The Federal Reserve Board (the Fed)
The purpose of this blog post is to give an overview of the Federal Reserve Board (the Fed) and its guidance related to cryptocurrencies.
INTRODUCTION
The Fed was created in December 1913 with the enactment of the Federal Reserve Act following a series of financial crises. It is the central bank of the United States and its purpose is to “provide the nation with a safer, more flexible, and more stable monetary and financial system.”
The Fed is comprised of three key entities that make up the Federal Reserve System: the Board of Governors, the Federal Open Market Committee (FOMC) and the 12 Federal Reserve Banks.
As stated by the Fed, each entity shares responsibility for the Fed’s four main areas of concern:
Conducting the nation's monetary policy by influencing money and credit conditions.
Supervising and regulating banks and other important financial institutions.
Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets.
Providing certain financial services to the U.S. government, U.S. financial institutions, and foreign official institutions, and playing a major role in operating and overseeing the nation's payments systems.
So far, the Fed has not set any specific rules or guidance for financial institutions about their responsibilities as they pertain to cryptocurrencies.
Rather, the Fed has made statements (usually joint) with other agencies about their plans for future guidance/regulation.
More specifically, the Fed’s work in this regard has been focused primarily on the potential development of a Central Bank Digital Currency (CBDC).
DEVELOPMENT OF A CBDC
The Fed took the first step towards the potential development of a CBDC with the issuance of a paper titled “Money and Payments: The U.S. Dollar in the Age of Digital Transformation” in January 2022.
As stated by the Fed, the paper was designed to “foster a broad and transparent public dialogue about CBDCs in general, and about the potential benefits and risks of a U.S. CBDC” and was not designed to advance a specific policy outcome or signal the appropriateness of a CBDC. The paper also noted that the Fed does not intend to proceed with the issuance of a CBDC without the “clear support” of the executive branch and Congress, ideally in the form of a “specific authorizing law.”
The paper defines a CBDC as “a digital liability of a central bank that is widely available to the general public” and that the Fed’s initial analysis suggests that any potential CBDC should be “privacy protected, intermediated, widely transferable and identity-verified.”
Critically, the paper notes that a CBDC would differ from existing digital money available to the general public at financial institutions in that a CBDC would be a direct liability of the Federal Reserve, as opposed to a commercial bank/financial institution.
The current state of money in the U.S. is this: an individual or entity that deposits dollars at a financial institution enters into a deposit agreement at that institution, whereby the institution promises to repay the amounts deposited upon demand of the individual. Thus, the deposit is a liability of the financial institution to the consumer.
In contrast, a CBDC would be a liability of the Federal Reserve (i.e, the government). According to the paper, this means that a CBDC would not require mechanisms, such as FDIC insurance, to maintain public confidence, nor would a CBDC depend n backing by an underlying asset pool to maintain its value.
The paper outlines the potential benefits of a CBDC:
serving as a new foundation for the payment system and bridging different payment services, both legacy and new.
maintaining the centrality of safe and trusted central bank money in a rapidly digitizing economy.
offering the general public broad access to digital money that is free from credit risk and liquidity risk.
improving cross-border payments.
supporting the Dollar’s International Role.
promoting financial inclusion.
extending public access to safe central bank money.
The paper outlines the potential risks and policy considerations of and for a CBDC:
“fundamentally” changing the structure of the U.S. financial system and altering the roles and responsibilities of the private sector and the central bank.
the paper describes that a widely available CBDC would serve as as a close or near-perfect substitute for commercial bank money, which would in turn reduce the amount of deposits in the banking system, which would reduce credit availability.
posing a risk to the safety and stability of the financial system in that during times of financial panic, individuals may convert large amounts of currency into a CBDC, causing large outflows of commercial bank deposits into CBDC.
altering the supply of reserves in the banking system.
creating cybersecurity risks and threats.
PROJECT HAMILTON
To further explore a CBDC, the Federal Reserve Bank of Boston and the Massachusetts Institute of Technology Digital Currency Initiative are 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.” This project is called Project Hamilton.
On February 3, 2022, the results of the first phase of their research was published. Project Hamilton Phase 1: A High Performance Payment Processing System Designed for Central Bank Digital Currencies. The primary goal of this phase was to “design a core transaction processor that meets the robust speed, throughput, and fault tolerance requirements of a large retail payment system.” The core system of a bank is the ledger system that tracks all transactions across accounts and the order in which they occur. This phase of the project essentially experimented with different features of such a system to handle the use of digital currency.
Specifically, the Fed is using two current designs, both of which rely on the Fed controlling the system that process the transactions. The first “processes transactions through an ordering server,” thus creating an ordered ledger of transactions. The second uses "multiple computers to process the transactions,” which allows for higher transaction throughput (1.7 million tps), but “does not materialize an ordered history for all transactions.” Interestingly, the 1.7 tps number is about 1,000 times more transactions than Visa processes per second. See The Blockchain Scalability Problem & the Race for Visa-Like Transaction Speed.
The next phase of the project will focus on “more complex functionality,” such as high security, auditability, balancing privacy with compliance, and roles for intermediaries.
PROJECT CEDAR
Project Cedar is a project by the New York Innovation Center (NYIC) housed at the Federal Reserve Bank of New York seeking to develop a technical framework for “a theoretical wholesale central bank digital currency (wCBDC) in the Federal Reserve context.” Project Cedar.
Phase I of the project sought to demonstrate the potential of a blockchain-based wCBDC to improve the speed, cost and safety of cross-border payments.
Phase I successfully concluded in November 2022 and the results were:
Faster Payments: Transactions on the blockchain-enabled distributed ledger system settled under 15 seconds on average, as opposed to two days under the current infrastructure.
Atomic Settlement: Both sides of the simulated transactions were settled either simultaneously or not at all, and thus “reduced the risks currently borne by counterparties.”
Safer and Accessible Transactions: The payment system allowed settlement on a 24/7/365 basis and “supported objectives related to interoperability by enabling transactions across separate, homogeneous ledgers networks representing a variety of financial institutions, including central and private sector banks.”
On November 10, 2022, the New York Fed entered phase II of the project by partnering with the Monetary Authority of Singapore. Phase II builds off the previous phase by further investigating how wCBDCs could improve the efficiency of cross-border wholesale payments involving multiple currencies.
Specifically, Phase II will design a system for atomic (instant) settlement of cross-border cross-currency transactions, leveraging wCBDCs as the settlement asset.
A phase II report will be issued sometime in 2023.
GUIDANCE
The Fed has provided some guidance to “innovative financial firms with novel bank charters” regarding how they may access federal reserve accounts. Namely, on August 16, 2022, the Fed advised that all Federal Reserve-supervised banking organizations engaging or seeking to engage in crypto-asset-related activities should notify their lead supervisory point of contact at the Federal Reserve. Engagement in Crypto-Asset-Related Activities by Federal Reserve-Supervised Banking Organizations.
The Fed also advised that such supervised entities must be confident in the legality of any crypto-related activities and that if there is any uncertainty, the entities should work with the Fed directly and should have in place adequate risk management controls and consumer protection statutes and regulations.
On August 19, 2022, the Fed released more lengthy guidance to such firms seeking to access federal reserve accounts while engaging in crypto-related activities. Guidelines for Evaluating Account and Services Requests.
STATEMENTS
As noted above, statements from the Fed pertain to the research and possible development of a CBDC.
In this vein, on June 17, 2022 Fed Chairman Jerome Powell stated that “a U.S. CBDC could also potentially help maintain the dollar's international standing." Welcoming Remarks at the "International Roles of the U.S. Dollar."
Other statements include:
Vice Chair Lael Brainard, Digital Assets and the Future of Finance: Examining the Benefits and Risks of a U.S. Central Bank Digital Currency.
Governor Christopher J. Waller, Risk in the Crypto Markets.
Governor Michelle W. Bowman, Technology, Innovation, and Financial Services.
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