Research Report | Fedcoin Blueprint and History of Non-Cash Currency

Overview

On January 20, there were rumors that the Federal Reserve planned to announce a plan to digitize the US dollar, similar to the central bank's DCEP, and the cause was a trade agreement between China and the United States.

In the past, the US government has been cautious about central bank digital currencies, so the Fed has repeatedly stated that it has no plans to issue central bank digital currencies. But the fact is that the US government has conducted a secret investigation of the central bank's digital currency a few years ago. This is the rumored federal digital currency Fedcoin plan.

The first part of this article describes the design goals of Fedcoin. The second part explores the operation mechanism and exit plan of Fedcoin.

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Report

What Fedcoin is going to replace

Modern currency issuance mechanism

Among the two highly liquid financial instruments currently issued by the central bank—tangible currency (M0) and demand deposits, government currency is tangible currency, and commercial bank demand deposits are intangible currency. Keeping accounts with central banks for payment purposes is limited to commercial banks, domestic and foreign governments, and other central banks. When the public, whether an individual or a non-financial company, wants to use this intangible money, they can only open an account at a commercial bank.

Another key feature of modern currency issuance mechanisms is that private banks cannot issue notes themselves. In contrast, issuing banknotes is a government-specific privilege. This was not always the case-in the 18th, 19th, and early 20th centuries, private banks had the power to print paper money. As the central bank increasingly assumes the role of implementing monetary policy, the government has passed legislation to give the central bank a monopoly on issuing banknotes.

Since the modern commercial banking system operates on the basis of partial reserves, that is, each dollar of bank deposits issued by the bank does not have a corresponding amount of banknote reserves, so there is a huge run-up risk in deposits. Instead, in addition to a small portion of banknotes held in the vault, the bank maintains a portfolio of income-generating assets, such as securities and loans, which must be liquidated to meet deposit redemption requirements. If these assets are damaged, banks may not be able to obtain enough paper money to redeem all deposits and will have to default.

In summary, Fedcoin should play a role not only as a substitute for physical currency (M0), but also as a substitute for bank demand deposits. Instead of replacing M0, it is better to replace M1.

Advantages of deposits and cash

Since it is a replacement for M1, in the process of designing Fedcoin, we must consider the foundation of the demand deposit and cash in M1, and design the advantages of the two into the Fedcoin mechanism.

Convenience of deposits

In most cases, non-tangible exchange media, such as deposits, are technically better payment options than paper money and coins. Deposits have an advantage: they earn interest, and when the interest rate becomes negative, this advantage is reversed. Banknotes can only be traded securely face-to-face, while intangible currencies can safely travel long distances at almost no cost. Banknotes can be easily damaged or stolen, but deposits are highly secure. Finally, cash is not easy to store and move. Although $ 1 million can be expressed in digital form in just a few bytes, it requires a suitcase-sized container to store and transport so many banknotes.

Deposit insurance

The public prefers deposits over banknotes. This is best evidenced by the fact that there are many more deposits in circulation than banknotes. Data from samples from developed countries show that transferable deposits are better than banknotes and coins in circulation The number is 9.4 times higher on average. Sweden led the way with 24.4 crowns per 1 crown, while the United States came last with a deposit of 1.40 dollars per dollar.

This is mainly because deposits are insurable. In the 1930s, in order to save the banking system that was on the verge of collapse under the impact of the economic crisis, the Congress passed the Grass-Steagall Act in 1933. The Federal Deposit Insurance Corporation (FDIC) as a bank deposit insurance The government agency was established in 1933 and began to implement deposit insurance in 1934 to avoid runs and ensure the stability of the banking system. It has opened the world's first deposit insurance system and a true deposit insurance system. Among them, the longest operating history and most influential is the US Federal Deposit Insurance System, which was formally implemented on January 1, 1934.

Government deposit insurance can partially reduce the default risk of commercial banks. The government's deposit insurance guarantees that if a bank goes bankrupt, depositors' funds will be returned.

Cash anonymity

Cash also has its own advantages. Unlike deposits, paper money can be used without the buyer providing identity information. As a result, banknotes have become a popular medium of exchange among those who wish to remain anonymous. Although inevitably used by criminals and tax evaders, the anonymity provided by cash can also be used for less evil purposes. For example, it protects consumers from potentially malicious sellers who may try to browse personal information in debit or credit card transactions.

Second, cash is not subject to scrutiny. This means that third-party operating payment mechanisms cannot directly prevent anyone who wants to accept cash or consume cash from doing so. In contrast, bank deposits do not resist censorship; individuals can be barred from opening an account with a bank, or after opening an account, they find that their ability to accept or pay deposits is hindered by the bank's risk department.

Cash offline liquidity

Cash is useful in areas where bank infrastructure penetration is slow, such as in remote western mountains or in areas where electricity and other infrastructure are temporarily paralyzed. Compared to deposits, cash is not always at a disadvantage. Charging negative interest rates on cash is difficult, which is good for cash owners. Finally, cash has less credit risk than bank deposits. Deposits provide bankers with claims on paper currency issued by banks, and paper money is a real thing, a feature that became crucial during periods of insolvency and "bank liquidation."

Cryptocurrency issued by the government for public use will represent a major breakthrough with the modern monetary system. The public (here, but not limited to the US public) will be able to buy and sell electronic money. This money may be in the form of a central bank deposit account or Fedcoin. If the central bank wants to get involved in the business of providing non-tangible currency to the public, it must have the above advantages in order to successfully accept the public.

Fedcoin operation mechanism

What distribution mechanism the Fed is most likely to adopt

After discussing the functions of Fedcoin, first of all, the currency needs to be put into use, and then it needs to face the decision of the distribution mechanism, which are: "how much" and "how".

There are two ways to set the supply of Fedcoin. Both of these methods are wisdom found in the field of traditional modern currency issuance models. A central bank that issues Fedcoin has the ability to create and destroy Fedcoin, or it can pre-allocate all supplies, both of which must meet one. As people bring existing banknotes to the central bank to buy new Fedcoin, the supply of Fedcoin in circulation also increases. When the public decided to reduce the number of Fedcoins and hand these coins to the central bank to exchange them for the same amount of banknotes, the supply contraction began. In turn, the central bank will destroy the Federal Reserve currency or use it as a reserve for future issuance.

How can the public get Fedcoin? For the central bank, the easiest option is to establish an Internet portal that allows individuals to buy Fedcoin directly from the central bank, or to fund the purchase by bank transfer or other means. As for the transaction between paper money and coins, there is a tangible medium, namely cash, which means that there must be a physical location for this exchange. Each central bank has offices to conduct such transactions. For example, the Federal Reserve has 24 branches throughout the United States. Although these branches may be repurposed to provide tokens and cash services, the network is too limited to provide comprehensive financial products.

Central banks certainly don't want to spend time and energy building branches across the country, which means they may want to work with existing businesses that already have extensive physical networks. The most suitable partner would be a commercial bank. In order to make banknotes and coins available to the public, the Central Bank has established partnerships with the banking system. When individuals or businesses need cash, they must go to a bank to convert their deposits into basic paper money. In turn, banks obtain this cash from the central bank by converting the balances deposited in the central bank into currency. It is very possible to simply extend the model to include Fedcoin, or have Fedcoin replace the cash in the current cash distribution model. If cash is to circulate with public digital currency products, then banks will provide customers with two options, one is to deposit Fedcoin, and the other is to deposit cash in exchange for deposits, and then cash out with any of the central bank products. The bank will provide customers with the ability to convert deposits to Fedcoin directly from the bank's website, and vice versa, without having to visit a branch.

The post office will be an alternative or complementary partner of the bank. The advantage of the postal system as a distribution network is that it is often better represented in poor areas than banks. In the United States, USPS seems to be open to the idea of ​​distributing cryptocurrencies to Americans; the agency recently published a study that suggested a US Post branded cryptocurrency called Postcoin, which would receive 100% reserve support and a fixed exchange rate for banknotes. If it becomes a publisher of Fedcoin rather than postal coins, the USPS will not have to worry about maintaining reserves and setting pegs, as this will be the job of the Federal Reserve.

Comparison of the advantages and disadvantages of licensed and unlicensed blockchains

There is also a very important question: Is it necessary to use a blockchain to issue central bank digital currencies such as Fedcoin? If necessary, what blockchain should I use?

First of all, the use of blockchain is considered necessary in this article. The reason is very simple. The main function of blockchain technology in the decentralization of the circulation of digital currency is that it cannot be tampered with and can be traced to the source. This is for issuers and administrators. It is more effective, and can avoid behaviors like corruption, money laundering, etc. Each of your income can be traced to the source, each transfer can be traced to the source, and the help for taxation in the future is also huge. So the more important question is whether to adopt an unlicensed blockchain or a licensed blockchain.

The blockchain is divided into "permitted blockchain" and "non-permitted blockchain", which is determined based on whether the entity can access the blockchain platform as a verifier node. In a "permitted blockchain", an entity runs a verifier node by granting permissions. In the "unlicensed blockchain", any entity that meets the technical requirements can run a verifier node. The permissioned blockchain is generally used to meet requirements such as compliance, faster payment speed, transaction throughput and settlement speed.

Speed ​​is especially important because a Fedcoin network needs to process a large number of transactions every day. Unlike allowing anyone to become a verification node, a permissioned blockchain will review a node before granting it permission to update the ledger. However, even if the blockchain is licensed, the behavior of "mining" will not be considered in this article. This article further asserts that it is unlikely to appear in any central bank digital currency.

The benefit of allowing the blockchain to review nodes and bind them to smart contracts is that once the transaction is completed, the system cannot recover the transaction. Bitcoin's final settlement result is less certain. By assigning the task of updating the blockchain to anonymous nodes, in a non-permitted blockchain network, completed transactions can be undone. For example, through a 51% attack, a miner can obtain enough control to change and restructure the old district. Piece. Licensing blockchain sacrifices a certain degree of censorship resistance to achieve better decentralization and anonymity. After all, if the true identities of these nodes are public, governments and other powerful participants can force these nodes to review transactions.

Although licensed blockchains provide faster speed, supervision, and settlement certainty, non-licensed blockchains are better at reproducing some of the characteristics of coins and banknotes, especially its ability to provide anonymity and censorship resistance. The Federal Reserve must evaluate each technology topic to determine the appropriate blockchain architecture. However, this article believes that, given the functions and historical status of the central bank, permissioned blockchain is a reasonable choice of blockchain architecture.

Should Fedcoin distribute interest to holders

One of Fedcoin's economic advantages is to allow society to eventually achieve the goal of an optimal amount of money for Milton Friedman. Friedman's point is that because cash does not generate any benefits, it causes severe Pareto inefficiency to the society; people who pay in cash must often go to the bank to save the money and obtain interest equivalent to the interest on the deposit. If you can design cash to pay interest, you can avoid unprofitable costs and society will become more efficient.

The modern central bank pays interest to those banks that hold overnight deposits with the central bank. This is called the central bank's deposit rate, or reserve rate. To what extent should the central bank provide the same level of compensation to individuals holding Fedcoin? The setting of public deposit rates is important because if central bank interest rates are too high, depositors will convert their deposits into Fedcoin. In turn, banks will be forced to raise their interest rates to attract deposits at the expense of profit margins.

The Bank of England does not pay interest on public deposits; in fact, for unprofitable accounts, it even charges a service fee, which actually sets negative interest rates on some depositors. Submarket rates are also a feature of the US currency market. When the US Postal Savings System was established in 1911, it allowed only 2% interest per year, which was lower than the approximately 3.5% interest offered by private banks. This 2% interest rate lasted until 1934 and later rose to 2.5%.

The ability to charge negative interest rates on Fedcoin is one of the key design features advocated by cashless economic proponents. When the central bank drops interest rates below zero, it must consider how to pass to the owners of Fedcoin. And vice versa, this is the best way to increase the efficiency of Pareto across society.

Fedcoin Anonymity and Regulation

Should Fedcoin have anonymity and censorship rules

Because the blockchain reveals the amount of Bitcoin in each address, the Bitcoin protocol does not provide users with complete anonymity. However, some Bitcoin-inspired cryptocurrencies, such as Dash, Monero, and Zcash, have modified their protocols to reduce the traceability of transactions. The privacy of users is replaced by the price risk brought by the high volatility of cryptocurrencies.

Banknotes and coins are unique in that they both embed anonymity and anti-censorship into a medium of stable value. Anonymity is particularly valuable in preventing situations where one party may use transaction information to exploit another. Take identity theft as an example. Given that the information provided by a debit or credit card may contribute to potential identity theft, cash is a useful form of protection for consumers to engage in transactions or they would feel unsafe.

A Bitcoin-like unlicensed blockchain is one way to achieve anonymity, and protocols like Zcash can provide anonymity. If anonymity is not as important as speed and controllability, then licensing the blockchain may be a better way to implement government digital currencies.

How Fedcoin provides settlement certainty

By default, participants in the blockchain network recognize the "difficult" chain, or the chain that contains the most blocks, which is the "standard ledger." Let everyone reach a consensus on this "regular ledger", which is the real driving force behind digital ownership in the blockchain. If tomorrow a new ledger is accepted as a truly regulated ledger without your transactions or cryptocurrencies recorded on it, then you suffer. Even if you have a local copy, the system will not recognize your "ownership" and you can no longer participate in the system.

The above applies to all blockchain protocols based on the longest chain rule (such as current Bitcoin and Ethereum). But the security guarantees of these protocols are not absolute. In these protocols, there is no guarantee that your transactions will never be reversed, and there is no guarantee that a new, longer chain will not appear in the Bitcoin protocol. In other words, the workload proves that the security concept of the blockchain is probabilistic. The longer it runs, the more blocks are generated, and the less likely your transaction will be reversed. The longer a certain proof-of-work chain (such as Bitcoin) runs, the lower the likelihood that previous transactions existing on the chain will be reversed. This concept becomes settlement finality.

It eliminates settlement risks and gives counterparties time to focus on minimizing more relevant business risks. Through large-scale value clearing and settlement systems, the central bank is an important provider of banking sector settlement certainty. For example, Target2 in Europe and CHAPS in the UK require all member banks to submit collateral to the system, ensuring settlement certainty. Over the course of the day, debt and credit are created between members. The Canadian Payments Bank guarantees that even if the actual settlement of debt and credit does not occur until today, any bank that becomes a creditor will actually receive an irrevocable final payment in real time. Member banks know that this guarantee of real-time end results is credible because if a member of Canada goes bankrupt within a day, the member's collateral will be confiscated to force termination of settlement on the day. If the collateral is insufficient, all surviving member banks have agreed to use their collateral to complete the entire system. If this is not enough, Canadian banks themselves will ensure the stability of the system, most likely by making Canadian taxpayers liable.

The central bank is the ultimate authority in determining the authenticity of banknotes. After receiving one day of cash from the customer, the retailer deposited the money into the bank at night, and the bank deposited the money into their account. The bank then hands the notes to the central bank, which scans each note to determine its legitimacy before depositing the notes in a bank account. Banks found to be holding counterfeit banknotes will not be credited to the central bank's account, and the central bank will not provide any form of compensation. Its previous transactions (converting a retailer's banknotes to bank deposits) were fictitious. Thus, counterfeiting banknotes in a banknote protocol is similar to double spending in a Bitcoin protocol; both activities reduce the ability of their respective protocols to provide settlement certainty.

Because there is no guarantee that blockchain users will not be deceived by malicious block reorganizations, non-permitted blockchains cannot provide settlement certainty. Instead, users of unlicensed blockchains must be content with probability certainty. If central banks want to provide the public with a final settlement solution, then Fedcoin, which is similar to fully centralized, would be best implemented by permitting blockchain implementation.

Fedcoin withdrawal plan

Exit plan and response

What if Fedcoin is a government-sponsored project but is not controlled by the government? If something goes wrong and the government wants to withdraw from the program? Can it initiate a controlled withdrawal?

There are actually ways to quit, just replace Fedcoin with a new exchange medium. The central bank will first set a time window during which users can take Fedcoin to a bank or post office to exchange an equivalent amount of banknotes or deposits. After the window period, the central bank will no longer accept Fedcoin as its liability and cancel its fiat currency status.

As far as Fedcoin is concerned, as long as the validator continues to work, the integrity of the Fedcoin ledger is maintained without similar wear and tear issues. However, if a competitive product like Libra appears, it will begin to steal market share, especially when Fedcoin no longer offers price stability, driving down Fedcoin's value to zero. If the central bank is willing, it can also disrupt the legacy Fedcoin issuance by creating an unlimited supply until Fedcoin loses value or spends all the Fedcoin allocated in advance.

Another risk is the Fedcoin hard fork. Assume that a large number of mining nodes agree to install the new version of the Fedcoin protocol, while other nodes choose to continue using the old protocol. This is not impossible. Consider the potential contradictions and checks and balances between the US federal and state governments, and federal court decisions are not always biased toward the federal government. Then you will understand that the concerns of this article are not groundless.

A typical example of a hard fork is the hard fork of the 2016 Ethereum protocol, which caused a significant number of adopters to continue using the legacy protocol, so Ethereum is effectively divided into the so-called Ethereum Classic and Ethereum. This can be problematic in the case of Fedcoin, as the supply of digital currencies will actually double; all those who previously held $ 1 worth of Fedcoin now hold not only $ 1 worth of Fedcoin, but also value New Fedcoin for $ 1. When Fedcoin users spend their excess Fedcoin in order to restore their desired currency holdings, the total demand will suddenly surge. In order to ensure that inflation targets are met, the central bank will have to spend a lot of resources to offset the impact of hard currency, especially open market operations, to absorb excessive Fedcoin. However, if the central bank lacks sufficient assets for liquidation, it will have to rely on taxpayers to provide funding.

In order to prevent the emergence of two versions of the blockchain, the central bank only needs to announce that it will be 1: 1 with Fedcoin and US dollars in cash, while the other version is decoupled from the US dollar. Decoupling from the fixed exchange rate system, the price of another version of Fedcoin will fall to zero. Therefore, when the central bank needs to upgrade the agreement, it can force users to exchange the remaining Fedcoin into banknotes, thereby pushing all nodes to the protocol version. Similarly, if the state government attempts to upgrade the Fedcoin protocol, but the central bank wants everyone to continue using the old protocol, it may threaten the owners of the new Fedcoin with non-convertibility, thereby preventing a malicious hard fork from occurring from the beginning.

Another risk is the exchange rate risk of the dollar itself. From the 1960s to the early 1970s, the international financial market sold a large amount of US dollars, snapped up gold and other hard currencies, which caused the US dollar's international credit to fluctuate. The first US dollar crisis since World War II broke out in October 1960. Since then, the international position of the US dollar has continued to weaken. By the early 1970s, the US dollar crisis had repeatedly occurred. The main reasons for the US dollar crisis are: the weakening of the United States ’external economic strength, a year-on-year deficit in the balance of payments, and the loss of large amounts of gold reserves, resulting in insufficient US dollar credit guarantees, coupled with severe US inflation, and the constant depreciation of the US dollar.

However, the problem of Fedcoin may be more serious. Fedcoin has legal effect in the United States, but the international market may not recognize Fedcoin as having the same value and legal effect as the US dollar. So unlike cash and bank deposits, Fedcoin purchases gold in the international market When waiting for assets, in the context of exchange rate risk, its depreciation rate may be much faster than the US dollar itself. This is also a problem that the Fed needs to consider. There is no good solution for this problem for the time being.

Conclusion

In the past year, the central bank ’s DCEP and the trade war between China and the United States have prompted other central banks to start researching central bank digital currencies. Although Bitcoin as a digital currency shows a future possibility, its volatility makes it impossible for most consumers to accept it as a settlement currency. The central bank's digital currency may correct this problem by allowing consumers to have a secure electronic currency that, like cash, is priced in existing account units. At the same time, unlike cash, this digital currency will have more use cases.

For monetary policy makers, replacing real currencies with digital currencies means that the central bank issuing the currency will be able to implement negative interest rates. In an environment where nominal interest rates are already very low or at the lower limit of zero interest rates, negative economic rates are a useful tool when an economic recession strikes.

The impact of central bank digital currencies on the existing banking system is a complex issue. As the history of economic thought and institutions shows, there are some precedents for non-tangible currencies issued by the government for public consumption. There are multiple ways to achieve government digital currency. Fedcoin can provide similar cash-level anonymity and anti-censorship capabilities, but requires a new mechanism to limit the use of micropayments to reduce the involvement of criminals and tax evaders.

risk warning:

• Beware of illegal financial activities under the banner of blockchain and new technologies. The standard consensus firmly resists the use of blockchain for illegal fundraising, online pyramid schemes, ICOs, various variants, and dissemination of bad information.

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