Central Bank Digital Currencies: The Next Money Milestone?

The complexities and risks of a CBDC system should not be ignored.

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On March 8, President Biden announced a landmark executive order which, among other things, directs the Federal Reserve to study digital currencies stating "My Administration places the highest urgency on research and development efforts into the potential design and deployment options of a United States CBDC."

The proliferation of privately-issued digital currencies such as Bitcoin has played a leading role in the transformation of the global economy. Because of the difficulties of effectively regulating these new forms of currency, central banks around the world have begun issuing their own Central Bank Digital Currencies (CBDCs) in an attempt to keep pace with or respond to these major developments. Now, the U.S. is joining the charge.

CBDCs are projected to be the "next great experiment in finance" and the "next milestone in the evolution of money." According to one survey, over 85% of central banks worldwide are in the process of considering, developing or implementing CBDCs, including those in China, Japan and Europe. In 2020, the U.S. Federal Reserve partnered with the Massachusetts Institute of Technology to test a hypothetical CBDC and requested public comment on CBDCs in a recent discussion paper.

The term "CBDC" is used to describe a wide range of concepts; there is no consensus on a precise definition or on the exact form a CBDC should take. In its January 2022 discussion paper on the topic, the Federal Reserve defined a CBDC as "a digital liability of a central bank that is widely available to the general public." The basic idea is that instead of holding an account with a retail bank, a consumer would transact with a central bank through a digital interface. There would be no middleman in most transactions, as customers would be able to transfer digital currency directly from their wallets to vendors.

CBDCs are promoted as being more efficient and less costly than traditional monetary systems. They are touted as offering similar advantages to private digital currencies — such as negligible delays in money transfers and reduced counterparty risk — but with increased stability. In his book, The Future of Money, financial scholar Eswar S. Prasad also argues that CBDCs' adoption could increase financial inclusion and make illicit activity more difficult because the identities of parties to each transaction are recorded and accounts using CBDCs are operated by government-run central banks.

Despite the obvious appeal of these potential upsides, critics cite a lengthy list of legal issues and risks raised by CBDCs that may delay or prevent their widespread use.

Before central banks can begin to adopt digital currencies, they will likely be confronted with several fundamental legal questions surrounding the legality of CBDCs under the central bank and monetary law, some of which "touch upon the very fundamental relationship between money, the State, and the law." In a State-run digital central banking system, the State incurs nearly all the risk—both financially and in terms of its own legitimacy. Although this is beneficial for consumers, it raises significant legal questions for the State as the central entity. Without answers to these questions, private alternatives will continue to dominate the digital currency space.

The legal issues and risks posed by CBDCs are not limited to questions under central bank and monetary law. CBDCs will no doubt raise questions under tax law, contract law, insolvency law and international law about increases in state authority and encroachment on civil liberties, and so on. The particular legal questions raised will depend greatly on the design features chosen and the consequences that ensue. What follows is a brief overview of policy considerations that, although perhaps not yet reduced to specific legal questions, may present an increased risk of legal issues or litigation for governments, companies and consumers to consider:

Destabilization of Retail Banks

Banks rely heavily on deposits to fund their loans. Assuming CBDCs are in fact less expensive, more stable, and more efficient, many consumers would likely shift their deposits away from private banks if CBDCs were to come into widespread use.

Privacy

The anonymity offered by cash and cryptocurrencies is unlikely to be offered by a CBDC system. For this reason, many countries, including the United States, have raised concerns about the privacy protection of CBDC users, with one commentator even calling the trend "Orwellian."

Financial Stability/Cybersecurity

Although one potential upside of CBDCs is the reduced risk of security breaches inherent in the government assuming responsibility for cybersecurity, a consolidated, State-run banking system may also bring with it heightened cyber vulnerabilities as any breach might occur on a more massive scale.

Potential Disruption of the Financial Sector

A centralized bank digital currency system would also likely alter the financial markets. The economic role of traditional commercial banks may shrink as customers adopt the State-run option. A January 2022 report by the Federal Reserve Board of Governors explained that once customers switch to the CBDC system, commercial banks would experience a significant decrease in deposits, which would "increase bank funding expenses" and "reduce credit availability."

Potential Threats to Civil Liberties

Although a CBDC system may function well in an already-authoritarian nation like China, there is concern that such a system would not align with the limits on government power important to American democracy. Washington Post journalist Charles Lane noted that American dollars are attractive because of the "robust body of law [behind them], among whose pillars is the Fourth Amendment protection against unreasonable searches and seizures."

In a CBDC system, it is not clear who would manage compliance, a job private-sector banks currently hold. Although private-sector cryptocurrencies such as Bitcoin and Ethereum have successfully begun to decentralize currency, the centralization of digital currency would undermine some of its goals, including preserving anonymity and avoiding complete government regulation. Increasing the role of the federal government in the financial systems beyond the role it already plays may cause concern. With some commentators arguing that "CBDC benefits are dubious but the downsides are certain," the complexities and risks of a CBDC system should not be ignored.

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