By the end of 2023, over 130 central banks representing 98 percent of global GDP will have initiated programs to develop central bank digital currencies (CBDCs). In the next five to seven years, it is reasonable to expect that quite a few of those countries will have issued CBDCs either in wholesale or retail formats. In 2023, policymakers quickly moved past proof of concept, delivering pilots across a range of jurisdictions.
CBDC initiatives continued to gather momentum during the first half of 2023 as noted in the Atlantic Council’s CBDC Tracker:
The current leaders in CBDC development and experimentation include the Euro Area, the UK, Sweden, Singapore, China and several developing countries. The United States remains conspicuous by its absence.
Divergent regulatory and technological standards are evolving along geopolitical fault lines. However, the cross-border role of digital currencies requires policymakers to provide at least a modicum of international interoperability in order to deliver operational efficiencies and cost-effective solutions. Therefore, we believe the most likely near-term scenario for CBDC development will see clusters of national CBDCs becoming interoperable only among geopolitically friendly countries—while being ring-fenced against outside state and non-state actors. Indeed, several multi-CBDC cross-border payment test projects have been going on. Generally speaking, fragmentation is the prevailing policy trajectory.
Such an outcome would be costly. Limited, geopolitically-constrained interoperability would introduce frictions and inefficiencies into the global payment system, which in turn would impose costs on businesses and consumers, further fragmenting the world economy.
Divergent regulatory standards
Three sets of regulatory standards are evolving, closely reflecting the three geoeconomic power centers in the world: China, Europe, and the United States. All seek to address the following issues concerning both CBDCs and the crypto sector:
- Protecting citizens’ privacy
- Safeguarding national security concerning the collection and use of data about financial transactions of individuals and firms
- Cybersecurity safeguards
- Strict parameters around the use of programmability which can restrict the unfettered use of digital money compared to cash
China: Full, unrestricted government monitoring
China has proclaimed a “managed privacy” regime where information belonging to businesses and individual users will be protected from each other, but open to the government—especially the security authorities. The “big three” data laws—the Cybersecurity Law, Personal Information Protection Law, and Data Security Law—have prescribed tight control of the collection, transfer, and use of data by companies and private organizations, especially involving the transfer of data to foreign entities. The enhanced ability to monitor citizens’ financial transactions through CBDCs will strengthen China’s efforts to perfect its social credit system to control and influence social behavior of its citizens.
Europe: Regulatory priorities on investor protection, financial stability, and privacy
The European Union (EU), by contrast, has chosen mostly to prioritize rule-making that provides guardrails around private market transactions. Borrowing heavily from securities regulation rules, EU policymakers in 2022 promulgated the regulation of markets in crypto assets (MiCA), covering issuers of utility tokens, asset referenced tokens and stablecoins, and service providers such as trading venues and digital wallets. The aim was to protect investors and financial stability while fostering innovation and competition in the crypto asset sector. The digital currency arena regulatory structure also includes the Digital Markets Act and the Digital Services Act to regulate digital market services and the General Data Protection Regulation which establishes a data protection framework for individuals vis-a-vis corporate and government actors. Substantial additional laws, rules, and regulations are expected as the European system prepares to issue a digital euro.
United States: Stablecoins, not CBDC
By contrast, the United States has been far more cautious. As of this writing, conflicting cross-currents among legislators, regulators, and the central bank render the policy landscape filled with ambiguities.
During 2022, the Fed had been quietly undertaking a range of important technical moves designed to create a glide path for digital dollar issuance. The most important of these initiatives involved a technical project between the Federal Reserve Bank of New York and the Monetary Authority of Singapore regarding a wholesale CBDC. Dubbed “Project Cedar”, the 2022 initiative explored whether distributed ledger technology could be used to make cross-border settlements between currencies more efficient.
But the FTX implosion in late 2022, followed quickly by the “speed-of-light” bank run at Silicon Valley Bank in March 2023, shifted the policy landscape materially. By the time the final report regarding the Project Cedar experiment had been published in May 2023, the policy landscape in the United States regarding digital currencies had shifted significantly.
The Federal Reserve is now deeply cautious if not ambivalent, consistently resisting calls for it to issue a digital dollar. In parallel, many Members of Congress, especially Republicans in the House of Representatives, remain hostile to CBDC issuance. Concerns center on the risk that private financial transactions could become the subject of federal government monitoring and that the acquired information could be used for political purposes. Some Republican House members have even introduced several bills to prohibit the Fed from issuing a digital dollar.
Separately, a crypto bill has passed the House Finance Services Committee seeking to constrain regulatory discretion regarding cryptocurrencies in general and stablecoins in particular. A stablecoin is a cryptocurrency whose value is pegged to another asset. The bill seeks to foster private stablecoin issuance, effectively creating an alternative to a digital dollar because the vast majority of stablecoins (98.9 percent) are backed by the US dollar. If passed into law and implemented, the bill would place the Federal Reserve at the core of oversight regarding privately issued digital dollars in addition to delivering regulatory clarity regarding cryptocurrencies.
The Federal Reserve is not waiting for the legislation to become law.
On August 8, the Federal Reserve formally shifted its stance to promote stablecoin issuance by banks. The new policy at least on paper provides a mechanism for automatic but tacit approval of such issuance for banks that meet specific pre-requisites. The most important pre-requisite involves ensuring that the issuing bank’s digital architecture provides visibility and access to transaction-level data for the purpose of complying with anti-money laundering (AML) laws and rules. The open question is whether such a structure will enhance or hinder market usage of USD-backed stablecoins. Legislative inaction thus provides ample opportunity for regulatory initiatives, with the current policy trajectory favoring private stablecoin issuance rather than official CBDC issuance.
A fractured future—led by Europe?
Potentially divergent US and European policy trajectories do not occur in a vacuum. Geopolitical conflict between the United States and China is undermining established, reliable frameworks for international cooperation across multiple disciplines. In global cross-border payments, growing policy divergences are imposing real costs and frictions on the global economy to the disadvantage of all.
The Chinese and American legal and regulatory frameworks regarding digital currencies are rather unique to their national circumstances. They are not likely to provide a policy template for many other countries. We therefore believe that many countries around the world will seek to conform to the comprehensive (and still evolving) digital currency policy framework articulated by the EU.
The United States and Europe have an opportunity to generate a better outcome together through cooperation—but that requires policymakers in Washington to resume their positive leadership role on the global stage.
Risks to the dominant role of the US dollar
CBDC fragmentation creates a significant risk that the US dollar (USD) will experience a gradual diminution of its current prominent role in the international financial and payment system—in three ways.
First, clusters of interoperable CBDCs will greatly reinforce the already growing tendency of using local currencies in bilateral and eventually plurilateral cross-border payments. At present, the dominant role of the USD remains unchallenged, accounting for 85 percent of the $7.5 trillion in global foreign exchange daily trading turnover. Increased interoperability among national CBDCs will reduce reliance on the USD as an intermediary currency in executing exchanges between pairs of currencies. As Hong Kong Monetary Authority Chief Executive Yue recently observed at an ASEAN + Three (South Korea, Japan, China) conference with the Bank of Finland, the questions is when, not whether interoperable CBDC local currencies will reduce the use of major reserve currencies.
Second, reduced demand for the USD in foreign exchange trading can trigger parallel decreases in central bank USD holdings, amid a long-term gradual decline regarding reliance on the USD as a reserve currency. In 2001 the USD accounted for more than 70 percent of global reserves. By 2023, the USD share has fallen to 59 percent. Interestingly, the shift away from the USD has not generated a parallel increase in any single alternative currency but has benefited a range of smaller currencies.
A shift by importers to rely on local digital currencies interoperable with other non-USD digital currencies decreases the need for central banks to hold USD to cover foreign exchange trading. Central bank reserves currently seek to provide importers with around three months of FX liquidity. As importers shift to local currency CBDCs, central banks will have no choice but to increase their holdings of those currencies to cover the trade account, thus reinforcing declining reliance on the US dollar.
While resistance to the US dollar has existed for decades, its continued dominance in private commerce has been predominantly driven by the lack of an alternative. Enduring value propositions require more than the lack of competition and low transaction costs. Continued free market reliance on the US dollar requires that counterparties globally trust the United States to make the right decisions and serve a positive leadership function. The fabric of trust in the United States has been fraying for two decades.
Globally, many resent being compelled to support US foreign and security policy as the restrictions on permissible counterparties for US dollar-denominated transactions have increased. The rapid rise of cryptocurrencies during the Great Financial Crisis gave voice to a generation of technologically savvy individuals who distrust central authority in general and the Federal Reserve in particular.
Historical precedent encourages economists and analysts to assume that only one global reserve currency can exist at any given moment. But a distributed financial system linked through electronic ledgers creates an alternative scenario for reserve currency shifts.
No individual currency needs to replace the US dollar for it to lose its role as the main reserve currency. A gradual shift to multiple alternatives can achieve the same result.
If the United States seeks to retain its role as a global reserve currency, it must now win back the trust of the global economy. Locking people into the US dollar through a privately issued stablecoin does not make the positive case for the US dollar. Trust is won in many ways, but one key avenue involves making a positive contribution at the global policy table. It requires joining the policy discussion with a positive, forward-looking agenda.
Instead, for the first time in post-war history the United States will be absent from, or much less effective in, global monetary standard-setting bodies and discussions as the policy focus shifts to CBDCs.
Failure to initiate a digital dollar strategy domestically creates a significant risk that the United States will be missing in action regarding cross-border payments interoperability. Driving digital dollar policy through a tokenized banking system and bank-issued stablecoins will do little to address the frictions and costs discussed earlier. Markets and central bank reserve policies could easily shift to least-cost alternatives, leaving the Federal Reserve with oversight of a smaller universe of economic activity.
Actively and publicly exploring CBDC architecture and policy options will at least ensure that US priorities are part of the global conversation. US policymakers should be aware of the saying, “If you are not at the table, you are on the menu!”
Hung Tran and Barbara C. Matthews are Nonresident Senior Fellows at the Atlantic Council’s GeoEconomics Center.
At the intersection of economics, finance, and foreign policy, the GeoEconomics Center is a translation hub with the goal of helping shape a better global economic future.