The Federal Reserve is testing a Central Bank Digital Currency (CBDC) in the Forex markets.
The New York Federal Reserve revealed Project Cedar on 4 November 2022. Project Cedar is the Fed’s New York Innovation Center’s (NYIC) test of a CBDC in the foreign exchange (FOREX) markets. Project Cedar is the Fed’s first test of a wholesale CBDC (wCBDC)
A wCBDC is a digital reserve financial institutions hold at a central bank. They use the wCBDC for interbank payment clearing, settlement, and other wholesale transaction. Hence, a wCBDC is a CBDC is a cryptocurrency banks use for transactions with other banks.
Fed Testing Wholesale CBDC in New York
Fed engineers think a wCBDC could make the wholesale markets faster, more secure, and more efficient.
Project Cedar was testing the blockchain as an infrastructure for wCBDC transactions. Strangely, the NYIC calls its blockchain distributed ledger technology (DLT). Ultimately, they hope to make cross-border payments through the blockchain with wCBDC.
The NYIC tested a wCBDC for 12 weeks in phase one. Phase 1 tested instant settlements and atomic settlements in a simulated foreign exchange between the New York Fed and other banks. They claim the wCBDC atomically settled instant settlements in under 10 seconds.
How the Fed plans to use wCBDC
The NYIC tested several uses of wCBDC in Phase 1 of Project Cedar. Potential Fed uses of wCBDC include:
- Central Bank Liabilities. Debt and other payments in US Dollars and foreign fiat currencies such as the Euro and the Pound Sterling to Central Banks. For example, a wCBDC transaction between the New York Fed and the Bank of England that converts US dollars into Pound Sterling.
- Market Structure. For example, spot exchanges of one fiat currency for another. Such foreign exchange or FX transfers are the basis of international trade. For instance, a US company could instantly pay for Saudi oil in dollars. The Fed hopes build a whole cross-border market with wCBDC.
- Foreign Exchange or Forex Transactions. The NYIC made Forex transactions with wCBDC to test the concept. NYIC’s engineers hope to use the data from these tests to build wCBDC capable of performing more complex tasks such as paying bond interest.
They are developing a wCBDC because the New York Fed is a major player in the FX markets. For example, the Fed executes transactions for the US Treasury Department (the federal government’s finance ministry), and international monetary authorities such as the World Bank and the International Monetary Fund (IMF).
Why is the Fed Developing Atomic Swaps?
A goal of Project Cedar is to develop atomic swaps for the payment of US Treasury bonds and interest. Another is to give the IMF and the US Treasury the ability to make atomic swap payments.
To explain, an atomic swap is a payment sent between two blockchains. For example, a payment from the Fed’s blockchain to the Bank of England’s blockchain. Another use could be atomic swap payments from the US Treasury to digital wallets such as PayPal, Apple Pay, and Venmo. For example, the US Treasury could send Social Security payments or pay Treasury Bond interest through PayPal (PYPL) or Apple Pay.
A smart contract or digital robot, built into a cryptocurrency or stablecoin, makes atomic swaps. For example, a smart contract built into Wrapped Bitcoin (WBTC) makes Bitcoin (BTC) payments when somebody spends a WBTC token.
Thus, one ultimate hope at Project Cedar is to build a programmable wCBDC. For instance, a wCBDC that pays US Treasury Bond interest on a schedule. Or a wCBDC that pays federal employees or Social Security recipients.
A big reason the Fed wants Atomic Swaps is to speed up cross-border (international transactions). For instance, if the US Treasury loans Ukraine’s government money to pay its army. Atomic swaps could send that money to the National Bank of Ukraine in a few seconds. Thus Ukrainian soldiers could get back pay in a few hours.
Is a Fed Stablecoin Coming?
Another use of atomic swaps is to power a central bank stablecoin. A stablecoin such as BinanceUSD (BUSD) and Tether (USDT) makes payments in a fiat currency when somebody spends it. Notably, both Tether and Binance USD pay in US Dollars.
For example, a US CBDC, or Fed Coin, that pays in US Dollars. The US Treasury could use a Fed stablecoin to make payments to people or institutions in foreign countries. For example, the CIA could use a Fed stablecoin to pay spies with US dollars. Plus, the US Defense Department could pay foreign contractors with Fed Stablecoins.
I think demand for a Fed stablecoin could be huge because the US Dollar is the world’s reserve currency. To explain, a reserve currency is the fiat currency banks and other institutions make international payments in. Notably, the Saudis accept US dollars in payment for oil.
An interesting use for atomic swaps and programmable wCBDCs is to build a decentralized exchange (DEX) for US debt. Individuals and institutions could trade the debt in the DEX.
The goal of Project Cedar could be to give the US Treasury and the Federal Reserve the power to issue debt instantly. For example, if the Fed needs money fast to bail out a monster bank, it could issue hundreds of billions of dollars worth of debt in a few seconds by creating and releasing wCBDCs. A DEX could allow traders and investors to buy and trade debt as soon as they issue it.
The possibility of instant debt raises many political and moral questions. For example, giving the Fed or the Treasury the power to issue billions of dollars in debt could allow the President or the Fed to ignore the US Constitution. The Constitution reserves the power to issue debt and write the budget to the US House of Representatives.
Do we want to give a President the ability to finance a war or giant new entitlement programs without Congress? For example, US President Bernie Sanders (D-Vermont) could use instant debt to pay for Medicare for all without Congress’s approval.
They built phase one of Project Cedar as a multi-ledger construct. That means they built several blockchains for several cryptocurrencies.
Each blockchain had a different cryptocurrency in it. Building separate blockchains allows the NYIC to test different models of cryptocurrency. For example, cryptocurrencies built on the Ethereum (ETH), EOS (EOS), and Binance Smart Chain (BNB) cryptocurrencies.
Project Cedar is the starting point for the NYIC’s blockchain and CBDC research. They will test the products Project Cedar develops in Phase one against apps they build in future phases. Project Cedar used an Unspent Transaction Output (UTXO) data model and the Rust programming language. They built Project Cedar with a permissioned permission structure, a proof-of-authority (POA) consensus protocol, and hash-time lock contracts as the asset transfer mechanism.
The NYIC has made no design choices for a US CBDC or wCBDC. However, they claim the Phase 1 tests transacted payments in under 10 seconds. In detail, they claim Phase 1 made a minimum of 8.52 transactions a second and a maximum of 98.93 transactions per second (TPS). Hence, the Phase 1 test was faster than Bitcoin (BTC). Blockchain.com estimates Bitcoin was transacting 2.674 TPS on 7 November 2022.
A US CBDC will need a high TPS because the US Treasury makes hundreds of thousand or millions of transactions a day. Hence, the NYIC’s CBDC is not ready for US Treasury use.
Why is the Fed developing a wCBDC?
I think the New York Federal Reserve is researching a wCBDC to give the Federal Reserve some control over stablecoin and cryptocurrency markets.
The Fed will need some control over stablecoins, because they back some of the biggest stablecoins with US Treasury Debt. For example, US Treasury Bills comprised 54.57% of Tether’s cash and cash equivalents on 7 November 2022. Coin Market Cap estimates Tether (USDT) had a Fully Diluted Market Cap of $72.147 billion on 7 October 2022. Moreover, they backed Binance USD (BUSD) with $5.34 billion in US Treasury Debt and $14.32 billion in US Treasury Collateralized Repurchase Agreements in September 2022.
Thus, stablecoins could become major holders of US Treasury debt and a threat to the Treasury. To explain, stablecoin operators could have to sell billions of dollars’ worth of debt if millions or hundreds of thousands of people try cash in stablecoins at once. That could sink the value of US Treasury debt and force the Fed to buy up enormous amounts of debt to prevent economic collapse.
Notably, the British economy almost collapsed in October 2022 when pension funds started selling off enormous of British government debt. The sell off forced the Bank of England to buy up enormous amounts of British government debt to prevent a total economic meltdown.
I think a Fed Stablecoin could be less prone to meltdowns because users will have more trust in it. Thus, I think a Fed Stablecoin is coming. Project Cedar could be the beginning of a Fed Stablecoin project.