CRAFTING THE FUTURE OF FINANCE WITH A CENTRAL BANK DIGITAL CURRENCY (CBDC)

RESEARCH INTO THE SYSTEMIC RISK IMPLICATIONS OF CBDC

This article was first published in TabbFORUM

In this article, Dr. Zachary Feinstein and Dr. Rui Fan (in collaboration with Park Avenue Finance and the CRAFT CENTER ) share some of the observations and insights from their ongoing research project on the systemic risk implications of Central Bank Digital Currencies (#CBDCs). They compare the existing wholesale payment systems, #Fedwire and #FedNow, and highlight their differences and trade-offs. They also distinguish between retail and wholesale CBDCs and argue that wholesale CBDCs are the more suitable option for central banks. We hope that this post will spark your interest and curiosity in this topic, and we welcome your feedback and suggestions.

Research Project Overview

Central Bank Digital Currencies (CBDCs) are a hot topic in the financial world, as more and more countries are exploring the potential benefits and risks of issuing their own digital money. CBDCs could have significant implications for the stability and efficiency of the payment system, as well as for the monetary policy and financial inclusion. However, CBDCs also pose many challenges and uncertainties, such as the optimal design, the impact on the banking sector, privacy and security issues, and cross-border interoperability.

As part of the CRAFT (Center for Research and Advancement of Financial Technologies) initiative, funded by members of its Industry Advisory Board and the National Science Foundation, a team of researchers from Stevens Institute of Technology and Rensselaer Polytechnic Institute (with advisement from Park Avenue Finance, Innovation Trust Bank International, Goldman Sachs, SWIFT, Wells Fargo, and Vanguard) is studying the systemic risk implications of CBDC, especially in the US context.

Initial Assumptions and Findings

The impact of CBDC on the economy and society depends on many factors, such as the demand, adoption, and usage of CBDC, the substitution effects with other forms of money, and the interaction with other policies and innovations. Therefore, we had to narrow down our scope and focus on the specific aspects of CBDC that are most relevant and feasible for our project.

We decided to concentrate on a domestic US CBDC. We initially thought CBDC would offer a clear alternative to the existing Fedwire payment system by offering 24/7 real-time settlement with low transaction costs. However, at the outset of this project, the Federal Reserve launched FedNow, a new service that provides 24/7 real-time settlement; with this new service, we needed to consider more fundamental elements of these different real-time gross settlement systems. Within this post we concentrate on highlighting distinctions among Fedwire, FedNow, and (wholesale) CBDC. We also decided to explore the different definitions and classifications of CBDC and highlight the differences between retail and wholesale CBDC in terms of their purposes, benefits, and risks.

The rest of this post highlights the observations made in following that approach.

Fedwire, FedNow and CBDC Comparative Analysis

Fedwire, a real-time gross settlement system, has been run by the Federal Reserve ever since it was created along with the Federal Reserve System in the United States. It started as a telegraph service, but it has changed its communication protocol over time. However, it only works during market hours.

On July 20, 2023, the Federal Reserve introduced a new settlement system, FedNow, which allows 24/7 cash settlement. FedNow service transforms the structure of the Fedwire system beyond the technological changes, enabling nonstop operations.

Central Bank Digital Currency (CBDC) is a novel solution for real-time gross settlement which would allow decentralized wire transfers in a wholesale system. While the hours of operation, theoretically, can be limited, most discussions present this as a 24/7 settlement system.

While other technical differences exist, e.g., a cap on the size of individual transactions, the following table summarizes the key distinctions between these systems:

In summary, there are two key areas where these settlement services differ: hours of operation and counterparty risk.

• Hours of operation: The operational timeframe for the Fedwire system goes from 9 pm ET of the previous calendar day to 7 pm ET, Monday through Friday, excluding designated holidays. These limited hours restrict Fedwire's availability and functionality within a globalized, 24-hour financial environment. In comparison, FedNow is always-on; neither the time of day nor day of the week affect when or how transactions can be made or settled. This change alone marks a significant shift in how transactions can be done, making it very attractive for a globalized and digitally driven world. CBDC, similar to FedNow, would seemingly operate on the always-on system.
• Counterparty Risk: Fedwire is set up as a hub-and-spoke network, with the Federal Reserve Banking system acting as a central counterparty for all transactions, settling its books at the end of the day. This centralization ensures that even if a bank initiates a transaction without sufficient funds, the recipient organization will still receive the transfer in full, eliminating counterparty risk in any Fedwire operation. The reduction of counterparty risk in Fedwire comes from the imposition of overdraft fees on banks that fail to settle all debts by the end of the day. In contrast, CBDC would follow a continuous settlement approach at the Federal Reserve. Without a net debit cap, CBDC participants with insufficient funds are expected not to initiate any additional transaction, leading to a failure-to-pay model. While the failure-to-pay approach minimizes the risks of overdrafts, it introduces the possibility for counterparty risks. Functionally, FedNow is developed to mimic the structure of Fedwire with the same overdraft system. However, as FedNow aims for broader accessibility among financial institutions and payment service providers, it is anticipated that a larger number of participants without net debit caps will exist compared to Fedwire, increasing the likelihood of encountering the failure-to-pay model.

Wholesale or Retail CBDC – Which is More Suitable?

One of the main challenges in designing and implementing a CBDC is to clearly define its target audience and use cases. Wholesale and retail CBDCs have different purposes, features, and implications for the financial system and the economy. Therefore, it is important not to conflate them and to analyze them separately based on their own merits and drawbacks.

Retail payments are those made by consumers and businesses for everyday purchases, such as buying goods and services, paying bills, or sending remittances. Retail payments typically involve small amounts, high volumes, and low urgency. They also require a high degree of convenience, accessibility, and security for the users. Examples of retail payment systems include cash, cards, mobile wallets, and online platforms.

Wholesale payments, on the other hand, are those made by financial institutions for large-value transactions, such as interbank transfers, securities settlements, or foreign exchange operations. Wholesale payments typically involve large amounts, low volumes, and high urgency. They also require a high degree of speed, efficiency, and finality for the participants. Examples of wholesale payment systems include Fedwire, CHIPS, and SWIFT.

Both retail and wholesale payments are essential for the smooth functioning of the economy, but they have different characteristics, needs, and challenges. Therefore, when we talk about CBDCs, we need to consider how they would fit into the existing landscape of retail and wholesale payments, and what benefits and risks they would bring to each segment.

Wholesale CBDCs can improve the existing wholesale payment system by providing an always-on, secure, and low-cost alternative to traditional systems, such as FedWire in the United States or SWIFT internationally. Wholesale CBDCs can also enable faster and cheaper cross-border payments by facilitating interoperability and coordination among different jurisdictions and platforms. Moreover, wholesale CBDCs can support the development of innovative financial services and products by leveraging smart contracts and distributed ledger technology.

Retail CBDCs would be viewed as tokenized deposits at the central and be considered a new asset class for investors to hold in their bank accounts. Retail CBDCs would operate much like a "digital debit card" and can potentially weaken the role of commercial banks in channeling funds from savers to borrowers by offering a direct and appealing option for depositors, especially during crises. This can increase the frequency and intensity of bank runs, as well as reduce the availability and, therefore, increase the cost of credit for the economy. Retail CBDCs can also make the transmission and implementation of monetary policy more complex by creating new ways and tools for affecting the money supply and interest rates. Moreover, retail CBDCs can create operational and cybersecurity risks for the central bank, as well as raise legal and regulatory issues regarding privacy, consumer protection, and anti-money laundering operations.

Based on the above, we conclude that wholesale CBDCs are the more suitable option for central banks by complementing and improving the existing wholesale payment system, while retail CBDCs can disrupt and endanger the existing banking system.

Summary

In this post, we have shared some of the observations and insights from our ongoing research project on the systemic risk implications of CBDC, funded by the CRAFT initiative. We have compared the existing wholesale payment systems, Fedwire and FedNow, to proposed structures in CBDC. We have highlighted their differences and trade-offs in terms of hours of operation and counterparty risk. We have also distinguished between retail and wholesale CBDCs, and argued that wholesale CBDCs are the more suitable option for central banks, as they can enhance the efficiency and stability of the wholesale payment system, while retail CBDCs can pose significant challenges and risks for the banking system and the monetary policy.

We hope that this post has stimulated your interest and curiosity in this topic, and we welcome your feedback and suggestions. We also look forward to collaborating with other researchers and practitioners who are working on related issues, such as cross-border payments, interoperability, privacy, and security.

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This article is a product of research conducted through the Center for Research toward Advancing Financial Technologies (CRAFT). CRAFT brings together industry partners, academic researchers, federal agencies, and students to conduct and advance interdisciplinary fintech research, innovation, and workforce training in support of new technologies often associated with innovation and growth, including new products, services, and ventures. CRAFT aims to contribute to a more vibrant economy through research projects that will allow policymakers and industry participants to better understand the benefits and risks of potentially disruptive technologies — and thus manage those risks, reducing the possibility of unintended consequences. Its projects will also lead to technologies and processes that can be used in education and training.?For more information, comments, or suggestions, you may contact Paul Lashmet at [email protected]

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Acknowledgements

• The authors acknowledge the support from National Science Foundation (NSF) IUCRC CRAFT center research grant (2113906) for this research. The opinions expressed in this publication do not necessarily represent the views of NSF IUCRC CRAFT.
• The authors thank Park Avenue Finance for their subject matter expertise and insight into this topic. The opinions expressed in this publication do not necessarily represent the views of Park Avenue Finance."

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