Originally published January 22, 2022
INTRODUCTION
New technologies are redefining the financial sector. Cryptocurrencies are used as alternative investments, speculative assets, and methods of payment, while digital financial technology, better known as fintech, accelerates payments, lending, and investing. Simultaneously, central banks like the US Federal Reserve reckon with the complexities of the modern economy, striving to stabilize inflation, prices, and the economy as a whole. But a new risk looms: the possibility that the Federal Reserve will move toward creating a government-backed, central bank digital currency (CBDC) that goes beyond existing private sector cryptocurrencies, laying the seeds of next-generation financial crises. The Federal Reserve should not take the risky step of creating a CBDC, but rather should coordinate with Executive Branch regulators to support the development of private sector stablecoins that lack the systemic economic risks posed by a CBDC.
This paper will examine the case against a CBDC through a rules-based monetary policy framework that considers: (1) how US financial regulators should regulate fintech and cryptocurrencies with an eye to financial stability, and (2) the extent of Federal Reserve monetary policy involvement in new technologies. Part I will examine the monetary history of the US since the creation of the Federal Reserve system, proposed and implemented rules-based monetary policies, and the advent of fintech and cryptocurrencies. Part II will analyze the current state of fintech and cryptocurrency regulations. Part III, in turn, will assess next steps for fintech and cryptocurrency regulations by Executive Branch regulators, the involvement of the Federal Reserve, and the question of a CBDC versus private sector stablecoins, all assessed within a rules-based monetary policy framework.
I. MONETARY POLICY: AN OVERVIEW
A. The Federal Reserve System: From Origins to Inflation
Monetary policy is intentional adjustment of the money supply by a central bank to achieve monetary equilibrium. [1] The Federal Reserve was created in 1913 as the American central bank, setting monetary policy for the nation.[2] The Federal Reserve was created at the behest of financial magnate J.P. Morgan, senior bankers, and Progressive reformers. The plan for a central bank took shape at a meeting of politicians and finance leaders at Morgan’s estate on Jekyll Island, Georgia.[3] Emerging from the Panic of 1907, Morgan sought a national bank that would stabilize the economy through panics and recessions.[4] Today, the Federal Reserve is intended as an independent central bank that does not create the currency it circulates.[5] The largest private banks in the Federal Reserve's regions elect its twelve regional directors, who in turn oversee the Fed's role as a lender of last resort, the mandatory reserve requirements for banks, and the federal funds rate—the interest rate charged to banks borrowing funds from the Fed.[6]
The US is famous for its dual banking system, with chartering and regulation of banks by both the federal and state governments, which has existed for over two centuries.[7] Long before the emergence of the Federal Reserve System, in 1791, Congress at the urging of Secretary of the Treasury Andrew Hamilton granted a twenty-year charter to the First Bank of the United States.[8] The new bank was a private enterprise with twenty percent ownership by the national government which enraged small government-oriented Jeffersonian Republicans because it allowed foreign influence over currency and national affairs.[9] After a lapse in the charter of the first bank and financial difficulties during the War of 1812, Congress chartered the Second Bank of the United States for another twenty year span in 1816, with similar drawbacks, prompting populist firebrand Andrew Jackson to mount a successful presidential campaign on the bank's elimination—which occurred with the lapse of its charter in 1836.[10]
By the time the Federal Reserve came about, President Jackson's opposition to the Bank of the United States nearly eighty years earlier was by then merely a part of history, William McKinley had defeated William Jennings Bryan's populist free silver movement in 1896, and banks in New York City sought a central bank to compete with the financial primacy of London.[11] Following the tumult of World War I, and throughout the 1920s, the Fed dealt with US dollar deflation problems and lowered its discount rate to support Britain's return to the gold standard.[12] Bank runs swept the nation after the 1929 stock market crash, while the Fed refused to engage in expansionary monetary policy, then ratcheted money market rates back up in 1931 in an effort to stabilize the gold standard.[13] President Roosevelt set out to depreciate the dollar to boost domestic prices; the Fed abandoned interest rate targeting and US deflationary pressures spread across the globe.[14]
To some, the Fed seemed impotent amidst the Great Depression, the sudden shift from high unemployment to full employment during World War II led to a change of mindsets in the economics profession in favor of large government, interventionist Keynesian policies. At war's end, Americans feared a return to economic depression, and based on prevailing understandings of commodity money, the Fed was obligated to return to pegging rates.[15] Inflation rose after the war, most sharply during the Korean War as commodity prices surged due to fears of a Third World War; during this time, the Fed began a "lean-against-the-wind" policy of countercyclical monetary policy intended to stabilize the economy.[16]
Under the Eisenhower administration, the Fed tried to combat inflation by dropping short-term interest rates in 1958. [17] Chairman Martin advocated for a role for monetary policy and criticized Keynesian ideas that government fiscal policy alone could create full employment.[18] In spite of the efforts to combat inflation, a period of sustained and serious inflation—dubbed the Great Inflation—lay around the bend.
Under President Kennedy, the Council of Economic Advisors won out over more conservative Treasury Department officials, advocating expansionary policy under the 1946 Employment Act to achieve sustained full employment.[19] The civil unrest brought on by the Vietnam War and the civil rights movement gave credence to calls for reduced unemployment, together with President Johnson's populist avoidance of increased interest rates to finance his Great Society program.[20]
A. Great Inflation, Great Moderation, and Low-Interest Rates: The State of Monetary Policy
American economists commonly remark that the Fed is an "independent" central bank.[21] However, through much of the Fed's history, the Executive branch through the US Treasury Department has enjoyed considerable sway over the Fed's actions.[22] Presidents have often pressured the Fed to change the monetary policy to support Executive policy goals.[23] In a dramatic example in 1965, Chairman Martin warned Columbia University graduates in a speech about the dangers of an overheating economy.[24] President Johnson asked the Attorney General if he could fire Martin, then invited Martin to his ranch in Texas, pushing the erstwhile Fed Chair up against the wall and saying, "[M]y boys are dying in Vietnam, and you won't print the money I need."[25]
In spite of such browbeating, Martin mostly maintained Fed independence.[26] But his successor under President Nixon, Chairman Arthur Burns, proved far more pliable.[27] Through a combination of in-person meetings and leaks to the press, Nixon swayed Burns to engage in an expansionary monetary policy for political gains after Burns took over the chairmanship in 1970.[28] Under Burns' watch, inflation surged to nearly fourteen percent per year.[29] The federal government had closed out the 1960s with high spending associated with President Johnson's Great Society and the Vietnam War.[30] President Nixon ended the exchange of dollars for gold by foreign central banks, thus dismantling the Bretton Woods international monetary system in-place since the end of World War II.[31] A mere two years later, in response to US support for Israel in the Yom Kippur War, Arab OPEC oil producers launched an oil embargo, quadrupling oil prices, yielding a combination of economic stagnation and inflation, famously termed "stagflation."[32] "[During the Great Inflation] the Federal Reserve accommodated large and rising fiscal imbalances and leaned against the headwinds produced by energy costs. These policies accelerated the expansion of the money supply and raised overall prices without reducing unemployment."[33]
The Fed opted for a reset as the 1970s came to a close. The Great Moderation followed the Great Inflation, under the leadership of Volcker, Greenspan, and (briefly) Bernanke.[34] Economists have put forward a variety of different explanations for the era's low volatility, such as a shift to services from more volatile manufacturing, enhanced information technology, just-in-time logistics, deregulation, improved capital flows, and greater international trade.[35]
[G]ood policy, especially monetary policy, is [a]. . .possible reason for the Great Moderation. Monetary policy is generally thought to have performed better during the Great Moderation than in earlier periods. After inflation climbed from below 2 percent in the mid-1960s to over 12 percent in the mid-1970s, Federal Reserve Chairman Paul Volcker brought it down and returned the focus of monetary policy to price stability, thereby laying the foundation for the Great Moderation.
Rather than adhere to earlier "go-stop" methodologies, which involved loosening the money supply to combat recessions, then tightening it rapidly to fight inflation, the Federal Reserve under Volcker and his successors adopted what would later be dubbed Taylor-type rule controls, increasing the federal funds rate greater than the rate of inflation, and setting targets around inflation rates defined by policymakers. Greenspan's Fed went a step further, enhancing communication after February 4, 1994, when the Federal Open Market Committee (FOMC) began announcing policy changes, so that banks would no longer need to divine such changes themselves.[36]
According to some narratives of American monetary history, the Great Moderation came to a screeching halt in the autumn of 2007 with the sub-prime mortgage crisis, which in turn spawned the 2008-2009 financial crisis.[37] Mortgage debt climbed from sixty-seven percent of GDP in 1998 to ninety-seven percent in 2007.
"In the period after the 2001 recession, the Federal Open Market Committee (FOMC) maintained a low federal funds rate, and some observers have suggested that by keeping interest rates low for a “prolonged period” and by only increasing them at a “measured pace” after 2004, the Federal Reserve contributed to the expansion in housing market activity. . ."
Economists disagree about the exact cause of low interest rates, in other cases pointing to savings in the developing world, rather than the federal funds rate. However, the maintenance of low interest rates likely did not help in combination with fiscal, policy, and market changes that promoted risky mortgage lending.[38]
Ultra-low interest rates have predominated throughout the 2010s in response to the 2008 financial crisis, giving way to equally dramatic monetary policy prescriptions coupled with trillions in federal spending during the 2020-2021 Covid-19 pandemic.[39] The monetary response to the Covid-19 pandemic may now be triggering more traditional forms of inflation, albeit played out in unfamiliar ways, thanks to a globalized economy.
B. Rules-Based Monetary Policy
Researchers at the Mercatus Center at George Mason University has advocated for rules-based monetary policy.[40] An important question is whether central banks should have set rules to control what actions they may take to stabilize the economy. Such a binding rule would not need to necessarily be a strict mathematical formula, but rather a set of plans of action or contingencies.[41] Superficially, discretionary policy by monetary experts seems appealing, but thinkers like Beckworth, Taylor, and Salter have argued for the importance of rules.[42]
"If the central bank could somehow commit itself to following a rule for monetary policy that it cannot later change, social welfare would improve."[43] Where the public makes assumptions about a future rate of inflation in-reliance on the central bank, the central bank has an incentive to break its promise and launch surprise expansionary monetary policy, delivering the social welfare of low inflation and low unemployment over the short-term.[44] But because the public does not believe the central bank's promise, decisionmakers incorporate anticipation of higher inflation into contracts, eliminating any reduction in unemployment.[45] A set rule would anchor expectations for market participants and not subsume decision-making to a small committee.[46] Central bankers are not immune to public and private pressures, such as Fed Chairman Arthur Burn's use of monetary policy to cater to President Nixon's political desires, and set rules would guard against this type of influence.[47]
What form do rules take? In 1960, Milton Friedman famously articulated his k-percent rule, contending that the money supply should increase over fixed intervals. Friedman's view interprets variables in the real economy as the result of technological factors over the long-run. This largely autonomous approach is "intuitive[ly] appeal[ing]" because it could be accomplished with little input from Fed governors or economists.[48] But in the real world, factors informing the "k" growth rate are not fixed and could lead to miscalculations.
John Taylor's Taylor rule tackled the question of rules from a different perspective in 1993. His formula indicates that if output or inflation are above a set level, the central bank should raise the target rate and constrain the money supply. "Rather than a broad money supply target, the Taylor rule can tell the monetary authority how to adjust the short-term interest rate in
response to changing economic conditions, thus making it more adaptable than Friedman’s rule, at least theoretically."[49] However, there are risks if the monetary authorities set the wrong target interest rate.
Perhaps the most famous monetary rule, and the only one widely implemented, is inflation targeting. But as with the other rules, inflation targeting is not without its risks. During a negative supply shock that reduces the quantity of goods and services, but not money, inflation would soon increase. But if the central bank responded by contracting the money supply it could reduce employment and output.[50] Conversely, to meet a particular inflation target, the central bank might grow the money supply potentially contributing to dangerous speculation in financial markets.
Looking retrospectively at American monetary history, rules-based advocates argue for the success of rules relative to ad hoc policymaking.[51] "The late 1960s and 1970s were a period where the Federal Reserve exercised little long-term thinking and a great deal of short-term fine-tuning."[52] After a low-point during the "go-stop" era of Chairman Arthur Burns in the early 1970s, Volcker and Greenspan instituted a rule-focused era between 1985 and 2003, which was abandoned after the early 2000s.[53] Taylor presents evidence for a return to discretionary policy after the 2001 Internet bubble burst: keeping interest rates between levels implied by a rules-based approach, term auction funds in 2007 to reduce stress on the interbank market, intervening to rescue creditors of failed financial giants, and lending to Fannie Mae and Freddie Mac.[54] "The discretionary period [compared to the rules-based period] included a massive housing boom and bust with excessive risk taking, a financial crisis, and a Great Recession whose depth was much greater than any recession in the Great Moderation period. . .with economic growth averaging only 2.4%. . ."[55] However, it should be acknowledged that some critics cite Greenspan himself for policies culminating in the financial crisis, such as ineffective communication.[56]
Writing in 2015 amidst the continued fallout of the 2008 recession, Norbert Michel called for Congress to require the Fed to adopt a rules-based policy and create a monetary policy commission.[57]
C. Fintech
Fintech, or financial technology, encompasses an ill-defined set of financial services involving digital technology. Banks were early adopters of computers and digital technology, leading some commentators to be dismissive of fintech as merely a catchy term. One commentator defined fintech as "the new breed of companies that specialize in providing financial services primarily through technologically enabled mobile and online platforms."[58] Although fintech defies easy definition, one definition identifies areas of financial activity such as payments, remittances, peer-to-peer lending, crowd-investing, point-of-sale, wealth management, and blockchain as typical of fintech companies.[59] In contrast to highly-regulated and institutional banking, fintech has enjoyed its greatest recent successes in asset management. Robo-advisors and mobile apps have helped what was already a highly-profitable industry to cut costs, automate, and manage investments more effectively than many huma advisors.[60] Equally, crowdfunding options and cryptocurrency exchanges have emerged as major focal points for the fintech industry.[61]
D. Cryptocurrencies
Cryptocurrencies burst onto the scene in 2008 when the elusive Satoshi Nakamoto launched Bitcoin as a private currency.[62] Founded on distributed blockchain ledgers, rather than traditional bookkeeping, cryptocurrencies have a decentralized way of tracking transactions shared by all users.[63] The "crypto" in cryptocurrency comes about because cryptocurrencies harness encryption to prevent duplication, counterfeiting, and double-spending.[64]
Blockchains are essentially databases, tracking transactional data and distributing it to different computers that are the "nodes" of the decentralized network.[65] Some cryptocurrencies, particularly Bitcoin, use blockchains to create scarcity as well as a slowly growing coin supply. Special miner nodes compete to create validated transactions packaged as blocks, based on a consensus algorithm.[66] Bitcoin's "proof of work" consensus algorithm requires massive computational power, consuming substantial electricity in the process, totaling more annual consumption than many countries.[67]
Phrases like "coin" and "token" are often used interchangeably, but in fact cryptocurrencies can be subdivided between currency tokens, investment tokens, and utility tokens.[68] Currency tokens like Bitcoin are perhaps the most famous cryptocurrencies and can be used to make payments.[69] By contrast, investment tokens are pegged to a fiat currency and can be directly exchanged into that currency, such as J.P. Morgan's JPM Coin.[70] Investment tokens function like stocks or shares and may be accompanied with voting rights, whereas utility tokens provide access to a service or resource.[71]
Cryptocurrencies are typically issued through an initial coin offering (ICO), which can be likened to an initial public offering (IPO).[72] ICOs are often a means of raising start up funds, with new coins or tokens purchased using preexisting cryptocurrencies or fiat currency, exchanged through a digital coin wallet.[73] Unlike IPOs, ICOs are largely unregulated and are accompanied by a high risk of fraud and failure.[74] The advent of Ethereum in 2014 as both a cryptocurrency and decentralized application technology helped to spur ICOs.[75]
In contrast to currency made out of intrinsically valuable material like copper, silver, or gold, today's cryptocurrencies rely on network effects not dissimilar from large technology platforms.[76] "Network effects are economies of scale derived from standardization and widespread to universal acceptance. Success of payment innovations seems unlikely until critical mass is achieved. The same holds true for money and payment systems."[77] As a result, while there are thousands of cryptocurrencies, interchangeability for many is limited and long-term prospects as competitors to traditional currency is limited.
II. REGULATION ENSUES: THE RISE OF FINTECH AND CRYPTOCURRENCY
A. Fintech Regulation
The US is famous for its dual-banking system, with regulations at both the state and federal level.[78] The Office of the Comptroller of the Currency has taken a leading role in federal fintech regulation, proposing to create a Special Purpose National Bank (SPNB) under the authority vested in it by the National Bank Act.[79] Certain activities such as lending money, receiving deposits, or paying checks are under the jurisdiction of OCC, but it is less clear whether OCC has the power to charter non-depositary national banks.[80] Nevertheless, in 2018, OCC moved ahead with plans to charter fintechs involved in the "business of banking" as SPNBs.[81] The proposal has so far survived scrutiny in the courts. Recognizing the growing significance of fintech, the Second Circuit Court of Appeals overruled a district court ruling preventing the Office of the Comptroller of the Currency from accepting special-purpose national bank charter applications from "non-depository" fintech institutions.[82]
Although OCC is the primary body involved in American fintech regulation, other federal agencies are also involved. In 2018, the Consumer Financial Protection Bureau announced a newly created Office of Innovation would review regulatory barriers facing fintech entrepreneurs.[83] Meanwhile, the Commodity Futures Trading Commission premiered LabCFTC to encourage fintech entrepreneurship in fields it oversees.[84] The Federal Trade Commission also gets involved. In 2018, FTC reached a settlement with PayPal related to deceptive practices and privacy problems with its Venmo app.[85]
Operating outside of traditionally regulated banking, fintech companies have sometimes struggled as they encounter regulations. For instance, the US-based peer-to-peer lending platform, LendingClub, suspended operations for six months in 2008 due to concerns that it was not in compliance with the Securities and Exchange Act.[86] Famed crowdfunding platform, Kickstarter, also faced such concerns.[87]
Because the US with its massive technology industry and venture capital resources had early advantages in fintech, the national governments of other countries have created fintech sandboxes, allowing testing under supervision from a financial regulator.[88] By 2020, sixteen different sandboxes were in operation or planned, perhaps most notably the UK Financial Conduct Authority's Project Innovate, launched in 2014.[89]
B. Regulation of Cryptocurrency
Cryptocurrency regulation remains comparatively light in most countries, including the US. Only New York and California have attempted to create comprehensive regulations.[90] How a coin is traded typically defines how it is regulated. CFTC has the power to regulate transactions where the coin will be delivered in the future, whereas an initial coin offering by a company to raise funds falls within the definition of a "security" under the Securities and Exchange Act of 1933.[91]
The SEC applies the Howey test for ICOs. "[A]n investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party. . ."[92] Not all ICOs qualify as securities under this approach.[93]
A high risk of fraud accompanies ICOs, because criminals can provide a coin claiming it is to raise funds for a business, and then disappear with actual currency, leaving investors with a valueless coin.[94] Between 2017 and 2019 there was a brief heyday for ICOs that came to an end when the Chinese central bank blocked banks from offering services related to ICOs, and Twitter, Facebook, and Google prevented ICO advertisements.[95] As a caution to ICO investors, the SEC set up the bogus HoweyCoin coin offering in May, 2018.[96]
As the center of state-level financial law in the US, New York was early to step into the regulatory fray. In June, 2015, the New York Department of Financial Services began requiring BitLicense registration for new and established firms offering virtual currency.[97] However, by 2019, only sixteen companies had BitLicenses.[98]
Taxation was an early frontier for cryptocurrency regulation. "The concept of a totally distributed, censorship-resistant virtual currency understandably exceeded the boundaries of what policymakers had considered thus far. Adding to the mystification were the myriad applications of blockchain technology. Cryptocurrencies were simultaneously used by different people as a kind of transaction platform, standard currency, investment vehicle, or even a complex financial instrument."[99]
In 2013, the GAO recommended the IRS begin formulating cryptocurrency regulations, but the report was based primarily off of previous tax analysis of online games like World of Warcraft.[100] The IRS weighed whether to treat cryptocurrency as a foreign currency or property, which might be subject to capital gains. Based on a statutory reading, the IRS determined that cryptocurrencies like Bitcoin did not meet the definition of currency, and therefore subjected cryptocurrencies to more complex gain and loss capital gains documentation and calculation. Major coin exchanges like Coinbase have created calculators to determine changes in value, but coin owners are on their own if they switch to many smaller services.[101]
Cryptocurrency regulations are also emerging in the realm of campaign finance. Multiple states treat cryptocurrency as an in-kind contribution, treated similarly to stock contributions.[102] Federal regulations are similar, with the FEC treating cryptocurrencies as in-kind contributions since 2014.[103] But the in-kind model is beginning to change, suggesting some degree of mainstream acceptance of cryptocurrencies as a form of currency. For instance, Tennessee and Colorado have recently adopted laws to treat cryptocurrencies as monetary contributions.[104]
Perhaps the most unusual cryptocurrency regulatory field is environmental law, although this is largely limited to electricity-intensive Bitcoin mining. The European Commissioner for Digital Economy and Society expressed concerns about the environmental effects of cryptocurrency mining in March, 2018, but for now neither the US nor the EU has taken any regulatory action.[105]
E. Stablecoins: The Quest for Stability
The cryptocurrency market has been turbulent from the start, prompting the development of stablecoins, which maintain stable value relative to an official currency like the US dollar, or a valuable commodity like gold using an algorithm.[106] In 2014, Tether (originally known as Realcoin), launched as the first stablecoin, becoming the most capitalized by 2018.[107] "[W]hile stablecoins are a consequence of the emergence of cryptocurrencies, they emerged as a rather distinct phenomenon and work in a manner that can be compared to money market funds in the ecosystem of cryptocurrencies."[108] Stablecoins are perceived by some owners as a way to save more effectively in economies where interest rates have remained low for long periods of time.[109] But they have also attracted attention from central banks.
Central banks have expressed interest in stablecoins as a form of central bank digital currency (CBDC). In an October, 2020 report, the European Central Bank touted a conceptual "digital euro" as a way to quickly and securely carry out daily payments.[110] The ECB went further in July, 2021, instituting a twenty-four month digital euro study.[111] For its part, China also rolled out a CBDC project in 2020, focusing on four provinces, state-owned banks, and wallets provided by fintech companies such as Tencent.[112] Japan, Estonia, and Sweden are all considering cryptocurrencies, while Venezuela launched Petro in 2018. "A government-backed digital currency could (or would, depending on the level of adoption government-backed cryptocurrencies might enjoy) be nearly equivalent to electronic cash and would be a part of the average citizen's daily life."
Why are central banks suddenly interested in stablecoins and cryptocurrency more broadly? In the case of the ECB, a CBDC is seen as a way to eliminate remaining cross-border costs and rents collected by existing payment providers.[113] Attractive to both ECB and Chinese authorities is the possibility to observe private transactions, nominally to combat money laundering.[114] Additionally, the two central banks seek to compete for depositors and engage in direct monetary policy such as helicopter money drops and small loans witnessed during the COVID-19 pandemic.[115]
III. PLANNING A (DE)REGULATORY FUTURE
A. Implementing a Rules-Based Monetary Policy Approach: Next Steps for the Fed
Based on the success of rules-based policies during prior eras of the Federal Reserve's history, Congress should require the Fed to adopt monetary policy rules and collaborate with a newly created monetary commission.[116] These new policies would serve to counterbalance discretionary monetary policy, targeting objectives like inflation, unemployment, or price levels as measured with the Consumer Price Index.
However, many technological changes have occurred since the end of the Greenspan rules-based era, deepening the IT revolution that began under Chairman Volcker. The Federal Reserve must consider the monetary policy impacts of fintech and cryptocurrency. A newly created monetary commission might afford an opportunity to coordinate with federal regulatory agencies.[117] A collaboration between the Federal Reserve and regulatory agencies should strive to support fintech and cryptocurrency innovation, with light regulation that: (1) clarifies jurisdiction, (2) protects consumers and the nation from fraud, criminal financing, and systemic financial risk, (3) allows innovation and private credit creation, and (4) prevents direct federal speculation cryptocurrencies.
B. Clarifying Jurisdiction
Congress should devise a streamlined and centralized national law that clarifies the bounds of jurisdiction for cryptocurrencies. Currently, jurisdiction is divided in uncertain ways between Department of Justice, SEC, IRS, FinCen, CFTC, and the Secretary of the Treasury.[118] From the standpoint of the Federal Reserve, having streamlined regulations promulgated by Congress would help to shore up an area of vulnerability for the financial sector. As the value of cryptocurrencies rises, the risk of fraud or theft will increasingly threaten the stability of the economy, potentially creating an unfamiliar systemic risk for the central bank to respond to.
Cryptocurrencies produce potential systemic risks, with the possibility of ripple effects to other parts of the financial system if investors lose confidence in a widely held cryptocurrency. In this way, cryptocurrencies can be likened to the instability generated by privately created bank currencies in 19th century America.[119]
A national law should embrace the traditional dual-regulation of financial activities, allowing states like New York to continue with their own measures like BitLicense unless there is a compelling reason to centralize all regulation under the federal government.
C. Protecting consumers and the nation from fraud, criminal financing, and systemic financial risk
Most policymakers now accept the premise of some form of regulation in the financial services sector to protect customers from fraud. Barrack argues that where cryptocurrencies are concerned, regulators have a duty to (1) prevent fraud, money laundering, and criminal activity by requiring issuers and exchanges to file disclosures, (2) make information available about cryptocurrencies, and (3) make compliance "simple and straightforward."[120] This analysis is broadly correct, with some cautions about the type of reporting requirements discussed in the following section.
In addition to clarifying jurisdiction, federal regulators could require certain disclosures from coin exchanges. Such a regulation could also stipulate security standards similar to those outlined in Department of Defense Impact Levels to protect investors from hackers who could raid a coin exchange.[121]
"The potentially greatest threat of cryptocurrency flows directly from its originally most fervently touted, but now curiously muted, claim of advantage: secretive money transmission."[122]
D. Supporting Innovation and Private Credit Creation
Efforts by OCC and CFTC to cater to fintech companies are appropriate within the context of promoting free market innovation. Although there is a risk of imposing barriers on innovation, the creation of special purpose banking institutions by OCC has the benefit of removing uncertainty for fintech's in this area through a clear assertion of jurisdiction. Consumer protection and financial stability motivations both support some degree of regulation for fintechs.
Congressman McHenry's ultimately unsuccessful Financial Services Innovation Act of 2016 and state-level fintech sandboxes are steps in the right direction to promote innovation.[123] Arizona's efforts to formalize a process for fintechs through statute is also a positive development.[124] One approach to fintech sandbox regulations calls for size caps, disclosure of algorithms and cybersecurity measures to regulators, and "bridge" agreements to operate in other countries.[125]
Size caps are a potential barrier to innovation and regulators should welcome innovators of any size to the sandbox. Nevertheless, size considerations should come into play with fintech regulation, perhaps excluding fintechs below a certain size from regulation even if activities do amount to the "business of banking," in order to spur new developments. Congress should develop a standardized statute to clarify remaining jurisdictional questions surrounding fintech, formalize a process for interoperating with foreign fintechs, require cybersecurity measures, and encourage continual review of regulatory barriers.
IV. THE CASE AGAINST A FED CENTRAL BANK DIGITAL CURRENCY
Stablecoins created by the private sector are fundamentally different than CBDCs.[126] As the name suggests, stablecoins are intended to minimize risks and “bake in” stability over the long-term, offering a potentially valuable market pre-commitment, based on algorithms, commodities, and currency.[127] In a sense, stablecoins may even achieve financial goals better than the government itself, although the newness of the technology means that kinks are still being worked out.[128] By contrast, a CBDC would be an open invitation for government manipulation of the monetary supply to achieve short-term economic and political goals.[129] What follows is an analysis of the benefits and downsides of a CBDC. In a “first-best” regulatory scheme where best intentions play out in the real-world, there might be characteristics to recommend a CBDC. But in a realist’s “second-best” scenario, a CBDC appears as a dangerous alternative to private sector stablecoin innovation.
For all of the discussion of CBDCs, for now governments other than Canada have proven reluctant to explore government-backed cryptocurrencies.[130] According to one interpretation, this is for the best. Writing in 2020, Goldsmith imagined a near future in which Russia skirts sanctions with an e-ruble; the US and EU in-turn respond with their own e-currencies. "[In this scenario] The near constant currency manipulation, amid global adoption of government backed cryptocurrency, results in the collapse of the international monetary system, setting the globe back nearly eighty years."[131] Further financial analysis would be needed to weigh these concerns.
Under a "first-best" regulatory scheme, a sort of regulatory nirvana with few political entanglements, honest actors, and near perfect information, a CBDC might have benefits. It might allow cross-border funds transfers with essentially no fees, potentially boosting the US economy—and other national economies—through expanded commerce. A CBDC might provide low-income workers with more rapid clearing of funds, the option to transfer funds domestically or internationally without the same types of limitations applied by many banks, and reduce reliance on credit cards to make ends meet between income payments.
The key argument for a CBDC is that it might make discretionary monetary policy more effective, allowing the Fed to rapidly change the value of money, and serving as a new policy tool along with quantitative easing and changing the federal funds rate. However, this does not change the fundamental problems with discretionary monetary policy and indeed encourages even more radical discretionary measures.
The real world is usually a world of "second-best" regulations. Information is imperfect, the Fed and the broader federal government are subjective to wide-ranging political pressures, and limitations imposed by economic philosophy or statute. In this world, CBDC is dangerous because it opens the door to the Fed "playing god" in the economy even more than it does now, changing economic processes and usurping the market in the process. The economy is dynamic, and nitpicking tax enforcement or sudden changes to a CBDC made by the Fed would likely distort the economy in other ways, for instance with a switch of capital to real estate, physical assets, or stocks. Above all, a CBDC would further obscure the value of money, making it easy to hide expansionary or inflationary activity.
Applying the ideas of rule-based monetary policy advocates, the Federal Reserve could take the lead as superintendent of the world's reserve currency and stipulate that it will not create a national government-backed cryptocurrency in any centralized regulation on the topic of cryptocurrency. Furthermore, the Federal Reserve could stipulate that no type of quantitative easing or asset purchases in the future will involve cryptocurrencies.
The Federal Reserve needs to avoid the temptation of creating a CBDC, even if other central banks in Europe, Canada, Japan, China, or Russia create such a mechanism. It may be years until there is a sufficient after-action analysis of the impacts of helicopter money and CARES Act lending.[132] Although it might be appropriate for the Federal Reserve to work with commercial banks and fintech providers to improve the architecture of accounts to integrate cryptocurrencies, the Fed must be cautious not to co-opt private custodial and transfer services with any form of account-based, bearer, or token-based CBDC.[133]
Central banking is a well-established melding of state and private economic functions. CBDCs may eliminate certain costs, particularly in context of the European Union, but would likely impose significant costs elsewhere. With the potential to compete with the private banking sector and private credit institutions, CBDCs as envisioned by the ECB and China threaten to usurp private credit creation.[134] Furthermore, CBDCs raise the specter of overconfident monetary policy, that is too responsive to political whims—particularly where consumers are deeply integrated with the central bank.
By contrast, private sector stablecoins pegged to an existing government-backed fiat currency have none of the foregoing challenges. Private stablecoins would have much lower risks of debasing the money supply, and might even promise the kind of cross-border ease of payment touted by CBDC proponents with little of the attendant risk.
In the 1970s and 1980s, during debates over the misery of “stagflation,” leading free market economists F.A. Hayek and Milton Friedman debated the idea of marketized, competing currencies.[135] Hayek wrote: “[The] convenience [of a single currency] is much less important than the opportunity to use a reliable money that will not periodically upset the smooth flow of the economy-an opportunity of which the public has been deprived by the government monopoly.” Hayek observed that denationalizing currencies would remove a powerful incentive for governments to manipulate interest rates and currency valuation.[136] Friedman countered with a defense of government involvement in currencies, within a rules-based scheme.[137]
At the time of the slow-burn Hayek-Friedman debate on this topic, the idea of free-banking was pie in the sky. But with blockchain technology at the helm, today’s financial picture is different. Private cryptocurrencies, particularly private stablecoins, are rekindling the possibility of competitive currencies—but only if these technologies are not hijacked by traditional central bank monopolies.
A rules-based approach that tolerates private stablecoin innovation and sets legal standards for its development, but avoids CBDC creation promises to bridge the gap between Hayek and Friedman, coming close to a “first best” regulatory scenario.
CONCLUSION
Fintech and cryptocurrency are here to stay. But these novel developments in the financial system must find their niche through the application of market forces and the bare minimum of regulation. The Federal Reserve must avoid the temptation of creating a CBDC and work with its Executive Branch partners to craft a minimal regulatory framework, inspired by rules-based monetary policy, that supports private sector stablecoin innovation.
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