U.S. Adoption of a Central Bank Digital Currency Could Revitalize Payments Markets With Competition

The ailing U.S. payments markets could get a shot of much-needed competition if the U.S. government follows through on proposals to adopt a Central Bank Digital Currency (“CBDC”)—which would be issued by the Federal Reserve.

The competitive failings of U.S. payments markets were highlighted a few weeks ago at a Senate Judiciary Committee hearing on interchange or “swipe fees,” the fees that merchants pay on every debit and credit card transaction that operates as a hidden tax on the economy.  Senator Dick Durbin and others grilled senior executives from Visa and Mastercard for imposing a $1.2 billion hike in interchange and network fees despite the fact that retailers are reeling from the ongoing pandemic, record inflation, and already-high swipe fees that are among the highest in the world. A central focus of the hearing was that these high swipe fees, and banks and networks’ unfettered ability to hike these charges, are the product of an anticompetitive U.S. payments system.

Meanwhile, on the other side of the National Mall, the Board of Governors of the Federal Reserve System has been actively studying whether and how to launch a CBDC, which would be a digital form of money that would be widely available to the general public, and—significantly—would be a liability of the Federal Reserve, not a commercial bank. In January, the Fed published Money and Payments: The U.S. Dollar in the Age of Digital Transformation, a discussion paper setting forth initial considerations regarding a U.S. CBDC, and solicited feedback from the public. By doing so, the Fed has (somewhat belatedly) joined over a hundred other central banks that are in various stages of studying and implementing CBDCs.

These two separate streams have more in common than it might seem at first. CBDCs have been touted for their potential digital efficiencies. They present the rare opportunity to holistically upgrade the country’s currency to keep pace with the digital transactions that permeate our lives. But perhaps more importantly, CBDCs also presents the rare opportunity to fix anticompetitive problems in payments markets, which are currently dominated by card-based payments. Regulators, legislators, and courts have all tried to fix this paradigm, with limited success.

A Broken Payments System

In the U.S., credit and debit card fees have grown to record levels because the U.S. payments system is not open and competitive. Visa and Mastercard—the dominant payment networks, which were created by competing banks—have aggregated the bargaining power of virtually every bank in the U.S for decades. These banks wrote the Visa and Mastercard rules that eliminate any competition among banks for payment acceptance. As merchants are unable to negotiate against the collective power of thousands of banks, costs rise, and quality suffers. In fact, this past April, in the midst of the ongoing pandemic and record inflation, Visa and Mastercard implemented a combined $1.2 billion increase in swipe fees, which were designed to disproportionately tax digital transactions.   Unfortunately, because merchants typically operate in highly-competitive and low-margin environments, they cannot absorb these costs and must pass them on to consumers. Even worse, studies have repeatedly shown that it’s actually the most economically vulnerable that subsidize these swipe fees. In regressive fashion unworthy of any developed country, the poor pay for bankers’ breakfasts.

Viable digital alternatives do not currently exist. While cryptocurrencies and stablecoins have some advantages, the regulatory landscape is unclear, their volatility is well known after recent crashes, and private monies will always carry liquidity and compliance risk. Meanwhile, Visa and the banks have systematically co-opted and neutralized other emerging competitive threats that could pressure swipe fees, including digital wallet providers.

The CBDC Antidote

This paradigm will not change if banks and payment networks continue to be the only viable means to store and transfer our money.  But a CBDC issued by the Fed can revitalize this system. As long as the Fed keeps competitive problems in mind, the technology exists to design CBDCs to act as another rail for consumers to efficiently pay for goods and services. And unless the Fed replicates the errors of the current system and forces consumers to hold their CBDC only in banks, rather than directly or through a wide array of non-bank service providers, incumbent banks and existing payment networks will immediately have to compete for consumers’ share of spend like never before. And with competition comes innovation, lower prices, and lower fraud. With one intelligent, common-sense swoop, a CBDC can disrupt the monopoly in payments that has persisted for decades.

The potential of a CBDC to inject competition into payments is increasingly being embraced. The Bank of Canada last year found that CBDCs could force “competitive discipline” in a payments system that suffers from high swipe fees. Even more recently, a Bank for International Settlements paper noted that “by enabling a new class of payment service providers to enter the market, CBDCs could introduce more vibrancy and innovation, leading to more tailored and compelling value propositions for both payers and payees.” Everyone wins, including banks. It is no surprise that in his executive order on digital assets, President Biden pressed the Federal Reserve to continue considering how CBDCs could “improve the efficiency and reduce the costs of existing and future payments systems.”

The Fed should also bear in mind that not only do other countries not have the same level of anticompetitive conduct as the U.S., but swipe fees in those countries are also much lower than in the U.S. In other words, no country has more to gain than the U.S. from the competition that could be invigorated by a well-designed CBDC.

Missing this opportunity would be a serious mistake. And if the Fed doesn’t address payments competition and the unnecessary cost of domestic payments in its design and implementation of a CBDC—replicating all of the same problems with today’s forms of digital money—what’s the point?

Even without a CBDC, U.S. Consumers can already send cash digitally from their bank to the merchant’s bank. And while CBDCs can theoretically transfer and settle instantly, unlike credit and debit card transactions which can take days to settle, parallel real-time payments rails like the Fed’s FedNow and The Clearinghouse’s RTP are inching closer to launch and wider adoption. If a CBDC is not designed to cure the anticompetitive ills of U.S. payments systems, the high fees will persist, a regressive tax on consumers will grow worse, and so will the lack of innovation, including high rates of fraud.

If the Fed fails to tackle the core anticompetitive problems in payments, American consumers may never share in the full promise of a CBDC. They will be left relegated to legacy payment rails as the rest of the world evolves.

American consumers have long suffered from a subpar payments ecosystem relative to their international peers. Let’s not continue that status quo.

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Written by Kristian Soltes and Owen Glist

Edited by Gary J. Malone