Federal Reserve Governor Talks Digital Innovations

Financial Services Law

How will digital innovations impact the financial system? Speaking at the Decoding Digital Currency Conference sponsored by the San Francisco Federal Reserve Bank, Federal Reserve Board Governor Lael Brainard discussed cryptocurrencies, digital currencies and distributed ledger technologies.

Given the “transformative potential” of such technology, the Federal Reserve is actively monitoring digital innovations in the financial system to understand them through a multidisciplinary lens, he told attendees.

What happened

The past decade has brought a wave of important new developments in digital technologies for payments, clearing and settlement, Brainard explained, with cryptocurrency at the leading edge. Bitcoin was the first to give shape to the “vision of a decentralized digital currency.”

“This combination of a new asset, which is not a liability of any individual or institution, and a new recordkeeping and transfer technology, which is not maintained by any single individual or institution, illustrates the powerful capabilities of today’s technologies,” he said. “But there are also serious challenges.”

Extreme volatility, the potential for investor and consumer protection risks (with consumers vulnerable to mistakes, thefts and security breaches without much recourse) and money laundering issues (such as the ability to easily transfer cryptocurrency across borders and facilitate illicit activities) present concerns for more mainstream use.

However, “the still relatively small scale of cryptocurrencies in relation to our broader financial system and relatively limited connections to our banking sector suggest that they do not currently pose a threat to financial stability,” Brainard noted. “Of course, if cryptocurrencies were to achieve wide-scale use, or their impact [were] greatly magnified through leverage, the effects could be broader.”

To avoid such problems, the Federal Reserve will continue to monitor cryptocurrencies as they evolve, he added, “with particular vigilance for any signs of growing materiality to the broader financial system.”

Brainard also responded to suggestions that central banks should create their own digital forms of currency as more stable and reliable alternatives to cryptocurrencies. A central bank digital currency might be able to overcome issues with volatility, he agreed, but “serious technical and operational challenges” exist, such as the risk of creating a global target for cyberattacks.

In addition, the issuance of central bank digital currency could have implications for retail banking beyond payments, he told attendees. “If a successful central bank digital currency were to become widely used, it could become a substitute for retail banking deposits,” Brainard said. “This could restrict banks’ ability to make loans for productive economic activities and have broader macroeconomic consequences.”

Most importantly, the Federal Reserve Board governor saw “no compelling demonstrated need for a Fed-issued digital currency. Most consumers and businesses in the U.S. already make retail payments electronically using debit and credit cards, payment applications, and the automated clearinghouse network. Moreover, people are finding easy ways to make digital payments directly to other people through a variety of mobile apps.”

With a multiplicity of mechanisms available to make payments electronically in real time, it is unclear what additional value a Fed-issued digital currency would provide over and above such options. Brainard did mention that wholesale digital settlement tokens could prove to be a more targeted use of digital currency down the road.

However, the technology behind cryptocurrencies—specifically, distributed ledger technology—could offer improvements in the way traditional financial assets are transferred and recorded, he said. The financial services industry has conducted several use cases on “operational ‘pain points’” that generate inefficiencies and delays (such as post-trade clearing and settlement of securities transactions), with promising results.

Challenges remain, however, including the need for trust and preservation of confidentiality, concepts not always present in distributed ledger technology. “The financial industry … must develop distributed ledgers that adhere to laws, regulations and policies that protect important information of the parties and their customers,” Brainard said. “Clearly, a model where every entity on the network can see everyone else’s account holdings and transactions history will not satisfy broad industry confidentiality requirements.”

With possible solutions ranging from encryption to zero-knowledge proofs, work remains before the technology can be utilized by the financial services industry, he said.

“It is an exciting time for the financial sector as digital innovations are challenging conventional thinking about currency, money and payments,” Brainard concluded. “The Federal Reserve is dedicated to continuing to monitor industry developments and conduct research in these vital areas. I remain optimistic that the financial sector will find valuable ways to employ distributed ledger technology in the area of payments, clearing and settlement in coming years.”

To read the prepared remarks, click here.

Why it matters

Highlighting a few areas of the digital innovations flooding the financial services industry, Brainard appeared most optimistic with regard to distributed ledger technology. Cryptocurrencies pose challenges with regard to volatility, consumer protection and money laundering risks, while central bank digital currencies have related problems as well as potential impact on the retail banking system. Distributed ledger technology, however, “may hold promise for strengthening traditional financial instruments and markets,” Brainard told attendees.



pursuant to New York DR 2-101(f)

© 2024 Manatt, Phelps & Phillips, LLP.

All rights reserved