If the Fed wants a digital currency, rethink deposit insurance first

Efforts to get the Federal Reserve to issue a “digital currency” should be refocused on reforming federal deposit insurance. From a depositor’s perspective, the only material difference between a Federal Reserve digital currency deposit and a traditional bank deposit is that the latter has limited deposit insurance coverage.

The Federal Reserve issues two types of central bank money — paper Federal Reserve Notes and digital Federal Reserve deposits recorded in (electronic) ledger entries that have no physical form. Digital Federal Reserve deposits can only be held by financial institutions (primarily banks) that are eligible to have master accounts at a Federal Reserve bank. 

Most businesses and consumers are prohibited from owning Federal Reserve master accounts, so they own central bank money in the form of paper currency and “bank money”— digital currency in the form of bank deposits which are exchangeable at par into paper Federal Reserve Notes. Unlike central bank digital money, bank-issued digital deposits can be subject to default losses if the bank issuing deposits fails. Bank deposit balances up to $250,000 per depositor are fully insured by the Federal Deposit Insurance Corporation, but the maximum effective insurance coverage on bank deposits can be increased simply by keeping deposit accounts in multiple banks. 

The Bank for International Settlements defines central bank digital currency as, “a digital payment instrument, denominated in the national unit of account, that is a direct liability of the central bank.”  Deposits in Federal Reserve master accounts are digital central bank currency, but under current laws and regulations, their ownership is tightly restricted. The debate about the merits of the Fed issuing digital currency is, at heart, a debate about the purposes and restrictions associated with Fed master accounts.

A Federal Reserve digital currency available to any nonbank depositor could be created in a straight-forward way using existing institutions and payments systems.  It could be created by inventing a new class of bank deposits that was backed 100 percent by deposits in the issuing bank’s Federal reserve master account with ownership rights fully segregated from other deposit accounts issued by that bank in an FDIC bank resolution. In other words, if the bank should fail, the Federal Reserve balances associated with this special class of depositors would remain the property of the bank’s account owners, and these accounts would be transferred to another solvent financial institution just as the FDIC now does with regular insured bank deposits when a bank fails.

Since this special class of bank deposits is fully guaranteed by the Fed, they should be fully exempt from deposit insurance premium assessments, which unfortunately would require new legislation to exclude these deposits from the deposit insurance assessment base. From a practical standpoint, there would need to be some legal delay time imposed between the time a customer requests that normal bank deposits be transferred into this new class of deposits and the actual transfer takes place. Banks would need a reasonable period of time to adjust their investments to accommodate the change in the required reserve balances in their Fed master account generated by the shift among deposit accounts.

Banks would be free to offer these new types of deposits if they so choose, and perhaps to place their own restrictions on the ability of account holders to move funds between regular deposits and Federal Reserve digital deposit accounts at the bank. These new Federal Reserve digital deposits would be fully transferable through existing bank payments systems, which are becoming increasingly fast and efficient with the availability of real-time retail payments processing. There is no need for a new “blockchain” payments system network or any other changes to current payments systems.  

One big open question is whether the Fed should pay interest on these segregated master account bank balances. If the Fed paid no interest, these balances would receive the same treatment as paper currency, or bank transactions deposits before the passage of the Dodd-Frank Act. If these accounts paid interest, the interest rate might be set differently than the interest rate the Fed currently pays on banks’ master account balances. Under this approach, the special digital currency account rate becomes a new tool for conducting monetary policy. A “high” rate on these accounts would draw money out of traditional bank deposits and money market funds and into Fed digital currency, which would reduce the lending capacity of financial intermediaries and restrict economic growth.

There remains the possibility that Fed digital currency could become a destabilizing force in a financial panic if bank investors ran out of traditional bank deposits and money market funds and into the safety of Fed digital currency accounts. A legally mandated time delay between the time a funds transfer application is received and the time the funds are transferred could go a long way to eradicating these concerns.    

Paul H. Kupiec is a resident scholar at the American Enterprise Institute (AEI), where he studies systemic risk and the management and regulations of banks and financial markets.