introduction of a CBDC would represent a highly significant innovation in American money.”⁴ As we have alluded, a CBDC essentially represents the government’s response to cryptocurrency – it melds the technological advancement of private cryptocurrencies onto existing fiat currency systems that dominate the globe (i.e., those backed by the full faith and credit of the central bank, not a precious metal or other commodity such as gold or silver). Proponents of CBDCs offer the following potential key benefits⁵:

• A CBDC could provide faster and cheaper payment services that could eliminate the risk associated with other cryptocurrencies, as it would bear the “full faith and credit” of the U.S. government.
• Transferring money and making payments across international borders could become more streamlined and effective, potentially reducing transactions costs.
• As other countries introduce digital currencies, a U.S. CBDC would allow us to compete technologically, supporting the continuation of the U.S. Dollar’s role as the global reserve.  
• A widely held digital currency would enhance monetary and fiscal policy action, allowing finer tuning of the economy. For example, money could be transferred directly into individual accounts when stimulus is needed, avoiding delays associated with current channels (i.e., banks). A central bank could induce consumer spending by linking a date deadline for using digital currency it puts in an account. 
• A digital currency may provide greater access to electronic payments for typically underserved (or unbanked) communities, which could enhance delivery of paychecks and tax refunds. This could potentially expand access to credit and easier electronic payments, thus avoiding the predatory practices of pay-day lenders.
• Also, because any digital dollars held in a CBDC account at the Fed are a direct obligation of the central bank, it would not be limited to the $250,000 FDIC protection offered at U.S. depository institutions. For example, if you held $500,000 in such an account, it could theoretically be 100% insured, whereas if you held it at a traditional bank, only $250,000 would be insured per FDIC limits. 

Potential Risks   

Of course, many of the headlines surrounding CBDCs also focus on the potential risks associated with a digital currency controlled by a central bank. Many, including two leading presidential candidates,⁶ are even framing CBDCs as a major threat to civil liberty. Key examples of these concerns include the following:    

• Financial privacy is already a tenuous concept, as anti-money laundering laws and tax enforcement allow considerable surveillance of transactions.  A direct relationship between the central bank and individual activity that would allow the central bank to view all of your financial transactions may serve to lessen what protection of privacy does still exist.
• Financial freedom, or the ability to spend your money when and where you want, could also be hampered due to the “programmability” component of a CBDC, which is a function of cryptocurrencies backed by blockchain technology. For example, a parent could program their child’s lunch money so it couldn’t be spent on sweets. However, a CBDC could likewise be used to bolster policy (in the case of providing stimulus that must be spent within a certain time period or administering negative interest rates to spur economic growth) or restrict spending (only allowing spending on certain goods). In this regard, the ability to more broadly dictate how and when money can be spent is a potentially concerning concept, which would require considerable policy safeguards.
• A CBDC could potentially disrupt financial markets. Banks make loans and extend credit from the deposits that customers keep with them.  If customers moved their deposits to a CBDC account with a central bank because of unlimited insurance or higher interest rates, banks could lose a material portion of their deposit base. If that happened, a bank’s ability to lend would be severely curtailed, which in turn could negatively impact economic growth. To avoid economic stagnation from a crippled banking industry, a central bank would have to engage in lending activities – for which they have no underwriting experience.
• Private development of digital currencies (like Bitcoin) is likely to be stunted with the introduction of a CBDC. Like with paper currency, to sufficiently support monetary policy, substitutes must be limited. Therefore you may see over-regulation⁷ and sometimes outright banning⁸ of competing cryptocurrencies as part of a robust CBDC launch.

These criticisms have merit. In fact, The Deputy Managing Director of the International Monetary Fund (IMF), Bo Li, had this to say: “By programming a CBDC, money can be precisely targeted for what people can own and what [people can do.]”⁹ In a similar vein, BIS General Manager Augustin Carstens, at an IMF briefing on CBDC, noted that “we don’t know who’s using a $100 bill today” and a CBDC would give a central bank the ”absolute control” on how the currency is used, along with the technology to enforce those regulations.¹⁰

It should be noted, however, that most legitimate policy papers concerning CBDCs, including those written by such bodies as the Fed, BIS, and IMF, cite these same privacy and disruption concerns as areas that demand attention, which should force them to be major policy considerations when discussing any path forward.

Potential Misuse of a CBDC – The China Example

A CBDC controlled by a central bank, in the wrong hands and without appropriate safeguards, has the potential to be misused. For example, the Chinese Communist Party (CCP) would like to replace all cash in the Chinese monetary system with their digital renminbi.¹¹  If this happens, a digital currency may allow the CCP to track every purchase, expand domestic surveillance initiatives, and exert even greater control over private transactions.¹²  The CCP could then, with its new-found visibility into monetary transactions, exert greater control over its populace to enforce party discipline. This new power, along with the CCP social scoring system, would allow the CCP to wield punitive power over Chinese citizens that act in a way contrary to CCP goals. For instance, if a Chinese citizen has a lower social score, that citizen may have limited access to currency or receive a lower interest rate than “good” Chinese citizens (as defined by the CCP). 

How likely is a U.S. CBDC?
“We would not want a world in which the government sees, in real time, every money transfer that anyone makes with a CBDC.” -  Fed Chair Jerome Powell

Despite these concerns, we are still seeing a persistent push globally for such currency alternatives. So is a U.S. CBDC simply a forgone conclusion? We don’t think so, at least not in any currently proposed form.

Consider the political and social landscape of the United States. A CBDC would inherently shift the dynamics between the Fed, the Treasury, and the executive branch, and this shift would impact economic rights. While many arguments for CBDCs appear, at least on the surface, to grant greater economic freedom, the opposite outcome must also be considered. With a CBDC, at least in theory, the government gains new and powerful levers to pull during times of crisis and the ability to monitor transactions for illegal or illicit activity is increased. At the same time, central bank independence (which currently makes the U.S. near-unique and trustworthy relative to countries that have fewer barriers between fiscal and monetary policy) may weaken as the temptation to use these tools to target specific segments of the population or to support fiscal goals may override prudent action. This combination of potential detriments is why we believe a CBDC policy faces its toughest challenge here.  

The importance the U.S. places on the sovereign individual is not universal – it’s a relatively new idea, historically speaking, that found its home in English common law and then its most powerful codification in the U.S. Constitution. Thus, we must be careful not to extrapolate and assume that the same worrisome abuse of government oversight we see in other countries would occur in the U.S. Our emphasis on private property and privacy not only explains why popular support for CBDC is severely lacking,¹³ but ensures that the legal and regulatory barriers to any major overhaul of our monetary system will not be brushed aside, meaning considerable work will need to be done to ensure the risks and worries listed above will be adequately addressed in any policy that is put forward.

Practical considerations aside, policy makers remain unconvinced as well.  Despite the White House focus on development,¹⁴ Fed Chair Jerome Powell has stated that no progress will be made towards a CBDC without legislative approval and support, and he expressed a clear disinterest in handling retail accounts. Multiple Fed presidents have similarly been vocal about the dangers posed by the concept, and many see no compelling need to develop it. Congressmen and women on both sides of the aisle are speaking out against further developments,¹⁵ with some promising to shut down development if given the chance.

The bottom line is that despite the touted benefits of a CBDC, there are plenty of considerations and risks that prevent its imminent implementation. The introduction of a U.S. CBDC is likely to be preceded by many lengthy policy discussions and political and legislative processes that could take years.  As such, our opinion is that, if it is to be introduced, a U.S. CBDC would likely take on the following characteristics:

• A U.S. CBDC will not wholly replace U.S. cash or digital transactions with depository institutions (like the CCP is trying to do). It will most likely supplement them. This is what is known as a “wholesale,” as opposed to a “retail,” CBDC.
• Cash, deposits held at U.S. depository institutions, and a U.S. CBDC will be readily exchangeable, meaning you would be able to convert cash to deposits, deposits to CBDC, and back again. 
• The Fed will not want to disrupt U.S. depository institutions that provide fuel to U.S. economic growth through its lending functions. The Fed is not set up to underwrite loans and has no experience doing so.  They would not want to disintermediate the U.S. banking system as it would jeopardize the growth of the U.S. economy. This one consideration alone would make policy makers and legislators very careful about providing appropriate safeguards to prevent that outcome.

¹https://www.bis.org/publ/bppdf/bispap125.pdf.
²https://www.reuters.com/markets/currencies/g7-discuss-digital-currency-standards-crypto-regulation-2023-04-11/.
³https://floridianpress.com/2023/04/desantis-rails-against-fed-controlled-digital-currency/.
⁴https://www.federalreserve.gov/publications/files/money-and-payments-20220120.pdf.
⁵Ibid.
⁶https://finance.yahoo.com/news/robert-f-kennedy-jr-joins-224947258.html?guccounter=2.
⁷https://www.reuters.com/world/africa/nigerias-markets-regulator-publishes-rules-crypto-assets-2022-05-14/.
⁸https://www.theverge.com/2021/9/24/22691472/china-central-bank-cryptocurrency-illegal-bitcoin.
⁹https://www.harvardchina.org/past-conferences/2022-conference.
¹⁰IMF Webinar: Cross-Border Payments – A Vision for the Future.
¹¹https://www.congress.gov/event/117th-congress/house-event/LC67455/text.
¹²Ibid. 
¹³https://www.cato.org/survey-reports/poll-only-16-americans-support-government-issuing-central-bank-digital-currency
¹⁴https://www.whitehouse.gov/briefing-room/statements-releases/2022/03/09/fact-sheet-president-biden-to-sign-executive-order-on-ensuring-responsible-innovation-in-digital-assets/
¹⁵https://www.cato.org/study/risks-of-cbdcs

The information in this report was prepared by John Weitzer, Chief Investment Officer, Matt Wiley, Vice President of Investment Management, and Matt Conner, Investment Advisory Consultant of First Command. Opinions represent First Command’s opinion as of the date of this report and are for general informational purposes only and are not intended to predict or guarantee the future performance of any individual advisor. All statistics quoted are as of the date of this publication, unless otherwise noted. First Command does not undertake to advise you of any change in its opinions or the information contained in this report. This report is not intended to be a client specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Should you require investment advice, please consult with your financial advisor. Risk is inherent in the market. Past performance does not guarantee future results. Your investment may be worth more or less than its original cost. Your investment returns will be affected by investment expenses, fees, taxes and other costs.