Fedcoin: The New Federal Reserve Central Bank Digital Currency



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  • Fedcoin: The New Federal Reserve Central Bank Digital Currency

    What is Fedcoin?

    Fedcoin is a Central Bank Digital Currency (CBDC) that runs on the blockchain. Many Central Banks are interested in using CBDCs because of their potential to modernize payments, create interbank settlement systems, make micropayments more convenient and provide faster verification times. Central banks see these advantages as enticing and believe they could help solve some fundamental problems in our current payment system like high transaction fees, delays across borders because of slow and costly clearinghouses. Low accessibility for individuals who lack bank accounts has mobile phones instead, etc.

    The impact on commercial banks will likely be significant since they will lose out both from the loss of customers migrating to digital currencies and from mutual settlements with other banks that could become redundant. Central banks hope to regain control over their monetary policy through CBDCs. It might allow them to have more effective ways to manage the money supply and stimulate the economy during downturns. Central Banks may then achieve better results at a lower cost with a CBDC implementation than if they continued working with commercial counterparties.

    To enable Fedcoin, Central Banks will issue electronic reserves in Blockchain-based currencies and operate computer systems as nodes on public or permissioned blockchains. The process of creating Fedcoin is similar to how Central Banks currently create digital banknotes using the Central Bank's own "fractional" reserve system, except that cryptographic tokens replace any physical notes. Central Banks would issue a fixed number of Fedcoin tokens to the Central Bank and then use them for direct payments among themselves, making interbank transfers obsolete. The Central Bank could also choose to allocate some fraction of its reserves in other cryptocurrencies (e.g., Bitcoin) or even commodity money like gold.

    How will it work?

    Central Banks would have their public blockchain based on either Bitcoin's or Ethereum's codebase that they assign for clearing transactions undertaken by other banks. In contrast, private blockchains may be used for issuing Fedcoin tokens. Central Banks would act as nodes on these networks as well as run their permissioned side chains. CBDCs are issued peer-to-peer from Central Bank accounts and cleared using the Central Bank's balance sheet.

    Central Banks will be responsible for ensuring that Fedcoin tokens are allocated to individuals according to a predetermined set of rules and can transfer them between accounts to settle transactions, essentially becoming financial intermediaries with centralized ledger keeping. The Central Bank acts as an arbiter that takes care of transaction verification and record-keeping. Central Banks could assign certain users/institutions specific roles like "Authorized Participants" who would create new Fedcoin tokens and new blocks on private sidechains based on Bitcoin or Ethereum codebases. These Authorized Participants must fulfill predetermined KYC/AML requirements to participate in the creation or clearing process.

    Central Banks could determine how Fedcoin tokens are created and whether to use a proof-of-work (POW) or proof-of-stake (POS) consensus mechanism. Central Banks could also choose not to hand out the same amount of Fedcoin tokens to everyone and instead hold an initial public offering (IPO). In this scenario, Central Banks would create new units of Fedcoin and allocate them only to institutional buyers. At the same time, individuals may get tokens from other banks through peer-to-peer transactions with Central Bank accounts. Central Banks could distribute these newly issued Fedcoins in proportionate amounts across all existing bank accounts.

    Central Banks might allow individuals or corporations to run nodes as part of a private permissioned blockchain network to issue their cryptocurrencies. Central Banks could also decide to give out private keys for individuals or corporations holding Fedcoin that would allow them to create more tokens at their discretion and sell them on the open market. Still, Central Banks may require each participant in the network to undertake KYC/AML procedures before getting access to these keys.

    To combat price volatility, Central Banks will have a slight inflationary bias by issuing new Fedcoins slightly faster than retiring existing ones. This should be similar to Central Banks currently inflating digital banknotes at a rate of about 2% annually. Central Banks are likely not to give Fedcoin any credit or debit functionality for the foreseeable future, unlike Central Bank-issued cryptocurrencies in other countries. Central Banks will probably not allow corporations to create Fedcoin tokens and private blockchains as they could be used for illegal activities.

    There is a central authority that decides who can send payments. However, this would go against one of the main goals of CBDCs -- providing the general public with access to Central Bank money. Central Banks will likely follow similar standards when dealing with banks on payment networks today, such as Swift, to prevent fraud and financial crimes by tracking which accounts are sending/receiving transactions. However, transaction data will not be available to Central Banks. Central Banks may not even use a blockchain network themselves but instead, resort to existing distributed ledgers like Ripple or Hyperledger.

    Fedcoin tokens can also be used as an open-source payment network that Central Banks and other financial institutions could use for settlements, with the ability to choose the most appropriate tool (private or public blockchain) dependent on each situation. Central Bank cryptocurrencies could also offer higher levels of privacy by including confidential transactions where only the sender/receiver accounts are disclosed instead of a complete transaction history being recorded in a public ledger. Although users would still have the option of opting out from confidentiality if they wished, this scheme may seem similar to coin mixing, although it would be handled through Central Bank servers.

    Central Banks may also opt to provide some additional functionality such as enabling smart contracts that would allow Fedcoin tokens to be used for decentralized applications (e.g., Central Banks could register en******, and then those en****** could run their smart contracts to manage Fedcoin transactions). Central Banks will probably adopt a middle-of-the-road policy on blockchain governance instead of choosing controversial "on-chain" or "off-chain" approaches. They would like to steer clear from controversy. Central Bank blockchains may resemble private permissioned networks like R3 Corda, where each member has a copy of the entire ledger, but only specific nodes are authorized to process transactions. However, Central Bank systems might also facilitate interoperability with open public ledgers such as Bitcoin.

    To protect against bank runs, Central Bank cryptocurrencies can offer similar time delays that Central Banks have in place when dealing with physical cash. Central Banks will likely give Fedcoin tokens a set of pre-defined rules regarding alterations, similar to how Central Banks can only alter the money supply after extensive internal debates or by receiving approval from a committee. Central Banks can allow users to change the number of decimal places but cannot make any other changes without Central Bank authorization (for example, no one can create new tokens out of thin air).

    Central Banks will probably require all forms of Fedcoin transactions to be conducted in person unless they are very low-value transactions like what is seen today on vending machines (e.g., cash withdrawals would have to be done at ATMs. However, Central Banks cryptocurrencies could still be used online for reserves and the settlement of high-value transactions. Central Banks will also most likely refuse to discuss any changes with the public before implementation. However, Central Bank blockchains could deploy a mechanism known as "on-off ramps" where users can transfer funds from Fedcoin tokens back into fiat currencies if they wish (this does not necessarily apply for decentralized bitcoin exchanges).

    Central banks would probably want to maintain at least one Central Bank cryptocurrency to minimize exchange rates with other Central Bank cryptocurrencies. However, Central Banks may eventually end two or more duplicative Fedcoin projects, with one being controlled by an independent non-profit organization and another remaining under Central Bank control. Some wallets may only support Central Bank cryptocurrencies issued by governments such as USDtethers others may only support Central Bank cryptocurrencies issued by Central Banks such as Fedcoin. Individuals who want to use Central Bank cryptocurrencies may be required to open accounts with Central Banks and adhere to Know Your Customer/Anti-Money Laundering policies. However, individuals could still deposit fiat currency on Central Bank servers without having an account in the same manner that cash is currently deposited at Central Banks. Central Banks will probably prevent users from interacting with their wallet services through Tor or VPNs, which can protect against cyber criminals stealing user funds and has implications for privacy which has become a human right.

    Central banks may decide to incorporate KYC/AML laws into their blockchain cryptocurrency protocols (by default) and require anyone interacting with the network to submit identifying information to Central Banks. Central banks may decide to alter their cryptocurrency protocols (e.g., daily withdrawal limits) if they see a spike in unwanted transactions that can disrupt financial markets. Central Bank blockchains could also eventually have the ability for Central Banks to "pause" or freeze certain accounts from conducting transactions similar to how Central Banks currently close bank accounts based on suspicious activity. Central banks may choose not to support anonymity-enhancing features like CoinJoin mixing services and instead focus on tracing illicit activities by individuals. However, Central Bank blockchains could continue allowing commercial en****** such as exchanges and wallet services the freedom of choice supporting these types of privacy features.

    Central banks are likely going to embrace web applications where only authorized users can view blockchain data. Still, anyone can download the latest Central Bank blockchains and deploy a modified version of the Mimblewimble protocol, allowing third parties to verify Central Bank transactions without having access to Central Bank user balances. Central banks will want their Central Bank cryptocurrencies supported by exchanges and wallets to establish monetizable Central Bank reserves. However, most commercial en****** dealing with Central Banks will probably be required to undergo regular audits and submit semi-annual reports detailing operating metrics, including user growth, new signups, high-value transfers (e.g., > $10M), etc. Central Banks could also force regulated institutions such as banks and payment processors onto their blockchain to settle currencies issued on Fedcoin.

    Central Bank cryptocurrency will most likely be used as a settlement layer, and Central Banks will probably only support Central Bank cryptocurrencies compatible with their existing Balance Sheet and monetary policy. Central Bank cryptocurrency blockchains may feature open-source software licensed by Central Banks to commercial en****** such as exchanges and wallet services. The bank could also issue new "tokens" alongside Central Bank cryptocurrencies which Central Banks would control. If an exchange requests licensing, Central Banks may create tiers for different levels of compliance to incentivize exchanges to self-regulate their activities. These licenses would most likely have requirements similar to banks, including minimum capital reserves for operations, AML/KYC policies, etc.

    Central Banks will probably want to issue Central Bank cryptocurrencies in the same denominations as Central Bank-issued fiat currencies. Central Banks may choose to release physical Central Bank cryptocurrencies similar to how Central Banks currently issue paper banknotes. Central Banks could also release digital Central Bank cryptocurrencies that can be used by authorized users such as merchants or financial institutions within Central Bank jurisdiction.

    Central banks may eventually decide to use artificial intelligence and smart contract-enabled blockchains for cash withdrawals at ATMs or other service points using biometrics or a security token attached to a mobile device. This would allow for faster transactions since 'smart ATMs' wouldn't have to wait for multiple third-party verifications before comATMsthdrawal on behalf of an account holder. Central banks could also offer Central Bank cryptocurrency debit cards with access to Central Bank balances and Central Bank-issued cryptocurrencies. Central Banks may decide to release Central Bank-issued cryptocurrencies pegged to existing fiat currencies. Central Banks will probably target large corporations, remittance companies, financial institutions, and exchanges/service providers to support their Central Banks' blockchains.

    Central bank blockchains are likely going to use multi-signature addresses like the Lightning Network to reduce transaction fees. However, it is unlikely that most commercial users would want this feature as it increases the number of en****** involved in a given transaction. Central bank cryptocurrencies are much more likely than BTC or ETH as they have established reputations in issuing currency and monetary policy. In terms of scaling Central Bank cryptocurrencies, Central Banks will likely favor off-chain scaling solutions such as the Lightning Network, or Central Bank issued sidechain projects like Fedcoin Central Bank crypto could theoretically be used by Central Banks to issue subdirectories or tokens on top of existing blockchains to expand their monetary policy toolkit. Central banks could use these tools to expand their balance sheets without adding more base money. Central bank cryptocurrencies are most likely to be non-minable; however, mining may still play a role if Central Banks choose to create new currencies alongside Central Bank cryptocurrencies instead of for them.

    Central banks will most likely want to peg their Central Bank cryptocurrency reserves to fiat currency deposits held at commercial institutions (i.e., "FedCoin") and not just other Central Bank cryptocurrencies. Central Banks could do this to create Central Bank cryptocurrencies that are backed by actual Central Bank assets. Central banks may decide to issue new Central Bank cryptocurrencies in conjunction with Central Banks who have implemented inflation targeting; however, CBDCs will probably not be subject to an inflation-targeting regime. Central banks might eventually allow access to their Central Bitcoin wallets through web pages (e.g., 'central bank. digital') and offer BTC as a payments processor for commercial en****** within the jurisdiction of a Central Bank.


    Assuming there is general agreement among Central Banks regarding the economic benefits of issuing CBDCs over other monetary policy solutions like quantitative easing or negative interest rate policies, we could see significant countries implement CBDCs within the next 10 years. Central banks would probably want to start small with CBDCs and gradually increase Central Bank cryptocurrency supply through adoption over an extended period. Central Banks might eventually release additional Central Bank cryptocurrencies or 'subdirectories' for use by Central Banks in conjunction with other Central Bank cryptocurrencies.
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