A Primer on Digital Currencies

With cryptocurrencies increasingly fashionable, it isn’t surprising the Fed, ECB and other central banks would want to get in on the action with so-called “central bank digital currency” (CBDC). While payments have been electronic for decades, what makes CBDCs different and what form might they take? How would they differ from mainstream cryptocurrencies like bitcoin and “stablecoins,” asset-backed cryptos with a fixed value? Although we don’t think this debate intersects much with stock markets, a brief primer on the main players seems in order.

Cryptocurrencies, in general, strive for an electronic equivalent of handing someone cash. Mobile payment apps using dollars may seem to have that ease of use, but they are based in the banking system, using much of the same plumbing as checks, wires and other bank transfers. Payments can still take days to clear and settle through multiple intermediaries. That lunch bill you split with the payment app on your phone ultimately links back to a bank account you authorized to transfer funds—much more complicated than if you had handed your pal a fiver.

Enter bitcoin and its fellow cryptocurrencies, which operate outside the banking system. Once in possession of a token, you can direct it to anyone else who has an address on its blockchain (i.e., the digital ledger tracking transactions and possession). Bitcoin addresses are long alphanumeric keys, not names and other personal data, giving the perception of anonymity—much like physical cash—although that anonymity isn’t guaranteed, and the EU is now pushing to end it altogether. Blockchain settlement is also real-time, final and irreversible. But cryptocurrencies are only as good as what you can exchange them for—no one is legally obligated to accept them outside of El Salvador, and not everyone does. You can’t pay taxes with them—whereas the IRS does tax cryptocurrency transactions.^[i]

Being unregulated may be part of cryptocurrencies’ allure; you can access and transfer funds anywhere, without any official recognition or permission. But it also leaves users subject to fraud—which may be why it attracts scammers. Buyer beware; there is little (legal) recourse for lost or stolen funds in wild-west crypto-land. If you forget the key to your crypto-wallet, you are out of luck.

Cryptocurrencies have another big drawback: They are hugely volatile, making them next to useless as money. Stablecoins aim to solve that problem by having a fixed value (or close to it), much like a currency peg. Stablecoin operators usually back their coins with a basket of stable-value assets—e.g., Treasury bills, commercial paper, other short-term instruments and cash equivalents—similar to how a money market fund functions. Some use actual dollars or a basket of currencies. They then peg their token to government currency—theoretically making it a credible medium of exchange. But money is in the eye of the beholder. Fed head Jerome Powell, for one, sees stablecoins more as unregulated money market funds.

The question many have about this arrangement, including financial regulators, is whether they actually have sufficient holdings to back their trading value—or whether the composition of that basket is really so stable. One stablecoin, Tether, came under fire in 2019 for saying it was fully reserved when it held assets covering only 74% of what it claimed. The US Treasury is currently investigating this very practice. Curiously, Tether now includes “other tokens” in its reserves, along with precious metals and corporate bonds, all of which are rather more volatile than cash.

Furthermore, currency pegs are made to be broken. Neither they nor money market funds have proven particularly adept at maintaining a fixed value during times of high stress—when you may want them to most—and those are in regulated areas. In our view, it isn’t impossible that doubts about their claimed stability could lead to a crypto-version of a bank run (without a crypto-central bank as lender of last resort), resulting in a not-so-stable price crash. In our view, potential holders should conduct thorough due diligence on this risk before diving in. History is replete with fraud involving assets wrongly perceived as safe.^[ii]

CBDC differs from all of these. It isn’t a new currency—it wouldn’t replace the dollar, euro or pound. It would amount to a central bank-administered digital payments system. Basically, the Fed, ECB, BoE et al. would be competing with Venmo. China, whose digital yuan is actually in a trial phase, is already trying to internationalize it for cross-border payments. The Fed is exploring the idea now and is set to release a white paper on it in September. The ECB seems further along. Although nothing is set in stone, it has outlined the contours of what its CBDC might look like.

But we see several issues suggesting CBDCs aren’t imminent in the developed world. We aren’t citing these as risks, mind you, but rather barriers to getting CBDCs off the ground. A big one—which central bankers recognize: Who would administer CBDC accounts? For example, would central banks be responsible for verifying account holders’ identities? That is one reason why the ECB is leaning towards banks providing digital euro wallets to their clients on its behalf. Since private banks are already equipped to service millions of individual accounts, they could administer CBDC wallets, but on the ECB’s systems instead of their own.

Also, CBDC account transactions are highly unlikely to be anonymous. Though some say they could provide “selective” anonymity, privacy concerns may give many pause. Storing your money with the government could entail sharing a lot more information than you bargained for, as public-serving central banks may lack private banks’ discretion. See the IRS leaks to ProPublica with any questions.

CBDCs would be a big expansion in central banks’ remit, overseeing not only bank transactions, but potentially all transactions. Moreover, it could effectively nationalize the banking system—and end fractional reserve banking—if most everyone kept their money in de facto central bank accounts. Would central banks then lend directly to households and businesses, too? To head this off, the ECB suggests it would limit their CBDC accounts’ attractiveness, capping the amounts they can hold or penalizing them above some threshold. But then why do it all? Then, too, uncertainty over the ECB potentially lifting caps or penalties at some point may also be destabilizing. If the entire private banking system is just a hair trigger away from effective nationalization, then that might erode confidence in it a wee bit.

If central banks become back-end payment processors, would they be any better than current ones? The People’s Bank of China is testing its system now, competing with private networks that it also regulates (and using it as a further means to monitor cash movement). We see some pros and cons even in free-market democracies. Greater payments oversight could yield more fine-tuned control over monetary policy. The main transmission mechanism for monetary policy is bank lending, which is slipping in the US and across the developed world. Interest-bearing CBDC accounts—a possibility under discussion—could give central banks another tool to conduct monetary policy and more directly influence money supply growth and velocity. (Not that they would do it well or wisely, per se.)

Another potential benefit: CBDC could eliminate payment processing fees—or prevent excessive ones—but it isn’t as if fierce market competition and innovation are currently lacking.^[iii] A government-backed entrant—if not a monopoly—could limit options and may ultimately prove clunky (see also: the DMV). If a service is “free,” the provider may not always be especially responsive to user demands.

For now, all of this is an academic discussion. It isn’t sowing the seeds of a near-term sea change in the financial system or an imminent crisis. If anything, we think it best serves as proof digital currencies are far, far more boring than headlines allude and a lot further from going mainstream than many seem to suggest. If and when there is a stronger transmission mechanism for trouble in the digital currency world to infect mainstream capital markets, then this will probably deserve more attention. But that isn’t now, in our view.