A fully digital US dollar would be a better online currency than crypto, new Fed report suggests

• A new report from the Federal Reserve opened the door to debate around a central bank digital currency.
• The Fed avoided taking a side for or against the idea and instead raised a number of pros and cons.

Cryptocurrencies' ascent to global stardom put governments on alert. Some, like China and Sweden, are already tinkering with digitizing their own currencies. Now the Federal Reserve is dipping its toes in the water.

The Federal Reserve still hasn't sided for or against a central bank digital currency, but a new report lays out the potential benefits and risks of fully digitizing the US dollar.

The Fed kickstarted the debate over a US central bank digital currency on Thursday, publishing a highly anticipated report on the topic. A CBDC would serve as a purely digital version of cash that's backed by the Fed and just as available to the public as physical cash. It wouldn't require the same deposit insurance that banks need for cash, and it wouldn't need to be backed by a physical asset.

A Fed-backed digital dollar would then provide many of the benefits touted by cryptocurrencies without their wild price swings and usage fees. In theory, a CBDC would meld the best aspects of physical and digital currencies for the average American.

A CBDC likely wouldn't feel all that different from a regular dollar. People already use digital cash when they shop with credit or debit cards, but in those situations, the currency is backed by private-sector banks. Should the Fed introduce a CBDC, Americans would be able to shop with a digital dollar backed by the country's central bank. If that sounds outlandish, it shouldn't; physical dollar bills are already backed by the Fed, not by commercial banks.

The Fed stopped short of taking a position on a CBDC, saying it first aims to engage with the public, Congress, and other stakeholders on the topic. Still, the Thursday report detailed a handful of reasons why such a currency would benefit the country and serve as a better medium for spending than the commonly traded cryptocurrencies that have seen adoption explode over the past few years.

A CBDC could bring safe, fast, and accessible payments

Cryptocurrencies surged in popularity partly due to their use in real-time, peer-to-peer payments. A CBDC could offer the same. Transactions with a CBDC would be "final and completed in real time," and could be used for everything from buying groceries to receiving government stimulus, according to the report.

The digital cash would also be free from credit risk, liquidity risk, and, perhaps most importantly, the volatility that makes spending with crypto so unreliable. Stablecoins, or cryptocurrencies that aim to fix their exchange rate with a more conventional currency like the dollar, address some of the volatility problem, but a recent report from the President's Working Group on Financial Markets found gaps in the authority of regulators to address some stablecoin risks.

A CBDC would also allow for more flexible transacting, the Fed said. Payments could be scheduled for certain times and used for small transfers that traditional systems might not allow for. And while services like PayPal and Venmo already have some of these capabilities, a CBDC would allow users to make such transfers without a private third party.

CBDCs could even improve cross-border payments, but such gains would take time to materialize. International CBDC transfers would require new infrastructure, government coordination, and enforcement to curb illicit finance. Still, a future network of CBDC could do away with transfer fees and long settlement times.

A CBDC would come with 21st-century risks

A fully digitized dollar would come with its fair share of pitfalls, the Fed warned. For one, allowing the Fed to back digital payments could "fundamentally change the structure of the US financial system," according to the report. Commercial banks rely on deposits to dole out loans, but a CBDC could replace cash held in commercial banks with digital wallets offered by the private sector. That could make it far more difficult for people to take out loans.

The stability of a CBDC could also spark runs on commercial banks in times of economic uncertainty, the Fed said. Traditional measures used to prevent massive outflows from banks would be inefficient if people rushed to convert their bank holdings into CBDC.

Implementation of a Fed-backed digital dollar could even erode the central bank's policy power. By changing the amount of reserves in the financial system, a CBDC could affect how the Fed sets interest rates and steers inflation. The Fed would likely need to boost its level of reserves just to accommodate fluctuations between outstanding cash, bank reserves, and CBDC holdings.

Introduction of a CBDC, risks and all, would make for "a highly significant innovation in American money," the Fed said. The central bank is set to take comments on the matter until May 20, when it is expected to further mull the currency's pros and cons. While the future of a digitized dollar remains uncertain, the Fed's report unequivocally opens the door to such a project.