Imagine the mighty dollar someday being fully replaced by a digital token. Such a reality seems one step closer now that the U.S. Federal Reserve has revealed an ongoing project looking into the possibilities and pitfalls of a Central Bank Digital Currency (CBDC). The Fed's revelation came by way of a letter written by Fed Chairperson Jerome Powell in response to questions by two members of the House of Representatives.

CBDCs have been viewed as one possible solution to the cryptocurrency dilemma governments and central banks now face. The powers that be recognize that cryptocurrency is not just a passing fad. They understand that they now must make a concerted effort to keep up with digital currency technologies or risk being overwhelmed by them.

A general perusal of cryptocurrency news seems to suggest that it is only a matter of time before CBDCs become the norm. The real question is which country will release one first. China appears to be on the cusp, though leaders in that country continue to insist that the People's Bank of China is nowhere near ready to launch a CBDC.

The basic premise of CBDCs

A CBDC is essentially a digital currency created by a national government and managed by the country's central bank. In the case of a U.S. CBDC, the currency would be created by an act of Congress. Legislation would give the Federal Reserve the authority to manage the currency just as it already manages fiat. The Fed would continue to handle monetary policy while the federal government maintained control over fiscal policy.

Functionally speaking, a CBDC exists as a currency very similar to a typical stablecoin. A stablecoin is a cryptocurrency that is backed by some other tangible asset, like fiat or a basket of securities. Stablecoins are so named because backing stabilizes prices.

There are lots of different concerns with stablecoins, not the least of which is control. A stablecoin that is not truly decentralized and censorship-resistant is a digital currency that is only one step above fiat. The same concerns exist with CBDCs.

How a U.S. CBDC would work

Let us assume the Fed and U.S. congressional leaders can agree on launching a new CBDC. What would it look like? How would it work?

For starters, the CBDC would probably be a drop-in replacement for the U.S. dollar. Regulators would tend to move slowly as well. They would give consumers the option of continuing to use fiat, switch to the CBDC, or use both on an as-needed basis. The eventual goal would be to eliminate fiat altogether.

Having said that, fiat would only be eliminated in respect to minted coins and printed bills. A CBDC that acts as a drop-in replacement would be subjected to the same government constraints and central bank control, thus making it no different from fiat for practical purposes.

Consumers would obtain the CBDC by trading in their bills and coins. Eventually there would no longer be any cash in circulation. All business would be transacted by trading digital tokens on a computer network. Record-keeping would be a shared responsibility among merchants, banks, payment system networks and, ultimately, the Fed.

Powell says that the Fed is currently conducting its own research into the costs and benefits of a CBDC. That research includes small-scale experiments through which government researchers hope to get a better understanding of how such a system would function.

Many concerns to overcome

Will the U.S. be the first to issue a CBDC? Probably not. If they aren't even working on a prototype yet, it's highly unlikely they will beat others to the punch. Moreover, the Fed still has plenty of concerns to overcome. The first is technical capability.

It is one thing to create the Bitcoin network to support a relatively small number of users who invest in Bitcoin or spend it online. Doing so is not extremely difficult when you consider the limited number of Bitcoin transactions occurring on a daily basis. On the other hand, replacing the U.S. dollar with a digital alternative is a monumental undertaking from a technology standpoint.

If you know anything about Bitcoin, you know one of its biggest deficiencies is capacity. As Bitcoin's blockchain grows longer, the amount of work required to add blocks to the chain increases. This limits both speed and the number of transactions the network can complete in a given amount of time. Now, scale that up to a network that has to support the entire U.S. economy plus a significant number of international transactions as well.

There are fundamental questions as to whether the Fed has the technical capability to manage a CBDC. And even if they do, there are other concerns:

• Security - A national CBDC would have to be built with extremely robust security at its core. Otherwise, the system would be an open invitation to hackers looking to steal as many tokens as they can get their hands on. Poor security could cause the entire thing to collapse.

• Transparency - Everything government is supposed to be transparent to the people. But how do you make a cryptocurrency platform transparent when encryption is at the heart of security? It is a dilemma that has yet to be overcome.

• Illicit Activity - Government officials already have enough trouble dealing with illicit activity in the fiat arena. They would have their hands full with a CBDC. The way cryptocurrencies are structured makes illicit activity easier and the Fed's job harder.

• Price Stability - The Fed is also concerned about price stability given that a CBDC would probably struggle to become a reserve currency. Should it ever become a complete replacement of the dollar, its value could be undermined by the world choosing some other currency as its new reserve.

• Payments Management - The current global payments system revolves around the U.S. dollar. If a CBDC replaces the dollar but is not adopted as the world's reserve, all that goes out the window. Now the Fed has to come up with new payments policies to manage what is suddenly a wide-open economic environment.

There are other concerns not mentioned here. The point is that there is a lot more to replacing fiat with a digital currency than meets the eye. The task is not as simple as issuing digital tokens and asking consumers to turn in their bills and coins.

Why they are doing it

We finally get to the question of why the U.S. Federal Reserve is even thinking about launching a CBDC. The answer is found in U.S. Representative Bill Foster's response to the Powell letter. Foster said, in part:

"My main concern is that we are not caught flat-footed by fast moving developments in other countries that may put our economy at a competitive disadvantage and threaten the primacy of the U.S. dollar."

What Foster said is more or less, "we are terrified of Libra and China." That is really it in a nutshell. U.S. leaders are terrified that China will actually succeed in displacing the U.S. dollar as the world's reserve with its own CBDC (perhaps backed by gold). It is not likely to happen, but American law makers are terrified of it, nonetheless.

They are also scared to death of how much influence Facebook could have in global economics should they succeed in getting Libra off the ground and achieving all its stated goals. If Libra ever became all it is intended to be, consumers would have very little use for fiat currencies in the online marketplace.

What it boils down to is an understanding that the days of minted coins and printed bills are numbered. Whether they are replaced with pure cryptocurrencies, stablecoins like Libra, or CBDCs is irrelevant. They will be replaced by digital alternatives at some point in the future. World governments know that, and so they are now looking for ways to stay ahead of the private sector.

A CBDC not imminent

Anyone rooting for the private sector over governments and central banks can take some comfort in knowing that a strong national CBDC is not imminent. For all we know, China's huffing and puffing is just that. They may be no closer to launch than the U.S. And as this post demonstrates, the U.S. is not even working on a prototype yet. Everything is still in the experimental stage.

It will be interesting to observe how the EU and Japan respond. We know that EU leaders are pressing for their central bank to start work on a CBDC. We also know that Japan has been entertaining the idea. Sweden and Switzerland might also be closer to launch than any of them if rumors can be believed.

No matter how all of this plays out, one thing is clear: the U.S. has finally climbed aboard the CBDC train. It is only a matter of time before they have a digital replacement for the dollar ready to go. When it is ready, it will have a major impact on global economics if for no other reason than it will challenge our perceptions of a reserve currency. It should all be fun to watch.