The next iteration of the Internet, called Web 3.0, will have the ability to automatically execute transactions using digital currency. Will this digital currency be private stablecoins or a Federal Reserve (FRDC) digital currency?
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 Federal Reserve digital currency or 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 sold-out items from your preferred supplier, who delivers them to your doorstep. Your refrigerator will automatically pay for it with digital currency. This is the world of Web 3.0 from Buck Rogers. I don’t understand why your fridge couldn’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 replenish your fridge. If Web 3.0 requires payments to be processed on a distributed public ledger, those holding the Federal Reserve’s digital currency 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 faith in the value of stablecoins. In March, President Biden’s executive order sparked a “whole of government” approach to assessing the risks associated with crypto assets, including private stablecoins, and required federal agencies to design the policies and regulations necessary to mitigate those risks. This includes a mandate that the Federal Reserve, the US Treasury, and the US Department of Justice report on the legality of issuing Federal Reserve digital currency and the potential risks and benefits associated with such issuance.
Private stablecoins are digital money that is purchased and traded over the internet. To date, private stablecoins have not been universally accepted as a form of payment, and their growth primarily reflects their use to facilitate trade in other digital assets. Stable coins are designed to maintain stable values against a reference currency like the US dollar or a commodity like gold.
Many stablecoins attempt to maintain their value by investing the dollar proceeds of newly issued stablecoins in high-quality, short-term, liquid, dollar-denominated assets of equivalent value held by the sponsor of the stablecoins as that reserve that can be used to stabilize the market value of the coin. There are other versions of private stablecoins that hold crypto assets as reserves or use algorithmic arbitrage trading to maintain parity with the dollar.
Stablecoins transactions are processed using a distributed public ledger system where agents compete to earn rewards for processing stablecoins transactions. Different stablecoins transact using different public ledgers which are not interoperable. So far, private stablecoins have not been issued by any insured depository institution; instead, they were issued by entities that are either unlicensed, licensed as state-regulated money transfer agents, or licensed as limited-purpose trust companies.
In contrast, if the Fed issued a Federal Reserve digital currency, it would likely use insured depository institutions and other licensed financial firms as intermediaries to hold and service the associated accounts. Payments would likely be cleared and settled using a new system built and centrally managed by the Federal Reserve system in a manner similar to how checks and automated clearing house transactions ( ACH) (electronic transfers between banks) are cleared and settled today. It is highly unlikely that FRDC transactions will be processed on a distributed public ledger. In the most likely configuration, the Federal Reserve’s digital currency will not replace private stablecoins.
Crypto industry proponents argue that a public distributed ledger payments system is needed to facilitate smart contracts and Web 3.0 functions. While I don’t understand why this has to be the case, what is true is that public distributed ledger systems have been the key driver of smart contract innovation.
Be that as it may, the Federal Reserve digital currency has other serious drawbacks. It is a direct responsibility of the Fed and without risk of default, which means that 1 FRDC dollar can always be exchanged for a $1 Federal Reserve note. The Federal Reserve digital currency would be the ultimate safe asset and a magnet for investors seeking safety. Unless the FRDC’s holdings were limited, in the event of a crisis, investors would likely transfer large balances from banks and money market funds to the safety of the FRDC, creating a daunting new liquidity risk for the financial sector.
The Federal Reserve digital currency has downside potential even in normal times. Buyers will pay for their stake from bank deposits and money market fund account balances. The drain on financing from intermediaries could have negative effects 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 on 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 space of the stable rooms.
There is a simple solution to the tension between private stablecoins and the Federal Reserve’s digital currency issuance that doesn’t require countless government studies and new regulations. Banks and companies licensed to issue private stablecoins could form a consortium that develops and operates a ledger-based public payment system that can be used by private stablecoin issuers and banks. This reflects how credit, debit and ACH processing systems have been developed in the past. The energy-efficient public ledger could use a 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 oversight powers.
To my knowledge, there are no regulations preventing insured depository institutions from developing tokenized insured depository accounts that can be traded on this new payment system. These fractional reserve deposits would be a new type of checking account. We have already put in place bank capital, liquidity and other regulations to manage the associated risks. Similarly, licensed private “stablecoin payment” issuers envisioned in the Stablecoin TRUST Act can create tokens that use this common payment processing network ensuring interoperability.
The Fed would not need to issue a Federal Reserve digital currency and the entire government could stop writing unnecessary reports.
Paul Kupiec is a senior researcher specializing in banking and finance industry issues at the American Enterprise Institute.