What exactly is a digital dollar, and how would it work?

Right now, you likely keep your money in a bank account, where it exists digitally. But what if some of your funds could live in an account run by the Federal Reserve, and you could access it with a digital wallet? That’s the basic idea behind a digital dollar, and experts hope it will fix some of the problems in traditional banking. 

The banking system is experiencing an existential threat in the digital age, forcing it to either innovate, or face disruption. In response, two groups in the US are now researching how to build what’s known as a central bank digital currency (CBDC)—a digital dollar—to compete against private cryptocurrencies such as stablecoins, which are crypto assets pegged to the US dollar to stabilize their value. 

One of the CBDC projects in the US is helmed by MIT and the Federal Reserve Bank of Boston, and the other by The Digital Dollar Foundation and Accenture.

Currently, the MIT-led group is researching how CBDCs would work, theoretically, and they’re experimenting with different types of technology that can allow federally backed digital currency systems to be secure, private, and scalable. Taking inspiration from cryptocurrency research, MIT said that in the coming years, it will work with central banks, leading companies, merchants, regulators, academic researchers, and technologists to design a viable system through which digital money can be routed. 

And Reuters reported in May that The Digital Dollar foundation was launching a series of pilot programs in conjunction with financial firms, retailers, NGOs, and more to generate “real-world data” on the pitfalls and potentials of a digital dollar.  

If you’re wondering just what a digital dollar is—and how it’s different from the money that exists digitally in the hands of whatever bank you use, as well as how it could change banking—read on.

What exactly is a CBDC, and how is it different from what we have now?

CBDCs would be digital representation of a fiat currency, which is a wonky term that refers to currency issued by the federal government, like paper dollars you take out from an ATM. It wouldn’t completely replace all paper currencies, so you could still withdraw cash, but a portion of the reserve would be made available digitally. 

You could theoretically access it through accounts that would be held directly with the government, says David Andolfatto, senior economist at the Federal Reserve Bank of St. Louis. That’s different from how people access their money now, which is to withdraw from a commercial bank, like Citibank. 

[Related: Paying with your phone is safe and convenient. Here’s how to start.]

“Presently, consumers do not have access to digital fiat currency, or central bank digital currency,” Andolfatto says. “You and I, at the retail level, do not have direct access to accounts with the Fed. We have access to bank accounts, and banks have direct access to the Fed account. We already have at our disposal what I would call a private bank digital currency.”

Private bank digital currencies are linked to your checking account with vendors like the Bank of America, and they allow you to pay for things online or withdraw cash from an ATM. The central bank digital currency is then used to settle payments between banks. For example, if you wanted to pay a friend who’s banked at JPMorgan Chase while you’re banked with Citibank, Citibank will take the corresponding private bank digital currency out of your account, and send an equivalent amount of central bank digital currency over to JPMorgan so they can issue the appropriate balance into your friend’s account. 

In other words, each commercial bank has its own system and its own ledger, which makes paying people who share your bank easy and (usually) free. However, when transactions involve different banks (and ledgers), CBDCs, and sometimes other intermediaries, are needed to help move the money, which can rack up fees and result in delays. Giving consumers direct access to CBDCs would streamline that process.

Darrell Duffie, a professor of finance and management at Stanford’s Graduate School of Business, argues that CBDCs could improve the efficiency and inclusiveness of the banking system, although there might be some limits to those benefits. For example, there will have to be another access option for people without mobile phones.

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“The US payment system is not very effective,” Duffie says. “This may be a way to increase its effectiveness, in terms of the cost and speed with which payments are made and the degree of interoperability, meaning everybody is using the same thing as opposed to 100 different things that people have to check on how to use before they can use them.”

Consider this: Paying with a credit card is expensive. You don’t notice that it’s expensive because the merchant pays the fees, but it can show up in the price you pay. Additionally, the merchant doesn’t receive your money immediately. 

Waiting a few business days for money to arrive in the account “may not sound like much, but it’s pretty important if you have to fund the cost of your inventory,” says Duffie. CBDCs could reduce costs for making payments by shortening the distance the funds have to travel and reducing the number of third parties involved in the process. 

CBDCs, in theory, would move all transactions onto a single ledger, eliminating delays and fees. You could pay your local baker for a loaf of bread at 7 in the morning, and the money would be in his account by the time he takes the bread off the shelf. Instead of coming from a private bank, the money you used to pay for this bread would come from your federal account. 

And since it will be a payment form that everyone takes, there’s no need to fish around for whatever app or vendors that the point of sales terminal or online marketplace takes. “It will be just one thing and you’re authorized to use it [everywhere]. In terms of upsides, that’s a big one,” says Duffie.  

The Fed accounts would likely have no fees, no minimum balance requirement, but there would also be no overdraft privileges. This could lower some of the bars for entry, especially for the Americans who are unbanked. “There is this idea that the central bank digital currency might serve as this basic public option,” says Andolfatto. “We’ll process the payments, we’ll use the best technology, we’ll do it real-time. And we can come to an agreement about information we share, whether we keep it anonymous. It’s open-access, so everyone can access it directly.”

It’s not a completely novel concept, Andolfatto adds. He compares it to a repackaging of the postal savings system, active in the US from 1911 to 1966. Except now, all movements of money are tracked electronically on a computerized ledger, and your digital banknotes are secured through cryptography. 

[Related: Venmo just made some big privacy changes—here’s what to know]

It’s important to note that there can be multiple models for a central bank digital currency. Allowing consumers to open up personal accounts at the Fed is called the retail model. There’s also another model, called the wholesale model, which is being studied. 

Through the wholesale model, CBDCs would not only be offered to consumers, but also to an expanded set of agencies and companies other than depository institutions, like PayPal or Facebook. 

“PayPal right now is not permitted to have an account with the Fed. It has to go through the banking system to facilitate payments across customers who don’t share the same platform,” Andolfatto says. Normally, when PayPal goes through banks, it gets charged interchange fees. Having an account with the Fed would allow PayPal to bypass that process, and in turn, compete with banks, generating more diversity in the banking space. This version would look very similar to an idea economists have previously proposed called “narrow banks.”

Whose idea was it anyway?

MIT credits the Bank of England as the first central bank to seriously consider the potentials of digital currencies in a 2015 research agenda, in which they asked, in part: “Might central banks issue digital currencies and what would be the impact on existing payment and settlement systems? Is the cryptographic technology behind Bitcoin transformational?”  

According to Andolfatto, what spurred interest among US regulators and policymakers is when Facebook got involved. Novi, a subsidiary of Facebook, is going to offer Diem, which is a type of stablecoin cryptocurrency. The value of cryptocurrencies like Bitcoin can fluctuate wildly due to supply and demand. Stablecoins peg the liabilities of a financial entity (it could be crypto, securities, or just deposits) to some underlying object, such as the US dollar. They grant some sort of consumer protection and are mostly used in crypto trading and decentralized finance. 

[Related: Is Bitcoin really the future of money?]

“These look very much like government money funds, or for that matter, just banks,” says Andolfatto. “If you think about it, your bank deposit is a stable currency. My bank deposit can be converted into dollars at par. I never worry about the stability of my bank account. When I put 10 dollars in, there’s 10 dollars the next day.” 

A stablecoin like Diem would be “basically a bank that offers to facilitate payments off of the conventional payment rail: The central bank, intra-bank, to merchants. It’s potentially going through a separate rail, like a blockchain protocol.”

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With the introduction of stablecoins, governments and central banks became concerned about national stability and maintaining monetary solidarity, and they pondered if they needed to offer a competing service that could “prevent Facebook from having too much of a footprint in this space,” he says. “This is not small potatoes because Facebook has over 2 billion users worldwide. Now you’re talking about the possibility of people using the Facebook network to make payments to each other.”

Who’s interested? And how far along are they?

The Atlantic Council and Boston Consulting Group run CBDC trackers that follow how far along different countries are in developing and launching their digital currencies. According to the Atlantic Council, 81 countries are exploring a CBDC. Within the four countries that have the largest central banks, the US is the furthest behind in CBDC development compared to the European Central Bank, the Bank of Japan, and the Bank of England. The European Central Bank is in the process of launching a two-year investigation to determine how best to introduce the digital euro, the Associated Press reported in July. If it gets greenlit at the end of the investigation, officials say it would then take three more years to actually develop the digital euro. 

The Bahamas was the first nation to introduce digital currencies called the “sand dollar” (paired with mobile wallets) into its economy, MarketWatch reported. The intention was to offer extended financial services in places where there are no commercial banks or no credit cards accepted, especially in areas where the physical infrastructures of financial institutions were destroyed by hurricanes.  

“Having an interaction with your bank is flying from a remote island to the capital and dealing with your banker,” John A. Rolle, governor of the Central Bank of the Bahamas, told the WSJ. “The digital currency is a public good and, despite how it requires complex policy choices, is a sensible way for a small country to modernize its financial system.” 

[Related: Why Amazon Created Its New Virtual Currency, Amazon Coin]

However, Duffie says to get the “sand dollar” up and running might have been easy because the Bahamas is a small country. “And also, the amount of Bahamian dollar that’s circulating in the form of its central bank digital currency is pretty small,” he says. “It’s nothing like what the US would face in terms of size and impact of doing it.” 

On the other hand, out of the larger countries, the People’s Bank of China (PBOC) began rolling out pilot programs in several major cities just last year, Wired reported. Since then, more than 20 million digital yuan wallets were created, fielding over £3.6 billion in CBDC transactions. 

How will CBDCs impact the financial system?

Andolfatto thinks that it’s likely that both the wholesale and retail models of CBDCs will get pushback from banks, since it could squeeze their profits by directly competing with them for deposits. In fact, Denmark canceled their CBDC project because they didn’t want to compete with commercial banks. “They might argue that this might impinge on their ability to lend, to finance, that’s not a good argument at all because it’s not true,” says Andolfatto. “They can get funding from other sources. Deposit funding isn’t the only way you can finance lending activity.”  

[Related: Switching your bank might help slow the climate crisis] 

Still, experts believe that the private sector specializes in certain features, like dealing with customer service at the retail level, which could remain a draw for many customers. “Maybe the Fed CBDC acting as a basic public option discipline[s] these big banks in case they try to exploit us with interchange fees for merchants,” Andolfatto suggests. In short: people fed up with commercial banks could try a different option. 

There’s still a lot of unknowns that need to be solved for CBDC systems, which banks have already somewhat figured out. These are issues like how to store identity and payment data in a way that protects privacy but also enables regulatory bodies to check on whether you’re making legal payments. “Right now, that’s being left up to the banks, which are doing an ok job at it,” says Duffie. “But if it’s done with a central bank digital currency, you have to figure out who’s going to be doing this monitoring for digital payments, and who’s going to hold your data, and is it protected.” 

Since the implications of CBDCs could also ripple out internationally, countries have to think broadly in terms of policies and boundaries. “Without any safeguards, it could infiltrate the monetary systems of other countries and perhaps people will use digital dollars in other countries,” says Duffie. That could negatively impact the central banks abroad by obliterating the native monetary policy. 

Meanwhile, researchers are exploring a joint CBDC network that would bridge together the currencies of multiple countries. A pilot project involving Hong Kong, Thailand, the UAE, and China was announced earlier this year. An American technology firm, R3, is helping them develop their infrastructure. 

“If it works, then if you want to exchange your currency for another one in that set, there’s a simpler way to do it that doesn’t require all of the steps that are currently required in correspondent banking, which is expensive, slow, and time consuming,” Duffie explains. “There’s a number of startups in the private sector that are proposing to make it cheaper to do cross-border payments. So it’s not necessarily the case that you must have a CBDC to improve this. But a multi-CBDC banking system is one way to do it.”

Similarly, CBDCs aren’t the only way to improve the US banking system either. There’s also another program called FedNow that the government is experimenting with. It’s an instant payment system that is linked with your private bank account, and it’s expected to launch in phases starting in 2023. This service will allow users to make payments 24/7, 365 days a year, which is not possible at the moment with normal bank account payments, says Duffie. 

“It’s not clear to me what the best approach is. The government has to do a lot of research and development. They should start developing a central bank digital currency right now in case they find out it’s the best way to go,” he says. “But they may find in the course of development that the best shot at a CBDC is not as good as the alternative.”