The internet is upgrading — which digital currencies will make the cut? – Jahanagahi

The internet is upgrading — which digital currencies will make the cut?

The next iteration of the internet, so-called web 3.0, will have the ability to automatically execute transactions using digital currency. Will that digital currency be private stablecoins or a Federal Reserve digital currency (FRDC)?

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 with a list of contents you specify, and automatically orders items running low from your favorite purveyor, who delivers them to your door. Your refrigerator will pay for it automatically with a digital currency. This is the Buck Rogers world of web 3.0. It is unclear to me why your refrigerator could not pay using a credit or debit card, but cryptocurrency developers think in terms of public ledger payment systems when they design the smart contracts that will restock your refrigerator. If web 3.0 requires payments to be processed on a public distributed ledger, then those holding Federal Reserve digital currency will have to go to the grocery store.

The recent President’s Working Group report raises concerns about the growth of the private stablecoin market. These include insufficient private stablecoin oversight and the possibility that stablecoins could create financial instability should their owners lose confidence in the stablecoin’s value. In March, President Biden’s executive order unleashed a “whole of government” approach for assessing the risks associated with crypto assets, including private stablecoins, and required federal agencies to design the policies and regulations needed to mitigate these risks. Included in this is a mandate that the Federal Reserve, 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 using the internet. To date, private stablecoins have not achieved universal acceptance as a means of payment and their growth mostly reflects their use in facilitating the trading of other digital assets. Stablecoins are designed to maintain stable values ​​relative to a reference currency like the US dollar or a commodity, like gold.

Many stablecoins attempt to maintain their value by investing the dollar proceeds from newly-issued stablecoins in high-quality, short-term, liquid, dollar-denominated assets of equivalent value held by the stablecoin sponsor as a reserve that can be used to stabilize the coin’s market value. 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 public distributed ledger system where agents compete to earn rewards for processing stablecoin transactions. Different stablecoins transact using different public ledgers that are not interoperable. Thus far, private stablecoins have not been issued by any insured depository institution; rather, they have been issued by entities that are either unlicensed, licensed as state-regulated money transfer agents, or licensed as limited-purpose trust companies.

In contrast, should the Fed issue Federal Reserve digital currency, it would likely use insured depository institutions and other licensed financial firms as intermediaries to hold and manage associated accounts. Payments would likely clear and settle using a new system built and centrally managed by the Federal Reserve System in a manner similar to the way checks and Automated Clearing House (ACH) transactions (electronic transfers between banks) clear and settle today. It is highly unlikely that FRDC transactions would be processed on a public distributed ledger. In the most likely configuration, Federal Reserve digital currency will not be a substitute for private stablecoins.

Crypto industry proponents argue that a public distributed ledger payments system is required to facilitate smart contracts and web 3.0 functions. While it is unclear to me why this must be the case, what is true is that public distributed ledger systems have been the key factor driving smart contract innovation.

Regardless, Federal Reserve digital currency has other serious drawbacks. It is a direct liability of the Fed and free of default risk, meaning that 1 FRDC dollar can always be redeemed for a $1 Federal Reserve note. Federal Reserve digital currency would be the ultimate safe asset and a magnet for investors seeking safety. Unless FRDC holdings were limited, in a crisis, investors would likely transfer large balances from banks and money funds into the safety of FRDC thereby creating a new formidable liquidity risk for the financial sector.

The Federal Reserve digital currency has a potential downside even in normal times. Purchasers will pay for their holding by drawing down bank deposits and money fund account balances. The drain on intermediaries’ funding could have negative impacts on the cost and availability of credit in the economy. Banks deposits are an alternative form of digital currency, but deposits over the $250,000 federal insurance limit are technically at risk should a bank fail. Moreover, deposit payments clear and settle over systems centrally controlled by banks and the Federal Reserve and, at least today, these systems will not support the use of the smart contracts being developed in the private stablecoin space.

There is a simple solution to the tension between private stablecoins and Federal Reserve digital currency issuance that does not require innumerable government studies and new regulations. Banks and firms licensed to issue private stablecoins could form a consortium that develops and runs a public ledger-based payments system that can be used by private stablecoin issuers and banks alike. This mirrors the way credit, debit, and ACH processing systems were developed in the past. The energy-efficient public ledger might use a secure proof-of-stake system where banks and qualified nonbank financial institutions compete to process transactions. Like other payment systems, the Fed would have oversight powers.

There is no regulation I am aware of that prevents insured depository institutions from developing tokenized insured deposit accounts that can be traded on this new payments system. These fractional reserve deposits would be a new type of checking account. We already have bank capital, liquidity and other regulations in place to manage the associated risks. Similarly, the licensed private “payment stablecoin” issuers envisioned in the Stablecoin TRUST Act can create tokens that use this common payments processing network ensuring interoperability.

There would be no need for the Fed to issue a Federal Reserve digital currency and the whole of government could stop writing unnecessary reports.

Paul Kupiec is a senior fellow specializing in banking and financial industry issues at the American Enterprise Institute.

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