The digital dollar: an innovative project with many questions

The year 2020 was not only marked by the start of the Covid-19 pandemic. It has also moved crypto-assets into a new era, away from the purely speculative bubble of the early euphoria of 2017. There is now talk of digital assets becoming significantly more entrenched and institutional investors—aware of the disruptive potential as a currency—increasingly interested.

Indeed, central bank digital currency (CBDC) projects are on the rise. A CBDC is the digital form of a currency issued by a central bank, using some of the features of the blockchain, such as recording transactions in a networked ledger. However, it leaves out decentralisation and transparency. The question of the digital dollar is now being raised for the U.S. Federal Reserve (Fed), with many questions being asked beforehand.

The digital dollar, a CBDC project to improve the efficiency of the U.S. currency

The emergence of central bank digital currencies versus stablecoins

Crypto-assets such as Bitcoin (BTC) have always been frowned upon by central banks and financial institutions. As they are considered pure speculation, the monopoly of issuing money did not seem to be under threat. But that was before the emergence of stablecoins, which pose a real threat to central banks. To understand why, let us go back to the basics: stablecoins.

A stablecoin—or stable money—is a digital asset that replicates the price of a currency in circulation and issued by a central bank. It is intended to provide stability in the highly volatile crypto-asset market.

A stablecoin can be issued by a centralised entity. This is the case, for example, with USDT, issued by the U.S. company Tether Limited, and USD Coin (USDC), issued by the U.S. consortium Circle, while retaining the decentralised register of blockchain technology. Stablecoin can also be fully decentralised, like TerraUSD (UST) or DAI. Its issuance is then managed by an algorithm.

The emergence of CBDC projects coincides with the emergence of decentralised finance, where stablecoins are widely used. Decentralised finance allows some holders of crypto-assets to lend them to others, all without a bank intermediary. Central banks have indeed understood the competition generated by a crypto-asset replicating the price of a currency.

A digital dollar project just to counter stablecoins?

Like the digital euro project proposed by the European Central Bank (ECB), there are dozens of CBDC projects under development or under consideration around the world. It is therefore not surprising to find the Fed among them.

However, the U.S. project is far less advanced than those of other central banks; the balance between the advantages and disadvantages of such a project seems far from clear to the Fed. The choice between a consumer CBDC (for everyday payments) and a wholesale CBDC (for business-to-business payments) is still undecided.

So what would be the primary purpose of creating a digital dollar? At most, it would have the ambition to counter stablecoins replicating the U.S. dollar. In addition, it could use parts of blockchain technology to make money transfers more efficient, faster, and cheaper. But should the Fed embark on the creation of such a complex project for a potentially residual—even harmful—benefit? The question is being asked even before the project is officially launched.

The digital dollar, a potentially useless and damaging CBDC project for the U.S. currency

The overwhelming dominance of the U.S. dollar in the stablecoin market

Few would have thought that digital assets would come to the rescue of the dollar. Yet this is the main argument of those who oppose the digital dollar, starting with Christopher Waller, a Fed governor.

For Waller, stablecoins already fulfil the role of a potential digital dollar, have the merit of existing, and have shown their effectiveness. Above all, talking about stablecoins replicating the U.S. dollar is a pleonasm, since the overwhelming majority of stablecoins were created precisely to replicate the U.S. currency. This is a question that the ECB did not have to ask itself before launching its project, since euro stablecoins are as rare as snow in August.

So why would anyone want to create a digital dollar when stablecoins are already, in a sense, doing the job? For example, stablecoins are essential to the functioning of decentralised finance, as they help offset the volatility of other crypto-assets. Yet decentralised finance only uses stablecoins that replicate the U.S. dollar.

Moreover, the effectiveness of a digital dollar against dollar stablecoins—which have several years of experience behind them—remains to be demonstrated. For this reason, a partnership between the Fed and a stablecoin dollar issuer may be a more viable long-term solution than the creation of a competing CBDC.

The potential harmfulness of a digital dollar

While the innovation potential of the digital dollar is questioned by stablecoins, some point to the potentially harmful nature of such a project.

On the one hand, some elected members of Congress—starting with Republican Cynthia Lummis—do not look favourably on the expansion of the Fed’s powers vis-à-vis the commercial banks.

On the other hand, an inefficient digital dollar could destabilise the global financial system dominated by the U.S. currency.

Finally, the issue of privacy is also highlighted. Blockchain technology makes it possible to trace all transactions. However, by using a centralised register in the hands of a few people, digital dollar transactions would only be accessible to certain American authorities or agencies, starting with the intelligence agencies.

Some see the digital dollar as a means of increasing surveillance, not as a means of promoting more efficient technology and payment methods.

The question of the digital dollar therefore remains unresolved. It is thus possible that the Fed will not make a decision for several years.