Would a U.S. CBDC Impact MMFs?
A central bank digital currency issued by the Fed might disrupt the money-market fund market, particularly in times of financial distress. Here’s why.
As digital currencies increasingly infiltrate the financial world, figuring out how to regulate them remains at the top of policymakers’ to-do lists. Earlier this year, the Fed released a whitepaper on the topic, closely followed by an executive order from President Biden in mid-March.
One recurring exploratory theme is the notion of issuing a U.S. central bank digital currency (CBDC), which would be a digital version of physical U.S. dollars. Unlike private, decentralized cryptocurrencies such as bitcoin, a CBDC would be a direct liability of the Fed. This would also distinguish the prospective CBDC from the digital money currently available to businesses and individuals through bank accounts known as “commercial bank money,” funds that are essentially debt generated by commercial banks. Because the Fed would be acting as the sole counterparty for a U.S. CBDC, the digital fiat currency would entail no liquidity or credit risk.
The Fed’s whitepaper from earlier this year explores some of the potential ways that a CBDC could benefit the U.S. financial system. The research found that a CBDC could extend public access to safe central bank money, supporting broader inclusion in the financial system and lowering overall transaction costs for everyone. This would be especially beneficial to lower-income households.
On the other hand, a CBDC would also introduce some risks, including the possible disruption of money-market funds (MMFs) and other cash investments in the financial system. Investors and consumers may view CBDCs as an alternative to money-market funds or other short-term assets. This could lead to businesses and households electing to transfer some of their MMF investments into the digital currency. If investors moved cash to the U.S. CBDC during times of financial distress because they perceived it to be less risky, elevated redemptions for money-market funds and other investment products could exacerbate market illiquidity at a time of crisis.
In March 2020, during the height of pandemic-spurred market volatility, U.S. institutional prime MMFs had outflows of around $95 billion, or approximately 15 percent of assets under management (AUM). These outflows were largely driven by investors’ increasing appetite for lower-risk assets amid the pandemic fallout. While much of this cash moved to government MMFs at the time, a U.S. CBDC could provide an alternative destination for cash. In a future period of volatility—especially one associated with debate about the U.S. debt ceiling—the CBDC might even challenge U.S. Treasuries as the ultimate “risk free” asset.
The Fed acknowledges that there are significant complications surrounding changing the structure of the U.S. financial system, especially implementing a change that could alter the traditional roles of both the private sector and the central bank. Until the Fed shares a more concrete vision for how the potential rollout of a CBDC would look, the specifics remain unknown.
Many factors could shift how the introduction of a CBDC would play out in the financial system. For example, Fed-backed research found that the risks associated with inflows into a CBDC could be managed by limiting the yield of the CBDC relative to other monetary policy tools. The Fed is also considering a limit on how much of the CBDC a single individual or entity could own and/or how quickly a single party could accumulate the currency.
There is room for speculation about what will happen if a U.S. CBDC is implemented; the actual credit implications and disintermediation risks to MMFs and other cash products will depend on what the CBDC’s ultimate structure looks like.