Will digital currencies dethrone or cement the US dollar?
As crypto markets continue to attract attention and digital technologies threaten to upend the entire financial system, governments and reserve banks are racing to keep up and reassert themselves. Some, including India, Nigeria, and Turkey, have proposed banning decentralized crypto assets over the risk of money laundering and tax evasion. At the same time, many — especially China — are exploring how they might leverage digital technologies to create their own centralized Central Bank Digital Currencies (CBDC) and potentially challenge U.S. monetary hegemony and the value proposition of decentralized crypto assets.
U.S.-China competition in particular is heating up, with China taking steps to disrupt and outcompete the U.S. dollar-centered global financial system, including by investing heavily in the global fintech revolution, using an alternative to the SWIFT system, and launching a digital currency by the 2022 Winter Olympics.
The U.S. Federal Reserve has released a paper and is currently conducting consultations on the need for a U.S. CBDC. Officials have largely shrugged off the threat that China’s first mover advantage in digital currencies might pose to the U.S. dollar’s reserve status and central role in the global economy. But disruptive innovation has a habit of punishing hubris and inaction by incumbents. Dollar hegemony has provided tremendous benefits to the U.S., including ease of borrowing and the ability to enforce sanctions, terrorist finance and money laundering laws. The U.S. will not want to put it at risk.
Governments are right to call out the risks associated with new technologies that threaten to overturn the financial system which we depend on. The most-cited risks often relate to tax evasion, money laundering, terrorist finance, sanctions evasion, and systemic financial risk. As a case in point, China and Iran appear to be prioritizing bitcoin mining as a means for circumventing U.S.-led sanctions.
Overstated risks of crypto currencies
In reality, however, only an estimated 0.34 percent of all cryptocurrency activity in 2020 related to criminal activity, according to Chainalysis’ 2021 report, significantly less than the UN’s estimate of the proportion of money laundering in the global economy. This is because while cryptocurrencies appear anonymous, chain analysis methodologies can often reveal who owns a wallet in order to identify illicit activities and sanctioned entities. Furthermore, Know Your Client (KYC) style regulatory requirements force intermediaries and exchanges to collect tax and identity data to ensure compliance.
That said, privacy-focused currencies and assets, such as Monero and Zcash, obfuscate the public ledger, but unlike cash, they still provide some form of transfer record minus the source, amount, or destination details and fit within the financial regulatory structure used by the U.S. Financial Crimes Enforcement Network (FinCEN), the Financial Action Task Force (FATF) and others.
Legitimate risks of centralized digital currencies
CBDCs can come in two forms, wholesale or retail, which determines whether they will be disbursed through banks or by sidestepping banks altogether. Wholesale CBDCs would only be accessible to financial institutions and would thereby preserve the status quo while making wholesale financial systems faster, inexpensive, and safer. Retail CBDCs, however, would allow the general public to hold deposits directly with central banks, drawing deposits and transactions away from traditional banks and payment intermediaries, thereby jeopardizing their operating models.
Moreover, developing country central banks are concerned about third-party “stablecoins” as a key threat to their monetary sovereignty. These are blank-coin cryptocurrencies, such as Tether or Facebook’s Diem, which have no backing by a central bank. Contrary to what their name suggests they are not necessarily that stable and could still attract consumers away from fiat currencies, further undermining the central bank’s ability to conduct monetary policy.
With COVID-19 accelerating the shift from physical cash to digital payments, privacy advocates have also warned that a cashless and intermediated economy is also a surveillance economy. Navigating the trade-off between privacy and abuse will be key to maintaining open societies. It requires a mature regulatory framework, which keeps state power in check and respects privacy — a major concern with a centralized Chinese CBDC.
Opportunity to extend U.S. banking to the decentralized world
With a well governed and trusted CBDC, the U.S. has an opportunity to deepen its role in the global financial system and outflank China’s digital currency efforts by extending America’s banking power to the world and underpin the next generation of financial innovation and inclusions.
With 7.1 million families considered underbanked and a stated goal to improve financial inclusion and fight poverty, there is already a strong domestic case for the Federal Reserve to develop a CBDC. Moreover, a U.S. dollar CBDC could offer trusted, stable currency to cross-border transactions and help bolster innovation in decentralized finance (DeFI) by allowing consumers to off ramp into a stable asset. It could turn every phone into a bank account and bank terminal, capable of complex domestic and international transactions and attracting crypto capital from around the world.
Digital U.S. dollarization would pose a similar threat to smaller reserve banks as stablecoins; however, the U.S. has an opportunity to set the global regulatory agenda by working with the International Monetary Fund or Bank for International Settlements to mitigate this risk.
While the U.S. may prefer the status quo, China’s digital currency and other decentralized financial innovations threaten its position. The U.S. has little choice but to compete by exploring its own CBDC and shaping a new governing framework if it wants to maintain its leading role in the global financial order.
Arjun Bisen is a Fulbright scholar, technology policy advisor, former Australian diplomat, and affiliate of the Technology and Public Purpose Project at Harvard Kennedy School’s Belfer Center for Science and International Affairs. Follow him on Twitter @ArjunBisen1