Banks, investors need to plan as Fed’s digital dollar pilot launches

The Federal Reserve Bank of New York has started a 12-week proof of concept project with several large banks to study the feasibility of using distributed ledger technology to manage a digital dollar. The so-called “regulated liability network” pilot will be conducted in a test environment and use simulated data. The pilot will test how banks using digital dollar tokens in a common database can speed up payments. Participating banks include BNY Mellon, Citi, HSBC, Mastercard, PNC Bank, TD Bank, Truist, U.S. Bank and Wells Fargo.

In some respects, the Fed is trying to keep up with China and India. China has been testing a central bank digital currency since April 2020; the digital yuan was an accepted currency in the Olympic Village in Beijing at the Winter Olympics this year. India launched a virtual rupee on Dec. 1. Also, India has indicated that cryptocurrency regulation would be a priority when it hosts the G-20 summit in 2023.

So, three billion people out of a total world population of 8 billion – many of them currently considered to be “unbanked” – will soon be able to use a virtual currency. Business transactions using a virtual currency hope to clear transactions faster, which could dramatically change the pace at which business happens.

Two sectors that will be taking particular interest in the Fed pilot are the banking industry and venture capital/private equity.

Many banks are evaluating their exposure to digital assets and the underlying technology as it relates to the speed of transactions as well as the ability to offer new digital currency-related products that may potentially attract more customers.

Private equity, venture capital and even large family offices are always looking for the right opportunities to invest and have been very active in the digital assets space, specifically with technology platforms that support digital currencies.

With this background, here are a few suggested actions that banks and investors should consider while the Fed pilot is ongoing, to be better prepared for what happens next.

• Stay connected to the pilot, paying attention to what the Fed says – and what it doesn’t say – about the pilot, because both are equally significant.
• Monitor news related to the digital currency pilot projects in China and India.
• Track news from the 2023 G20 meetings in India to identify potential international regulatory developments.
• Follow developments in the financial technology (fintech) marketplace related to the platforms that are already facilitating transactions with bitcoin, stablecoins and other cryptocurrencies.
• Develop minimum standards for vendors, business partners and investments (regarding proof of reserves, governance and controls).
• Financial institutions in particular need to be aware of their current exposure to cryptocurrency. They likely have customers who have sent money into the cryptocurrency ecosystem, which makes the financial institution the source of funds for whatever transactions that occurred. Institutions will need to be prepared to answer questions about these transactions during their next exam cycle.

The recent bankruptcies of large crypto-native organizations will likely expedite the regulatory process globally and create a market void, potentially encouraging traditional financial services companies to enter the marketplace on their own, well regulated, terms. There is still significant uncertainty in the crypto market, fueled by a combination of mistakes, lack of corporate governance, malicious activity and fraud. While regulators are looking to provide guidance for conduct, the digital assets industry is expected to lead the charge by setting and implementing strong standards for corporate governance.

For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.