1.30 - Federal Reserve Board (the Fed)
The Federal Reserve Board (the “Fed”) has so far not set any specific guidance on what financial institutions can do, should do, or may not do regarding cryptocurrency or digital assets. Rather, it has indicated that in 2022 it, in conjunction with the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC), plans to “provide greater clarity on whether certain activities related to crypto-assets conducted by banking organizations are legally permissible, and expectations for safety and soundness, consumer protection, and compliance with existing laws and regulations.” The Fed, FDIC, & OCC, Joint Statement on Crypto-Asset Policy Sprint Initiative and Next Steps (2021.11.23). That clarified guidance will include statements on the following categories:
- Crypto-asset safekeeping and traditional custody services.
- Ancillary custody services.
- Facilitation of customer purchases and sales of crypto-assets.
- Loans collateralized by crypto-assets.
- Issuance and distribution of stablecoins.
- Activities involving the holding of crypto-assets on balance sheet.
So far in 2022 neither the Fed nor the FDIC nor the OCC have issued that guidance. The Fed has, however, issued a whitepaper on the potential use of a Central Bank Digital Currency (“CBDC”). Federal Reserve Board of Governors, Money and Payments: The U.S. Dollar in the Age of Digital Transformation (2022.01.20) (hereafter, “Money and Payments“). It identified four key characteristics of what it believes would be an effective CBDC:
- widely transferable; and
Id. at 1-2. The paper, however, explicitly disclaims any specific position on the wisdom of implementing CBDCs, noting at the outset that “The paper is not intended to advance any specific policy outcome, nor is it intended to signal that the Federal Reserve will make any imminent decisions about the appropriateness of issuing a U.S. CBDC.” Id. at 1, 2. The paper concludes by asking for public comment, and notes that the Fed will also be engaging in public forums and outreach. The period for providing public comments on the paper concluded on May 20, 2022. Regardless of comments and public engagement, the Fed advises that it will not issue a CBDC without “clear support from the executive branch and from Congress, ideally in the form of a specific authorizing law.” Id. at at 3, 21.
As of June 17, 2022, Chairman Jerome Powell has indicated more forcefully that "a U.S. CBDC could also potentially help maintain the dollar's international standing." Chair Jerome H. Powell, Welcoming Remarks at the "International Roles of the U.S. Dollar" (2022.06.17). If legislative and executive branches agree with this conclusion, the creation of a U.S. CBDC will become extremely likely.
To understand the Fed’s concerns with issuing a CBDC, it is first imperative to understand the current state of money as used in the existing financial system. American cash money is backed by the full faith and credit of the United States Government, meaning that a $100 bill (or bills of any other denomination issued by the Treasury) will be honored for its face value. However, a vast majority of consumers no longer rely primarily on cash. Instead, cash is deposited into national and local banks and credit unions. When cash is deposited into a bank or credit union, the consumer or business enters into a deposit agreement with the financial institution whereby the institution promises to repay the amounts deposited upon demand of the consumer. It is essentially a very low cost loan from the consumer to the financial institution that can be called for payment at any time.
The key here is that the financial institution makes a promise to pay the consumer. It is thus a liability of the financial institution to the consumer, not of the U.S. Government, that backs the cash deposited into the financial institution. Meanwhile, the financial institution is free to use the deposited cash as it sees fit — typically by lending the money to other consumers so that it can earn a return to fund its operations and earn a profit.
A CBDC, on the other hand, would be a direct liability of the U.S Government that must be honored at all times by the U.S. government, in the same way as central bank money, most commonly experienced by consumers in the form of physical currency — cash. This differs significantly from commercial bank money and nonbank money, both of which are subject to varying degrees of credit and liquidity risk because consumers are exchanging central bank money (cash) when they deposit it for a promise to repay from the commercial bank or nonbank. See Money and Payments at 25 (Appendix B: Types of Money). This promise creates credit and liquidity risk for the consumer; if the bank or (and especially) nonbank folds, the consumer might not get repaid. A significant transfer of money from central banks and commercial banks to nonbank money could thus create significant risks in the financial system, because nonbank money is not, for example, subject to the FDIC or NCUA insurance that serve to ward against destabilizing bank runs.
This is why the prospect of a CBDC is so intriguing. It would enable the general public to hold central bank money, directly, with zero liquidity or credit risk. But what would this actually look like? According to the Fed, it should be “privacy-protected, intermediated, widely transferable, and identity-verified.” Money and Payments at 13.
The provides no guidance on what it envisions by a “privacy-protected” CBDC, offering only this limited statement: “Any CBDC would need to strike an appropriate balance, however, between safeguarding the privacy rights of consumers and affording the transparency necessary to deter criminal activity.”
Reading between the lines, the Fed is acknowledging a common concern of crypto skeptics: truly private digital payments that require no central clearing house will be a boon to criminals and their money laundering operation. Example: a criminal’s illicit sale of cocaine yields millions of dollars in ill-gotten cash. This presents a big problem for criminals right now, because they have to explain to any financial institution where they got the cash. They cannot show up at a bank and say they would like to deposit several million dollars without triggering fairly intense scrutiny on where the funds came from. But if that cash is in the form of a CBDC that can be stored in a digital wallet that can then be used anywhere in the broader economy, huge swaths of anti-money laundering protections built into the current financial system will be undermined.
On the other hand, consumers do not want the government to have instant access to every financial transaction they engage in. This concern is evident in the recent proposal, and rapid withdrawal, of the requirement that banks turn over transaction flow data to the IRS for virtually all banked Americans annually for any accounts with more than $600 of inflow or outflow. Thus what kind of government monitoring is capable for a CBDC is critical to consumer acceptance.
This tension between a digital currency that functions like cash and is backed by the federal reserve, the need for privacy, and the need to not open the door for bad actors to be able to use money indiscriminately leads the Fed to recommend that a CBDC be intermediated, i.e., mostly used through an intermediary. The intermediary would host digital wallets and, presumably, engage in anti-money laundering checks for owners of those wallets and transactions occurring in them through existing regulatory frameworks.
The Fed also says that a CBDC must be “readily transferable between customers of different intermediaries.” Money and Payments at 13. In other words, it must be as easy to exchange as cash is, so that value does not get locked into an intermediary, creating a drag on the economy when considered on a large scale.
Confirming that the Fed anticipates intermediaries would conduct the robust anti-money laundering checks current financial institutions are required to perform, the Fed notes that “a CBDC intermediary would need to verify the identity of a person accessing CBDC, just as banks and other financial institutions currently verify the identities of their customers.” (emphasis added). Money and Payments at 14. Thus any institution that plans to host a CBDC, were one to issue, should be prepared to fully comply with existing anti-money laundering and terrorism financing regulations, such as the Bank Secrecy Act and the USA PATRIOT Act.
The Federal Reserve Bank of Boston (Boston Fed), in conjunction with the Massachusetts Institute of Technology Digital Currency Initiative (MIT DCI), is engaging in “a multiyear research project to explore the CBDC design space and gain a hands-on understanding of a CBDC’s technical challenges and opportunities.” Boston Fed & MIT DCI, Project Hamilton Phase 1: A High Performance Payment Processing System Designed for Central Bank Digital Currencies (2022.02.03). On February 3, 2022, Boston Fed and MIT DCI released the results of Phase 1 of their research, the primary goal of which “was to design a core transaction processor that meets the robust speed, throughput, and fault tolerance requirements of a large retail payment system.” Id. at 3. Phase 2 of the project will focus on “more complex functionality,” such as high security, auditability, balancing privacy with compliance, and roles for intermediaries. Id.
In banking, the “core system” or “core processor” is the name for the ledger system that keeps track of all transactions across accounts and the order in which they occur. In Project Hamilton, the Fed experimented with different design features for a new system to handle the use of digital currency, including different levels of identification for customers. Despite taking advantage of cryptographic keys and digital wallets, users would still interact with a “central transaction processor,” which differs fundamentally from the distributed and decentralized ledgers of most cryptocurrency. Id. at 4. Most cryptocurrencies, for example, rely on a consensus mechanism (usually proof of work or proof of stake) by which hundreds to thousands of different validation nodes around the world determine which transactions are valid, thus building a ledger.
The Fed has two current designs, but both rely on a single entity (the Fed) controlling the computer systems that process the transactions. Indeed, the Fed notes that “a distributed ledger does not match the trust assumptions in Project Hamilton’s approach, which assumes that the platform would be administered by a central actor.” Id. at 5. The first, “processes transactions through an ordering server” that creates an ordered ledger of transactions. The second uses multiple computers to process the transactions, which results in higher throughput (1.7 million transactions per second), but “does not materialize an ordered history for all transactions.” Id. at 4.
Since the focus of this core processor is on a retail payment system, widespread adoption by financial institutions could have important implications for consumer privacy. (Nearly all banks have their own core processing systems. Thus, under the current processing framework, the government ordinarily must subpoena a private entity to find transaction history for individuals, and it also must know where such individuals bank to do so.) The Project Hamilton processor could also have significant implications for retail bank revenue, a significant portion of which is “interchange income,” or the fees generated by debit and credit card transactions that are shared between the financial institution and the third party processor of the debit/credit cards.
If nearly all retail transactions were processed through the Fed’s servers, for example, government oversight of individual citizens’ financial transactions could be exceedingly easy, raising complex constitutional and ethical questions. The Fed notes that in the current design of its fastest system, “we do not keep a history of transactions nor do we use any cryptographic verification inside the core of the transaction processor to achieve auditability,” but that its next phase of work will focus “on adding privacy-preserving designs for auditability.” Id. at 6. Additionally, it is unclear how an unordered ledger of transactions would impact when and how consumers overdraw their accounts, or how the system would handle such overdrafts.
On the other hand, the Fed’s design of mostly-centralized systems with cryptographic components enables efficiency that is many orders of magnitude above that of current systems. The observed transaction throughput of 1.7 million transactions per second of the Fed’s experimental system is approximately 1,000 times more transactions than Visa processes per second, and 369,565 times more transactions than Bitcoin processes per second. See, e.g., Kenny Li, The Blockchain Scalability Problem & the Race for Visa-Like Transaction Speed, TowardsDataScience.com (2019.01.30).
In August 2022, the Fed provided lengthy guidance regarding how innovative financial firms with novel bank charters may be able to gain access to federal reserve accounts. The Fed, Guidelines for Evaluating Account and Services Requests, 87 Fed. Reg. 51099 (2022.08.19).
The lack of clarity — and decisions — on access to such accounts led cryptobank Custodia to sue the Federal Reserve Board in June 2022. See, e.g., James Rubin, Crypto Bank Custodia Sues Federal Reserve (2022.06.07). The case's docket may be accessed on Court Listener here: Custodia Bank Inc v. Federal Reserve Board of Governors, No. 22-cv-00125 (D. Wyo. June 7, 2022).
Days before the Fed provided its guidance on gaining access to a reserve account, it advised that all "Federal Reserve-supervised banking organization[s] engaging or seeking to engage in crypto-asset-related activities should notify [their] lead supervisory point of contact at the Federal Reserve." The Fed, SR 22-6 / CA 22-6, Engagement in Crypto-Asset-Related Activities by Federal Reserve-Supervised Banking Organizations (2022.08.16). Prior to engaging in any crypto-related activities, the Fed advises that supervised entities must be confident in the legality of the proposed activities. In the case of uncertainty, the Fed advises working with it directly. Regardless of the activity, any supervised entity engaging in crypto activities should "have in place adequate systems, risk management, and controls to conduct crypto-asset-related activities in a safe and sound manner and consistent with applicable laws, including applicable consumer protection statutes and regulations." Id.
One of the central functions of banks in the financial system is to provide credit. They do that by taking in deposits and then lending out a significant portion of those deposits to consumers and businesses. If a CBDC is poorly designed, it could trigger huge swaths of deposits to land in non-bank intermediaries, or if designed to operate without intermediaries, only in a consumer’s digital wallet. If those nonbank intermediaries do not issue loans, the credit available to the general public could dramatically decline. See, e.g., Francesca Carapella & Jean Flemming, Central Bank Digital Currency: A Literature Review (2020.11.09).
Thus, regulators designing a CBDC are likely to look for ways to incentivize CBDC deposits to continue into banks in sufficient quantity to keep credit flowing, crucial to the economy for everything from buying cars and houses to starting a business. This concern also holds true for moments of market panic, where individuals are looking to have the safest form of money and are rapidly withdrawing funds from banks (a run). It remains to be seen what regulations might be proposed to properly incentivize consumers to leave their CBDC on deposit with traditional financial institutions, or what alternatives would be available to traditional financial institutions to enable continued credit availability. The Fed in August 2022 released two research papers examining these types of systemic risks. See Francesca Carapella et al., 2022-057, Decentralized Finance (DeFi): Transformative Potential & Associated Risks (2022.06.16); Pablo D. Azar et al., 2022-058, The Financial Stability Implications of Digital Assets (2022.07.31).
Additionally, regulators will need to consider how the design of such a system could impact other revenue sources of the existing financial industry, such as interchange income. They will also need to consider what other impacts system design could have on consumers. For example, without significant interchange income, high rewards credit cards could become a thing of the past; on the other hand, the fees fueling such rewards could also disappear. If fees are mostly eliminated because transaction processing is handled by government system, consumers could save, in the aggregate, billions of dollars per year. See, e.g., Pulse, 2020 Debit Issuer Study, at 3, 9 (2020).
Such savings, however, would come at the expense of 24-27% of community banks’ and credit unions’ annual non-interest income revenue, and 5-8% of national and regional banks’ non-interest income revenue. Id. at 9. Policymakers will need to make explicit choices about the design of the system that will have far reaching impacts on consumers and financial institutions alike.
Sources are listed in reverse chronological order.