In July this year, the Federal Reserve will launch the most significant financial innovation in its history – FedNow. This 24/7 instant payment infrastructure has all the hallmarks of a CBDC precursor. However, is the tokenized dollar even needed?
Levels of Liability Expressions
When innovation comes along, the best way to grasp its importance is to place it in an existing framework. From this point of view, what is USD in its current form?
- Firstly, USD is a central bank’s note, expressed as a physical item. It is an anonymous form of the central bank’s liability. In turn, USD holders are exposed to the central bank’s liability via its money supply manipulation, such as the interest rate hiking cycle.
- Secondly, USD is an electronic record of the central bank’s balance sheet. As Fed Chair Jerome Powell put it, “we have the ability to create money digitally. And we do that by buying Treasury Bills or bonds for other government guaranteed securities.”
In other words, central banks’ liabilities come from banknotes and commercial bank reserves. Typically, the latter holds the bulk of the total money supply in their balance sheets. In both forms, this money is a type of IOU as a legally recognized vehicle to settle transactions.
Accordingly, the central bank guarantees the convertibility of commercial banks’ balance sheets into physical banknotes. By the same token, the role of the central bank is to provide this liability from its balance sheet.
It’s All About Ledgers
If the Fed can already “create money digitally,” what does having a Central Bank Digital Currency (CBDC) mean? If the central bank already creates such money as an expression of its balance sheet, what would be different with CBDCs?
Fortunately, there is little ambiguity on this question, courtesy of the BIS chief, Agustin Carstens:
“The key difference with the CBDC is that the central bank will have absolute control on the rules and regulations that will determine the use of that expression of central bank liability. And also, we will have the technology to enforce that.”
Agustin Carstens, general manager of the Bank for International Settlements (BIS)
The present pre-CBDC system works through different accounting layers. Commercial banks serve as the secondary money layer to the primary layer of the central bank. These layers are ledgers from which transactions are added and subtracted.
What CBDCs represent is the unification of those layers. However, the digital token itself – a retail CBDC such as Chinese eCNY – would simply be an extra utility of the new network infrastructure. For instance, BTC is a token of Bitcoin’s distributed ledger, keeping track of all transactions as a type of energy receipt from miners.
Because Bitcoin launched as a decentralized ledger without hierarchical top-down control, BTC was already baked in the DLT cake.
But within the context of the Federal Reserve, distributed ledger technology (DLT) would be deployed under the rules and conditions of the central bank. The upcoming FedNow network is a step in that direction, which may or may not build up to retail CBDCs.
After all, digital dollars already exist under the central bank’s control.
FedNow: More Stable and Efficient Financial System?
In March 2020, in a 60 Minutes interview, one of the Fed Governors, Neel Kashkari, said that “there is an infinite amount of cash at the Federal Reserve”. As already noted, this somewhat fantastical claim is born of the fact that the central bank is the sole entity that can “create money digitally” to express its electronic ledger.
This means that the central bank can be insolvent and have negative equity. The Fed’s balance sheet read $44.2 billion in unrealized losses at the end of March. However, when commercial banks go into negative territory, they are at risk of collapse, as happened with Silicon Valley Bank.
With FedNow in play, potential stress in the banking system can be relieved. When connected to FedNow, all financial institutions can settle payments instantly, 24/7, removing the long-standing payment legacy of having to wait 3-4 business days. More importantly, FedNow network participants can access cleared funds on the same payment day for commercial banks.
Previously, there was a considerable gap between made payments and those payments become available. FedNow’s intraday access to funds would provide commercial banks with a superior and more stable liquidity management system.