Guest Post: Professor Steven Schwarcz on “Central Bank Digital Currencies”

In yesterday’s post I mentioned in that my colleague, Professor Steven Schwarcz, gave a fascinating presentation at Federalist Society’s National Lawyer Convention for a panel entitled  “Central Bank Digital Currencies: A New Tool for Government Control?”   I’m thrilled to tell you that he’s kindly agreed to share his notes!

For some context, here’s how his panel was described by the organizers (Emphasis added):

Central Bank Digital Currencies (CBDC) are the subject of global debate. While proponents see CBDC as a new tool to promote financial stability and inclusion, critics point out that the Federal Reserve would acquire vast new powers to potentially implement a comprehensive government social credit system.

In theory, CBDC could be programmed to be used for only designated purposes, on specific items or at particular merchants. To stimulate the economy, CBDC could be programmed to expire in a certain limited time or deposited directly into certain individual’s bank accounts. These concerns about the risks posed by CBDC have been foreshadowed by the actions of American banks and payment processors to refuse to serve certain individuals, non-profit organizations, or merchants.

Actions by foreign governments illustrate the potential danger of comprehensive government control over personal financial transactions. China has banned cryptocurrencies and developed its own CBDC, which will enable the Chinese government to monitor and control personal transactions and behavior. In Canada, the government froze the bank accounts and cryptocurrency wallets of anti-vaccine mandate protestors and those who had made donations to support them. 

If the U.S. were to adopt a CBDC, how can the privacy and financial freedom of Americans be protected? Furthermore, how can the U.S. avoid some of the troubling trends seen in other countries and the troubling potential expansion of administrative power as it weighs the issue of CBDCs?

This is an area about which I knew little, but after hearing his presentation and reviewing his notes, i realize that we all need to stay current in this rapidly developing area.  (Needless to say, as you read I think you’ll the national security implications become obvious).  

Steven, being the great professor that he is, has somehow taken a topic that is complex and makes it accessible to everyone  You’ll want to be oriented to this development, so invest a few minutes!

Central Bank Digital Currencies

Steven L. Schwarcz            

            My comments draw in part from Regulating Digital Currencies: Towards an Analytical Framework, 102 Boston University Law Review 1037 (2022). 


          A U.S. central bank digital currency (“CBDC”) is virtually inevitable, in order to protect the value of the dollar.

          -There is increasing digital currency competition both from private-sector sponsored stablecoins and from foreign central-bank-sponsored digital currencies.

– For example, the People’s Bank of China digital currency, if successful, might further leverage the yuan to replace the dollar as the world’s reserve currency.

          The realistic question, therefore, should be how to design a U.S. CBDC to be efficient and yet protect personal freedoms.

          -In this regard, the immediate practical challenge is to create a “retail” CBDC—one that is used by consumers on a day-to-day basis as an alternative to cash.

          Such a retail CBDC need not, and should not, give the Federal Reserve vast new powers. For decades, we already have had a wholesale digital currency—one that is used to make payments among businesses and financial institutions. Article 4A of the Uniform Commercial Code (“UCC”) governs these electronic, or digital, payments.   

          The Fed could implement a retail CBDC simply by expanding the application of the wholesale digital payment system to retail payments.

          -To minimize government control, the Fed should (in a form of private ordering) delegate the operation of a CBDC to private-sector banks; that is, effectively, how wholesale digital currency already works.

          -Keeping bank accounts in the private sector would not disrupt the intermediated banking and regulated payment system.

          The wholesale digital payment system could easily be expanded to include retail payments.  

          This expansion would require the grafting of consumer protection and privacy laws onto UCC Article 4A, as well as clarifying the application to consumers of anti-money-laundering and know-your-customer laws.

          To assure private-sector competition, the U.S. government should not (as in China) ban private-sector digital currency development or attempt to control personal financial transactions. Non-governmental stablecoin digital currencies, for example, have real potential to add value to the monetary system, and should be encouraged.

          I have separately analyzed how governments should consider regulating such private-sector development to minimize harm. See Regulating Global Stablecoins: A Model-Law Strategy, 75 Vanderbilt Law Review (forthcoming issue no. 6, Nov. 2022), also available  here

Central Bank Digital Currencies

A. Developing Central Bank Digital Currencies.

          For central bank digital currencies, two approaches have emerged: account-based CBDC and token-based CBDC.

          Account-based versus Token-based CBDC.  In an account-based CBDC, the currency would represent a deposit at the central bank or its delegated-agent bank (for example, a commercial bank). A currency transfer would involve debiting the transferor’s account and crediting the transferee’s account. These are simply book entries in accounts that are held and managed by banks.

          In a token-based CBDC, the currency would represent cryptographically-evidenced “tokens” issued by the central bank. The recordkeeping would be maintained through a central-bank-specified form of identifying currency transfers. A currency transfer would involve the transferor producing a digital “signature” that verifies the transfer of token ownership to the transferee.

          Different jurisdictions are taking different approaches to developing a retail CBDC. The European System of Central Banks has engaged in a proof-of-concept for a token-based CBDC, designed to preserve cash-like privacy for CBDC transactions. The digital yuan being developed by the People’s Bank of China appears to combine account-based and token-based features.

          For both path-dependent and cost considerations, a retail CBDC in the United States might well start as account-based, at least initially.

          -This recognizes that wholesale digital payments are account-based.

          -As mentioned, retail digital payments could piggy-back on that technology.

B. Regulating Central Bank Digital Currencies.

          When used as a currency, a CBDC would raise both innovative legal issues as well as the types of legal issues normally associated with currencies and payment systems, although in novel contexts.

          The Regulatory Framework As discussed, an account-based retail CBDC could operate through electronic funds transfers using technologies already in place at commercial banks for wholesale electronic funds transfers.

          -To that extent, except insofar as differences between retail and wholesale currencies mandate, it should be regulated similarly to the regulation of wholesale digital funds transfers.

          -The main regulatory difference between retail and wholesale currencies concerns consumer protection.

          Transferring funds electronically from one customer’s bank account to that of another customer should be the same, in principle, whether the transfer is retail or wholesale.

          -A retail customer would initiate a funds transfer by sending a payment order to his bank; that bank would then (provided its customer’s account has sufficient funds) electronically send a payment order through an electronic network (e.g., Fedwire) to the beneficiary’s bank; and the beneficiary’s bank would (again, subject to receiving funds) credit the beneficiary’s account.       

          Regulation already covers risk of loss and counterfeiting.

          (a) Risk of loss Risk of loss includes at least three risks: mistakenly transferring funds to the wrong person; fraud risk, including fraudulently transferring funds to a wrong person; and credit risk (sometimes called insolvency risk), including the risk of the “receiving bank” paying out before being paid.

          – UCC Article 4A already covers these risks of loss.

          (b) Counterfeiting Traditionally, the counterfeiting risk for money has been concerned with illicit production of physical representations of the money. In contrast, there are two possible ways to counterfeit an account-based CBDC (although both also could be classified as fraud): by double spending, and by making transfers involving an unverified account.  

          -UCC Article 4A currently covers these counterfeiting risks.    

          Next consider privacy, money laundering, and consumer protection.

          (c) Privacy.  A CBDC might lead to more centralized data about the money supply. There is a long-established privacy interest in protecting individual financial records from government access. With private ordering, the same existing privacy protections would apply.

          We need to put privacy into perspective, however. SEC Commissioner Caroline Crenshaw describes the trade-off:

          “Investors have long been comfortable with a compromise in which they give up some limited degree of privacy by sharing their identity with the entity through which they trade securities. In return, they benefit from regulated markets that are more fair, orderly, and efficient, with less manipulation and fraud.”

          Most important, running a retail CBDC through private ordering would not require centralization of consumer information.

          -Digital payments would be made between private-sector banks, which should protect their customers’ information just like they currently do.

          (d) Money laundering Anti-money-laundering (“AML”) laws generally “set standards and promote effective implementation of legal, regulatory and operational measures for combating money laundering, terrorist financing and other related threats to the integrity of the international financial system.”

          If the introduction of a CBDC leaves the commercial banking sector as the retail depository institutions, no change should be needed, in principle, to AML laws because the CBDC would not impact existing laws.  

          In practice, though, a retail CBDC might require certain changes to AML laws. For example, these laws impose an obligation on banks to conduct customer due diligence (also known as Know-Your-Customer (“KYC”) laws). Requiring banks to scrutinize every retail digital currency transaction would impose high transaction costs due to the sheer volume of those transactions. To reduce these costs, AML laws could place a floor on the value of transfers that would trigger the need to conduct customer due diligence.

          (e) Consumer protection.  The primary goal of consumer protection is to give consumers certain rights when engaging in digital funds transfers. These rights may include limiting consumer liability for unauthorized transactions.

About the Author

Steven L. Schwarcz is a chaired distinguished professor of law & business at Duke University and has been a partner at two of the world’s leading law firms. He also has served as a distinguished visiting professor at Oxford and other top universities and has been a senior advisor to, or is a fellow of, numerous international organizations of thought-leading experts in law, finance, and insolvency.

Remember what we like to say on Lawfire®: gather the facts, examine the law, evaluate the arguments – and then decide for yourself!


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