The Fed is falling behind as other central banks leap ahead on digital currencies
This will be a year of divergence between the world’s major central banks. The source of this division won’t be interest rates or quantitative easing—it will be technology.
Over the past twelve months, some of the largest central banks in the world have all made significant strides forward in their development of central bank digital currencies (CBDC) and fast payment systems. This includes the European Central Bank (ECB), the Bank of England, the Bank of Japan, the Reserve Bank of India, and the People’s Bank of China.
The Atlantic Council’s GeoEconomics Center’s research shows that in India, for example, testing on the digital rupee project is scaling up, reaching the milestone of more than one million transactions per day processed by commercial banks throughout the country. In the eurozone, the ECB is now in the preparation phase for its CBDC. On January 1, the bank laid out a detailed roadmap and benchmarks for the year ahead, including testing of a digital euro and working with a variety of private sector companies on key design features including offline payments and fraud prevention. Already, conversations among the central bankers in Germany, France, and Italy are centered around how high to set the limit on individual wallets and which commercial banks will work with the ECB. The reality is that central banks and legislatures across the Group of Twenty (G20) have moved past debating the theoretical merits and concerns with CBDCs, and instead are actually testing and piloting the technology to see what works and what doesn’t.
Interestingly, these new pilot programs are not limited to wholesale (bank-to-bank) or retail (everyday usage) CBDCs. In addition, central banks are investing in new forms of technology in an attempt to “future-proof” their currencies for the rise of blockchain, artificial intelligence, and quantum computing—all innovations that could impact how people use money for both legal and illicit purposes.
Unfortunately, the US Federal Reserve doesn’t seem to be on the same page. Right now, technological payments innovation inside the Eccles building is lagging behind its peers and competitors. One way to assess this is by the resources available within the organization for research and development. The People’s Bank of China, for example, has more than three hundred people dedicated to working on digital currency. Across the entire US Federal Reserve system, there are fewer than twenty. The Bank of England has an official joint task force between His Majesty’s Treasury and Parliament and a dedicated website to answer common questions. The innovation gap is not just on CBDCs. FedNow, the long-awaited interbank settlement system, has taken years longer than comparable systems in Europe, and take-up is limited in the early days.
The apparent belief of some inside the Fed and on Capitol Hill is that the dollar does not need to innovate. That is a miscalculation.
Vice Chair of the Federal Reserve Michael Barr, speaking recently on Bloomberg’s Odd Lots podcast, said that it could take years to know if the FedNow system is working. But the future of money is not going to wait. Think of cross-border payments—an area clearly in need of an upgrade. The average cost of sending remittances internationally in 2022 was more than 6 percent, with major differences depending on the region. (It’s especially costly to send remittances to countries in sub-Saharan Africa, for example.) Meanwhile commercial banks often have to wait hours, and sometimes days, to settle large-scale transactions. In the end, many of these costs get passed on to consumers. So the idea that the system now is fine doesn’t align with reality—the financial payments architecture is old, creaky, and in need of a major upgrade.
Fed officials often have ready answers for why these innovations are slow going. Typically their answers include not seeing a strong use case at present and wariness about unknown consequences of changing the current system. It makes sense to not want to disrupt the currency that underpins the global economy. But the apparent belief of some inside the Fed and on Capitol Hill is that the dollar does not need to innovate. That is a miscalculation.
Instead of thinking about innovation defensively, the US government should drive payment innovation from a position of strength. As the issuer of the world’s reserve currency, the Fed has a unique opportunity to set standards and influence constructive developments on the future of payments. By using its influence at the International Monetary Fund, the G20, and the Committee on Payments and Markets Infrastructures, the United States can help set these standards. But the Fed, working with the US Treasury and other parts of the government, has to bring options and technological solutions to the table in order to influence the trajectory. Without its leadership, others will fill the vacuum.
As the GeoEconomics Center’s new dollar dominance monitor shows, there are new alternative financial plumbing systems—including China’s own version—expanding all over the world. Think of these systems like pipes being built. The pipes take a long time to construct, but once the water is turned on, change happens very quickly. If these cross-border systems are built without the United States—and the dollar—the way the dollar is used in trade, reserves, and especially sanctions enforcement could shift significantly.
While many are stepping in to fill the innovation gap, including the Bank for International Settlements, the ECB, and the Reserve Bank of India, none can substitute for the issuer of the world’s reserve currency.
What’s concerning about this approach from the Fed is that central bankers around the world are asking for the Fed’s help. Central bankers often privately ask some version of: “Where is the Fed on this?” On a range of issues from privacy to cybersecurity, the Fed’s leadership would be welcome and its guidance and technological expertise listened to, even if the United States doesn’t determine there’s a need for a specific kind of payments innovation in its own domestic system.
The United States could make progress quickly, if it wanted to. Researchers and universities across the country, including at the digital currency labs at the Massachusetts Institute of Technology and Stanford University, are doing fascinating work on how to build CBDCs safely and effectively. Major companies in the United States are similarly developing their own CBDC models. The United States is helping other countries build CBDCs with the talent of academia and the private sector—but the US central bank is not an active part of the collaboration. Meanwhile, the regional Feds, including the Federal Reserve Bank of New York, are doing important exploration on wholesale CBDCs, including Project Cedar, an experiment between the New York Fed and the Monetary Authority of Singapore. But it’s been close to a year since there has been a substantial update on the initiative.
An explanation might be that the Fed is working on this, but it is doing so quietly. That would be welcome, but it’s not enough. In a politically polarized environment, the Fed’s lack of public communication has led to misinformation on what a possible digital dollar would do—just turn on the news to see it.
What will the future look like if nothing changes? In the absence of more US technological models and standards, a fractured system will be constructed with different designs, cybersecurity standards, and varied messaging systems. Instead of faster, cheaper, and safer, money will be more siloed but less secure. In 2024, the digital euro will have an enormous standard-setting effect as other countries adopt European solutions on the challenges of anonymity and offline payments. But even the euro will not be able to create a new international standard—the Fed is the one actor that could unify a fractured payments landscape.
Critics of CBDCs have been quick to say these tools don’t work or will not be effective. But how can anyone know this without pilot projects designed precisely to test and answer these kinds of questions? Obviously, some of the Fed’s peers are coming to a different conclusion after investing resources, time, and talent into exploring the future of money. Imagine passing judgment that artificial intelligence won’t impact the future of work before ever using ChatGPT. Once people get their hands on the innovation, their perception of what is and isn’t possible changes rapidly.
The thinking in Washington right now on payments innovation is to wait until after the November election. But the United States doesn’t have a year to waste. A year is an eternity in technology. The gap between the Fed and other major central banks is likely to widen through 2024, and the Fed will have to play catch-up. Between now and next January, Fed officials should do more to accelerate exploration efforts on all of their payment projects, including faster cross-border transfers and CBDCs.
If they don’t, the future of money may quickly pass them by.
Josh Lipsky is the senior director of the Atlantic Council’s GeoEconomics Center and a former IMF advisor.
Ananya Kumar is the associate director of digital currencies at the Atlantic Council’s GeoEconomics Center.
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Image: Federal Reserve Chair Jerome Powell, European Central Bank President Christine Lagarde, and Bank of Japan Governor Kazuo Ueda take a break outside while attending the Kansas City Federal Reserve Bank's annual Economic Policy Symposium in Jackson Hole, Wyoming, U.S., August 25, 2023. REUTERS/Ann Saphir