BRIEFING

P A P E R
F eb rua ry 9, 2022 N u m b e r 134

A “Narrow” Path to Efficient

Digital Currency
B y G e o rg e S e l g i n

I
n November 2021, the President’s Working Group on more competitive digital currency market. This enhanced
Financial Markets (PWG), in cooperation with the competition would in turn result in more rapid and com-
Federal Deposit Insurance Corporation, the Office plete financial inclusion, with improved payments-system
of the Comptroller of the Currency, and the Federal efficiency stemming from enhanced price and quality com-
Reserve’s Board of Governors, released a report on stable- petition and more vigorous technical innovation.
coins, summarizing its recommendations for regulating
them.1 The PWG report was followed by the Federal Reserve’s
January 2022 “discussion paper” describing its preferred THE MEANING OF
central bank digital currency (CBDC) plan.2 Because the PWG “ D I G I TA L C U R R E N C Y ”
report would only let “insured depository institutions” issue Strictly speaking, “digital currency” refers to electronic
digital currency, were the proposals of both reports adopted, payments media that can pass directly and repeatedly from
overall participation in the digital currency market would be one electronic, or digital, wallet to another, much as old-
3
limited to insured banks and the Fed itself. fashioned paper currency can pass from one leather wallet
In this paper, I argue for broadening the scope for digital to another.5 This ability makes it unnecessary for recipients
currency market competition and innovation by allow- of digital currency to have bank accounts. Consequently,
ing for “narrow” stablecoins, meaning ones that, though digital currencies can allow even the unbanked, meaning
uninsured, are backed exclusively by Federal Reserve those who can’t afford to keep bank accounts or who simply
master account balances or, perhaps, by those balances prefer not to deal with banks, to take advantage of the
4
and certain U.S. Treasury Department securities. While speed, convenience, and low cost of digital payments.
narrow stablecoins needn’t be riskier than either insured Stablecoins are privately issued digital currencies.6 They
stablecoins or CBDC, allowing for them could make for a far are token-based, meaning that, like old-fashioned banknotes,

GEORGE SELGIN is a senior fellow and director emeritus of the Center for Monetary and Financial Alternatives at the Cato Institute.
they are claims upon, or liabilities of, their issuers only and to appropriate supervision and regulation at the depository
not (like checks) liabilities of the particular persons who offer institution and holding company level.”11
them in payment: someone offered stablecoins in payment But a plan placing the U.S. stablecoin market off-limits to
must trust the coins and the firm that issues them; but that all save insured depository institutions itself poses a serious
person needn’t worry that the payment will “bounce” because risk, namely, the risk of a highly concentrated or insuffi-
the payer lacks sufficient funds. ciently “contestable” digital currency market, dominated by
A CBDC, in contrast, can be either token-based or a small number of insured banks (or, if the Fed also enters
account-based: that is, it might simply consist of “retail” or the market, by them and the Fed).12 A digital currency mar-
“individual” central bank deposit accounts.7 The Fed’s dis- ket with few participants is likely to result in more limited
cussion paper, for example, defines a prospective Fed digital product variety, lower product quality, and higher fees than
currency as any “digital liability of the Federal Reserve that one that’s more hotly contested. It is also less likely to be
is widely available to the public.” Account-based CBDC can successful in banking the unbanked. Finally, and perhaps
also allow unbanked persons to transact digitally, provided most importantly, a stablecoin industry open only to insured
that “unbanked” is understood to mean not banked by any depository institutions may fail to provide strong incentives
8
private-market depository institution. for ongoing digital currency innovation.13
Responding to the PWG report, Fed Governor Christopher
Waller expressed similar worries.
BENEFITS AND RISKS
O F S TA B L E C O I N S I understand the attraction of forcing a new product
The above summary should suffice to justify the PWG into an old, familiar structure. But that approach and
report’s claim that, provided they are “well-designed and mindset would eliminate a key benefit of a stablecoin
appropriately regulated,” stablecoins might “support faster, arrangement—that it serves as a viable competitor
more efficient, and more inclusive payments options,” to banking organizations in their role as payment
9
including considerably cheaper cross-border remittances. providers. The Federal Reserve and the Congress
CBDC proponents believe it can offer the same benefits. have long recognized the value in a vibrant, diverse
Any digital currency also poses risks, including the risk payment system, which benefits from private-sector
of allowing illegitimate breaches of its users’ privacy or innovation. That innovation can come from outside
of serving criminal ends. But stablecoins pose a risk of the banking sector, and we should not be surprised
particular concern to regulatory authorities that CBDCs when it crops up in a commercial context, particu-
don’t pose, namely, the risk that an issuer might default as larly in Silicon Valley. When it does, we should give
a result of losses on assets backing its digital liabilities. In those innovations the chance to compete with other
theory, the mere prospect of such a default could inspire systems and providers—including banks—on a clear
redemption runs, not only on a troubled stablecoin issuer and level playing field.14
but also on solvent stablecoin issuers.10 Stablecoin issuers’
attempts to meet such runs can result in “fire sales” of their
less-liquid assets, spreading losses to other financial firms “ N A R R O W ” S TA B L E C O I N S
holding the same assets. The view that only insured depository institutions
Such systemic risk is, of course, also a feature of con- should be allowed to supply stablecoins rests on the
ventional systems of deposit banking, where it supplies assumption that stablecoins pose the same systemic risk
the rationale for deposit insurance. The assumption that posed by ordinary bank deposits. Such deposits are risky
stablecoins might also endanger not only digital currency because they’re only partially backed by perfectly safe and
users but “the broader financial system” leads naturally to liquid central bank liabilities. Otherwise, they’re backed
the PWG’s recommendation that Congress “require stable- by bank loans and other less than perfectly risk-free and
coin issuers to be insured depository institutions . . . subject liquid assets. These less-liquid and risky assets expose

2
banks to losses when their borrowers default and make it of a genuine CBDC and the status quo. Presently, the Fed is
impossible for banks to pay off all their depositors at once a “wholesale” supplier of digital currency only—and one
in the event of a run. By limiting potential depositor losses, that deals only with licensed banks, the U.S. Treasury, and
deposit insurance makes runs less likely. some government-sponsored enterprises. What’s more, it
But deposit insurance isn’t the only way deposits can be occasionally denies master accounts to banks that are legally
made safe. Another option, widely discussed if seldom put eligible for them. The Fed has been sitting on master accounts
into practice, is full-reserve or “narrow” banking. A narrow applications submitted by Kraken and Avanti, two uninsured
bank is one that fully backs its deposits with cash reserves, cryptocurrency firms that received special purpose depository
generally meaning (in the U.S. context) either Federal institution charters from the state of Wyoming in 2019. Avanti
15
Reserve notes or balances in their Fed master accounts. plans to offer a token-based stablecoin called the Avit.19
Narrow banking proponents see it as a substitute for deposit In a true CBDC arrangement, including the Fed’s “inter-
insurance, because it would also assure depositors that mediated” CBDC proposal, the central bank becomes a
their money is safe. It has the further advantage of avoid- retail supplier of digital media. In the Fed’s version, it uses
ing the “moral hazard” problem, that is, the problem of commercial banks and nonbank payment service compa-
bank depositors being inspired by insurance to favor banks nies as its digital currency distributors. Though it calls them
16
that take excessive risks. “intermediaries,” these private-sector agents are more like
Narrow stablecoins are the digital currency counterpart custodians that hold and manage retail Fed accounts on
of narrow banking, and what is proposed here is simply that behalf of the Fed and its retail customers.20
narrow stablecoin issuers be allowed to participate in the sta- The narrow stablecoin alternative is a middle course:
blecoin market along with insured stablecoin issuers. Though instead of having the Fed enter the retail CBDC business,
they would be uninsured, narrow stablecoin issuers would it would have it offer its wholesale accounts and ser-
not be exempt for other sorts of regulation. They might, for vices to a broad set of retail digital currency or stablecoin
example, be required to meet certain standards aimed at guar- providers—and not just to insured banks and thrifts. The
17
anteeing or enhancing their networks’ interoperability. They result would be a more competitive and contestable digital
should not, however, be subject to regulations that would be currency market and one in which separate stablecoin sup-
superfluous given the extraordinary safety and liquidity of the pliers would find it easier to interoperate with one another
assets backing their digital currency liabilities. as well as with ordinary banks.

A MIDDLE COURSE REFORM I: REVISED FED MASTER

Despite its name, the “synthetic CBDC” plan proposed ACCOUNT GUIDELINES
by the International Monetary Fund’s Tobias Adrian at The narrow stablecoin option could be partially imple-
the Swiss National Bank Conference in 2019 is actually mented without new legislation. Many licensed banks are
an example of a narrow stablecoin plan. Under it, central already allowed to issue digital currency. And according to
banks would offer stablecoin issuers access to their settle- Peter Conti-Brown, the Fed is legally obliged to grant master
ment accounts under the condition that they fully back their accounts to them, even if they aren’t insured.21
stablecoins with settlement account balances while insu- But as we’ve seen, the Fed has been unwilling to grant
lating that backing from claims by other creditors. Besides master accounts to uninsured institutions. Congress should
being safe, Adrian says, this arrangement “would ensure insist that it obey the law. The Federal Reserve Board is now
interoperability” of various stablecoins “by offering a com- developing master account application review guidelines for
18
mon settlement platform.” the reserve banks to follow. These guidelines should rule out
Although calling a narrow stablecoin plan one for a “syn- arbitrary refusals or delays. As I’ve suggested elsewhere, they
thetic CBDC” is a bit misleading, there’s a sense in which should also expressly provide that no master account sought
such a plan represents a compromise between the options for by an eligible, prospective narrow stablecoin issuer be

3
denied so long as the applicant meets other requirement no this is another important digital currency market entry bar-
22
more onerous than those that insured banks must meet. rier. More precisely, and more importantly, it’s a major barrier
But the Fed needn’t insist that uninsured stablecoin issu- to entry into the market for safe digital currency.
ers always maintain 100 percent reserve backing of their Fintechs’ entry into that market can be relaxed somewhat
currencies. It could safely relax the rules a little, making by making “bank” licenses available not only to ordinary
the stablecoin market that much more competitive, by banks but to providers of unbundled bank-like services.
allowing issuers to partially back their coins with short- Wyoming’s Division of Banking and several other state
term Treasury securities, while including them among banking authorities have taken this step, but as we’ve
counterparties that can use its new standing repo facility seen, the Fed still hasn’t granted a master account to any
to rapidly convert those securities into reserve balances Wyoming special purpose depository institution.
23
should they ever need to do so. The Office of the Comptroller of the Currency (OCC) has
likewise made way for unbundled “banks” through its own
special purpose national bank program. This program,
REFORM II: ENCOURAGE SPECIAL however, was held in abeyance by lawsuits, all of which have
PURPOSE BANK CHARTERS since been dismissed. The program may therefore attract
Requiring the Fed to adopt master account guidelines that some applicants at last. The suits’ dismissals may also
are friendly to narrow stablecoin issuers and already legally encourage the OCC to revive its 2020 “payments charter”
eligible for such accounts is only a first step toward achieving proposal, an alternative to the special purpose national bank
a truly efficient and dynamic digital currency market. Unless charter designed exclusively for fintech payments firms.
the set of firms legally eligible to apply for master accounts is Congress should encourage these OCC attempts to help
itself expanded, the U.S. digital currency market might still be fintechs, including actual or prospective narrow stablecoin
excessively concentrated and inadequately contested. issuers, gain access to the Fed.25
That licensed banks alone are eligible for Fed mas-
ter accounts is a legacy of the days when ordinary banks
and thrifts were the only suppliers of private-market REFORM III: NONBANK FED ACCESS
dollar-denominated payments media. It’s because these old- But Congress shouldn’t stop there. It should also amend
fashioned suppliers of substitutes for fiat money “bundle” Section 13 of the Federal Reserve Act to allow the Fed to
the provision of payments media with risky lending that grant master accounts to nonbank fintechs. That section’s
such banks can be a source of systemic risk. The Federal opening sentence begins, “Any Federal reserve bank may
Reserve Act’s denial of Fed bank master accounts and Fed receive from any of its member banks, or other depository
wholesale settlement services to all firms save licensed institutions, and from the United States.”26 The amend-
banks takes the inevitability of such bundling for granted. ment could simply replace “other depository institutions”
But new technologies can make the “unbundling” of the with “other payment service providers.” But to coun-
various services that ordinary banks offer not only possible ter reserve banks’ abuse of their discretion, it should go
24
but highly efficient. This unbundling allows specialized further by changing “may receive” to “must arrange to
financial technology firms (fintechs) to compete with banks receive” or some equivalent language.
in lending without supplying any sort of digital payments Although granting narrow stablecoin issuers and other
media—or to compete with them in supplying digital pay- uninsured fintechs direct access to the Fed may seem radical,
ments media without doing any lending. it’s a less radical step than granting that access to individu-
Although they aren’t banks, fintechs that supply payments als. It’s also a step several central banks have already taken.
media, including digital currency, can benefit by having the In 2018, the Bank of England, which long allowed only a
same access to the Fed’s accounts and services that ordinary handful of banks to have settlement accounts with it, made
banks enjoy. Today they can only access the Fed services indi- such accounts available to fintechs for the express purpose
rectly through bank correspondents. The extra cost of doing of making it easier for them to compete with banks.27 The

4
Bank of Lithuania did much the same thing when it estab- assessing every possible advantage put forward by CBDC
lished its CENTROlink payment system around the same proponents, Waller remained “skeptical that a Federal Reserve
28
time. Both programs have been quite successful. CBDC would solve any major problem confronting the U.S.
payment system. . . . Government interventions into the econ-
omy should come only to address significant market failures.”
CBDC: A FIFTH WHEEL? Waller saw no reason why the private sector should not be
Assuming that the proposed reforms allow a highly able to achieve all the benefits the Fed might achieve by issu-
competitive stablecoin industry to flourish, we must ask: ing its own digital currency.29 I share Waller’s opinion, subject
What more could a Fed CBDC contribute? Last August, Fed to a qualification: in my view, the stablecoin market is unlikely
Governor Waller asked the same question. After critically to fail, unless the government doesn’t allow it to succeed.

NOTES

1. President’s Working Group on Financial Markets, Federal perspective, there are about $2,200 billion in Federal Reserve
Deposit Insurance Corporation, and Office of the Comptrol- notes in circulation.
ler of the Currency, “Report on Stablecoins,” U.S. Department
of the Treasury, November 2021, https://home.treasury.gov/ 7. See Rod Garratt et al., “Token- or Account-Based? A
system/files/136/StableCoinReport_Nov1_508.pdf. Digital Currency Can Be Both,” Liberty Street Economics,
August 12, 2020, https://libertystreeteconomics.newyorkfed.
2. Board of Governors of the Federal Reserve System, “Money org/2020/08/token-or-account-based-a-digital-currency-
and Payments: The U.S. Dollar in the Age of Digital Trans- can-be-both/.
formation,” January 2022, https://www.federalreserve.gov/
publications/files/money-and-payments-20220120.pdf. 8. Board of Governors of the Federal Reserve System, “Money
and Payments,” p. 3.
3. Throughout this paper, the unqualified term “banks”
should be understood to refer to any licensed depository in- 9. President’s Working Group on Financial Markets, Federal
stitutions, including thrifts as well as commercial banks. The Deposit Insurance Corporation, and Office of the Comptrol-
so-called STABLE Act, introduced in the House of Represen- ler of the Currency, “Report on Stablecoins,” p.1.
tatives in November 2020, would have limited participation
in the digital currency market still further by confining it to 10. “In theory” because no stablecoin issuer has yet fallen
members of the Federal Reserve System. Stablecoin Clas- victim to a redemption run. This includes Tether, a stable-
sification and Regulation Act of 2020, H.R. 8827, 116th Cong. coin often singled out as being especially vulnerable because
(2020), https://www.congress.gov/bill/116th-congress/ of doubts concerning the assets backing its coins. See, for
house-bill/8827/actions?r=125&s=1. example, Sheila Bair and Gaurav Vasisht, “Stablecoins Are
Anything but Stable,” Barron’s, September 21, 2021, https://
4. “Backing” as used here and elsewhere in this briefing www.barrons.com/articles/stablecoins-are-anything-but-
paper refers not to any sort of government guarantees but stable-51632165895.
simply to the assets on a financial institutions’ balances
sheet that are the counterpart of certain of its liabilities. 11. President’s Working Group on Financial Markets, Federal
Deposit Insurance Corporation, and Office of the Comptrol-
5. A digital wallet is software that stores passwords and ler of the Currency, “Report on Stablecoins,” p. 17.
account information for a digital payment service, allowing
users to transfer digital currency to or receive it from other 12. While any market with many suppliers might be “com-
wallets. petitive,” a “contestable” market is one without significant
barriers to entry, and particularly one that gives all prospec-
6. The total quantity of stablecoins, which has been growing tive competitors access to the same technologies.
very rapidly, reached $172.3 billion in January 2022. Most of
these coins are pegged to the U.S. dollar. To put this figure in 13. On the relation between market contestability and

5
innovation, see Steven Bond-Smith, “Discretely Inno- nationally chartered banks and thrifts’ right to serve as
vating: The Effect of Limited Market Contestability on cryptocurrency custodians in July 2020. Office of the
Innovation and Growth,” Scottish Journal of Political Economy, Comptroller of the Currency, “Federally Chartered Banks
November 24, 2021, https://onlinelibrary.wiley.com/doi/ and Thrifts May Provide Custody Services for Crypto As-
full/10.1111/sjpe.12306. sets,” news release no. 2020-98, July 22, 2020, https://
www.occ.gov/news-issuances/news-releases/2020/nr-
14. Christopher J. Waller, “Reflections on Stablecoins and occ-2020-98.html.
Payments Innovations” (speech, Federal Reserve Bank of
Cleveland’s and the Office of Financial Research’s 2021 Fi- 21. See Peter Conti-Brown, “The Fed Wants to Veto State
nancial Stability Conference, Cleveland, Ohio, November 17, Banking Authorities. But Is That Legal?,” Brookings In-
2021), https://www.federalreserve.gov/newsevents/speech/ stitution, November 14, 2018, https://www.brookings.
waller20211117a.htm. edu/research/the-fed-wants-to-veto-state-banking-
authorities-but-is-that-legal/. Though the Fed appears to
15. Some narrow-banking proposals would also allow be obliged to grant master accounts to any licensed bank, it
banks to back their deposits with U.S. Treasury Depart- isn’t clear that it can legally issue its own CBDC as the law
ment securities. For a comprehensive website concerning now stands. Section 13 of the Federal Reserve Act allows
proposals for, and literature about, narrow banking as well the Fed to receive deposits from depository institutions
as other information regarding it, see “A Guide to Banking but not from ordinary citizens; and it is doubtful whether
Reform and Full-Reserve (Narrow) Banking,” http://www. the Fed would be acting in accordance with it by having
narrowbanking.org/. private “intermediaries” receive and manage individuals’
deposits on its behalf.
16. See Patricia M. McCoy, “The Moral Hazard Implica-
tions of Deposit Insurance: Theory and Evidence” (paper, 22. See George Selgin, “Public Comments on the Proposed
International Monetary Fund’s Seminar on Current De- Guidelines for Evaluating Requests for Accounts and Ser-
velopments in Monetary and Financial Law, Washington, vices,” May 24, 2021, https://www.cato.org/public-comments/
October 23–27, 2006), https://www.imf.org/external/np/ public-comments-proposed-guidelines-evaluating-requests-
seminars/eng/2006/mfl/pam.pdf. accounts-services; and “Keeping Fintech’s Promise: A Modest
Proposal,” The Hill, May 10, 2021, https://thehill.com/opinion/
17. On interoperability and how it would be relatively finance/552614-keeping-fintechs-promise-a-modest-proposal.
easy to achieve by issuers with access to Fed accounts, see
Manmohan Singh, Caitlin Long, and Charles Kahn, “In- 23. Concerning the standing repo facility, see Michael S.
teroperability of Stablecoins,” Central Banking, October 29, Derby, “Fed Launches Standing Repo Facility to Boost
2021, https://www.centralbanking.com/fintech/7892256/ Market Liquidity,” Wall Street Journal, updated July 28, 2021,
interoperability-of-stablecoins. https://www.wsj.com/articles/fed-launches-standing-repo-
facility-to-boost-market-liquidity-11627496260.
18. See Tobias Adrian, “Stablecoins, Central Bank Digital
Currencies, and Cross-Border Payments: A New Look at 24. See Dan Awrey, “Unbundling Banking, Money, and
the International Monetary System” (remarks, Interna- Payments,” European Corporate Governance Institute Law
tional Monetary Fund’s Swiss National Bank Conference, Working Paper no. 565/2021, June 2021, https://papers.ssrn.
Zurich, May 14, 2019), https://www.imf.org/en/News/ com/sol3/papers.cfm?abstract_id=3776739.
Articles/2019/05/13/sp051419-stablecoins-central-bank-
digital-currencies-and-cross-border-payments. 25. See Lucas Siegmund, “A Fintech Charter by Another
Name,” Regulatory Review, November 30, 2020, https://www.
19. See Cynthia Lummis, “The Fed Battles Wyoming on theregreview.org/2020/11/30/siegmund-fintech-charter-
Cryptocurrency,” Wall Street Journal, November 30, 2021, another-name/.
https://www.wsj.com/articles/the-fed-battles-wyoming-
cryptocurrency-powell-brainard-bitcoin-digital-assets- 26. “Section 13. Powers of Federal Reserve Banks,” Federal
spdi-fintech-11638308314. Reserve Act, Board of Governors of the Federal Reserve Sys-
tem, https://www.federalreserve.gov/aboutthefed/section13.
20. The Fed’s central bank digital currency “intermediar- htm.
ies” would thus play a role similar to that played by banks
presently offering custody services for holders of bitcoin 27. See Bank of England, “Bank of England Extends Direct
and other non-U.S. dollar cryptocurrencies. The Office Access to RTGS Accounts to Non-Bank Payment Service
of the Comptroller of the Currency officially recognized Providers,” news release, July 19, 2017, https://www.

6
bankofengland.co.uk/-/media/boe/files/news/2017/july/ of a Problem?” (speech, American Enterprise Institute,
boe-extends-direct-access-to-rtgs-accounts-to-non-bank- Washington, August 5, 2021), https://www.federalreserve.
payment-service-providers.pdf. gov/newsevents/speech/waller20210805a.htm. Compare
Douglas Arner, Raphael Auer, and Jon Frost, “Stablecoins:
28. See Poppy Koronka, “How Did Lithuania Become Risks, Potential and Regulation,” Bank for International
the EU’s Hottest Fintech Hub? 6 Insights from Our Ex- Settlements Working Paper no. 905, November 2020,
pert Panel,” Sifted, June 8, 2021, https://sifted.eu/articles/ https://www.bis.org/publ/work905.pdf: “it is an open ques-
lithuania-eus-hottest-fintech-hub/. tion whether central bank digital currencies . . . could in fact
provide more effective solutions to fulfil the functions that
29. Christopher J. Waller, “CBDC: A Solution in Search stablecoins are meant to address.”

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