Fed’s view on the digitalization of B2B payments and digital currency

“The ultimate flaw in bitcoin and alternative money is it is contesting the State for the control of money.” Ben Hunt, Epsilon Theory

Back in February, Lael Brainard, member of the Board of Governors of the U.S. Federal Reserve System, gave a speech at Stanford’s Payment Symposium on how technology platforms are enabling businesses to transfer value instantly via new digital currencies. Her focus was not on the speed, lower cost and convenience of such payments, but the risk, and in particular how some of the new players outside the financial system can pose challenges in areas such as illicit finance, privacy, financial stability and monetary policy transmission.

Banks and payment card networks still dominate payments and make fat fees doing so. Today, when money is moved cross border via banks, the funds must be routed through correspondent banks. Goldman Sachs estimates the transaction and foreign exchange (FX) fees average 4%-4.5% of volume. Card companies charge merchants interchange, which can typically range from 2%-3.5% of transaction value.

This all comes with the knowledge that banks are subject to regulatory oversight, (i.e., they are safe) and payment card networks promise to not make cardholders pay for fraud as long as they get the right to charge usury interest to cardholders. That’s the implicit arrangement they make with the Fed. But as non-banks make inroads into payments, the Fed has specific concerns, and Brainard brought out several of those during her speech:

  • First, there is an absence of statutory and regulatory protections on insured deposits, on who pays for fraud or provides data security, on who sets standards for payment transfers, and the lack of transparency on fees and other costs.
  • Data Privacy — the integration of payments with a variety of other services (like lending, early pay finance) rely intensively on user data, and there are questions surrounding the circumstances under which that information is disclosed to third parties.
  • Digital wallets and digital currency transfers — Brainard explicitly raised a concern of digital wallets and digital currency transfers, given that these transfers can cut out the banks. This concerns her because the Federal Reserve does not have absolute authority over payment systems. Their authority is over payment systems that cover two large-value interbank payment systems (like Fedwire) but no retail payment system to date. (For more see the Fed website’s payment systems page.)

The digital wallet and digital currency issues are what I would like to explore further. Brainard commented in her speech:

“A 2018 World Bank study found that the large majority of jurisdictions have some sort of license and/or registration requirement for mobile money platforms, payment card networks or switches, or clearinghouses. The United States requires registration of a money transmitter at the federal level for purposes of Bank Secrecy Act/Anti-Money-Laundering compliance, but it does not require broader federal oversight of payment system operators.”

What the Fed is really interested in, according to Brainard, is making sure banks are at the middle of any real-time payment solution. The Fed is not interested in digital wallets and digital currencies outside the banking system. The Fed is building its FedNow service to facilitate end-to-end payment services and ensure banks are the providers of real-time payments, at any time.

Private Digital Currency Concerns

In the area of private digital-currency-based payment systems, Brainard expressed concern that the issuers of non-bank money are not regulated to the same extent as banks, the value stored in these systems is not insured directly by the FDIC, and consumers may be at risk that the issuer will not be able to honor its liabilities. To make her case, she pointed out three examples of non-banks whose holdings exceeded deposits at many banks:

  • PayPal Holdings Inc. had customer accounts that totaled $22.5 billion as of September 30, 2019;
  • Walmart had roughly $1.9 billion in deferred gift card revenue as of October 31, 2019;
  • Starbucks reported $1.6 billion in stored-value card liabilities as of September 2018

In her view, the first phase of cryptocurrencies was not the answer due to volatility, limited throughput capacity, unpredictable transaction costs, limited or no governance, and limited transparency. The second phase, stablecoins, vary widely in their underlying reference assets, the ability to redeem the stablecoin claims for the underlying assets, and the extent to which a central issuer is liable for making good on redemption rights.

In designing a future digital currency where banks play a critical role, Branaird sees there important design considerations:

  1. Is a digital currency account-based or token-based? Meaning: Is there an underlying account structure for the asset owner?
  2. What is the method for authenticating the asset owner — to open an account and to make transactions? Here we are talking about KYC and AML.
  3. Finally, how does the digital currency convert into fiat money?

Digital currencies are an ongoing research and experiment globally with central banks, but in my view, I don’t see them giving up the control of money, regardless of form.

David Gustin runs Global Business Intelligence, a research and advisory practice focused on the intersection of payments, trade finance, trade credit and working capital. He can be reached at dgustin (at) globalbanking.com.

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