The Internet Is Catching Up: Which Digital Currencies Will Make The Cut?

The next iteration of the Internet, called Web 3.0, you will have the ability to automatically execute transactions using digital currency. Will that digital currency be private stablecoins or a Federal Reserve Digital Currency (FRDC)?

My guess is that web 3.0 will run on a hybrid digital currency that includes a new type of bank deposit as well as private stablecoins. With this system, there would be no need for digital currency from the Federal Reserve and no need for dozens of new government reports and regulations.

Imagine a future world where your refrigerator monitors its contents, compares them to a list of contents you specify, and automatically orders items that are running low to your favorite supplier, who will deliver them to your door. Your refrigerator will automatically pay for it with a digital currency. This is the Buck Rogers world of web 3.0. It’s not clear to me why your fridge can’t pay with a credit or debit card, but cryptocurrency developers think in terms of public ledger payment systems when designing the smart contracts that will restock your refrigerator. If web 3.0 requires payments to be processed on a distributed public ledger, then those holding digital currency from the Federal Reserve will have to go to the grocery store.

The recent President’s Task Force report raises concerns about the growth of the private stablecoin market. These include insufficient private oversight of stablecoins and the possibility that stablecoins could create financial instability if their owners lose confidence in the value of stablecoins. In March, President Biden executive order unleashed a “whole of government” approach to assessing the risks associated with crypto assets, including private stablecoins, and required federal agencies to design the necessary policies and regulations to mitigate these risks. This includes a mandate that the Federal Reserve, the US Treasury, and the US Department of Justice report on the legality of the Federal Reserve’s digital currency issuance and the potential risks and benefits associated with such issuance.

Private stablecoins are digital money that is bought and traded over the internet. To date, private stablecoins have not achieved universal acceptance as a means of payment and their growth primarily reflects their use in facilitating trading other digital assets. Stablecoins are designed to hold stable values ​​relative to a benchmark currency such as the US dollar or a commodity such as gold.

Many stablecoins attempt to maintain their value by investing newly issued stablecoin dollar proceeds in high-quality, short-term, liquid, dollar-denominated assets of equivalent value held by the stablecoin sponsor as a reserve that can be used to stabilize the market value of the currency. There are other versions of private stablecoins that hold crypto assets as reserves or use algorithmic arbitrage trading to maintain parity with the dollar.

Stablecoin transactions are processed using a distributed public ledger system where agents compete to earn rewards for processing stablecoin transactions. Different stablecoins transact using different public ledgers that are not interoperable. So far, no insured depository institution has issued private stablecoins; rather, they have been issued by unlicensed entities, licensed as state-regulated money transfer agents, or licensed as limited purpose trust companies.

In contrast, if the Federal Reserve issued digital currency, the Federal Reserve would likely use insured depository institutions and other licensed financial companies as intermediaries to maintain and manage the associated accounts. Payments will likely be cleared and settled using a new system built and centrally managed by the Federal Reserve System similar to the way checks and Automated Clearing House (ACH) transactions (electronic transfers between banks) are cleared and settled today. FRDC transactions are highly unlikely to be processed on a distributed public ledger. In the most likely configuration, the Federal Reserve digital currency will not be a substitute for private stablecoins.

Crypto industry proponents argue that a public distributed ledger payment system is required to facilitate smart contracts and web 3.0 functions. While it is not clear to me why this should be the case, what is certain is that public distributed ledger systems have been the key factor driving smart contract innovation.

Regardless, the Federal Reserve’s digital currency has other serious drawbacks. It is a direct liability of the Federal Reserve and is free of default risk, which means that 1 FRDC dollar can always be redeemed for a $1 Federal Reserve note. The Federal Reserve’s digital currency would be the ultimate safe-haven asset and a magnet for investors looking for safety. Unless FRDC holdings were limited, in a crisis, investors would likely transfer large bank and money fund balances into the safety of FRDC, thus creating a formidable new liquidity risk for the financial sector.

The Federal Reserve’s digital currency has a potential drawback even in normal times. Buyers will pay for their tenure through the provision of bank deposits and money fund account balances. The flight of funds from intermediaries could have negative impacts on the cost and availability of credit in the economy. Bank deposits are an alternative form of digital currency, but deposits above the federal insurance limit of $250,000 are technically at risk in the event of a bank failure. Additionally, deposit payments are cleared and settled in systems centrally controlled by banks and the Federal Reserve and, at least today, these systems will not support the use of smart contracts being developed in the private stablecoin space.

There is a simple solution to the tension between private stablecoins and the Federal Reserve’s digital currency issuance that does not require countless government studies and new regulations. Banks and companies licensed to issue private stablecoins could form a consortium to develop and manage a public ledger-based payments system that can be used by both private stablecoin issuers and banks. This reflects the way credit, debit and ACH processing systems have developed in the past. Energy Efficiency Public Ledger Could Use Secure Proof-of-Stake system where banks and qualified non-bank financial institutions compete to process transactions. Like other payment systems, the Fed would have supervisory powers.

I am not aware of any regulation that prevents insured depository institutions from developing tokenized insured deposit accounts that can be traded on this new payment system. These fractional reserve deposits would be a new type of checking account. We already have bank capital, liquidity and other regulations to manage the associated risks. Similarly, the licensed private “payment stablecoin” issuers under the Stablecoin TRUST Act can create tokens that use this common payment processing network to ensure interoperability.

There would be no need for the Fed to issue a Federal Reserve digital currency and the entire government could stop writing unnecessary reports.

Paul Kupiec is a senior fellow specializing in banking and finance industry issues at the American Enterprise Institute.

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