Blockchain could enable ‘instant’ FX transactions in $7 trillion market, NY Fed study finds

Federal Reserve researchers are optimistic that a central bank digital currency could greatly reduce the time and cost of cross-border foreign exchange trades, according to research released Friday.

The Federal Reserve Bank of New York’s Innovation Center published the results of the initial phase of Project Cedar, the bank’s effort to create a technical framework for a central bank digital currency that could be used by large financial institutions to verify and settle forex transactions.

“Safe and efficient cross-border payments are critical to the functioning of the global economy,” said Per von Zelowitz, director of the New York Innovation Center, in a statement

The study “revealed promising applications of blockchain technology in modernizing critical payments infrastructure, and our inaugural experiment provides a strategic launch pad for further research and development regarding the future of money and payments from the U.S. perspective,” he added.

The foreign exchange market sees more than $7 trillion in daily turnover, according to the Bank of International Settlements, and these transactions are critical components for trade between nations. Currently, FX transactions take about two days to settle, exposing parties to credit risks and making the global economy less efficient.

The New York Fed’s experiment sought to answer whether a new type of digital currency, issued by a central bank for use by the large financial institutions typically on either side of an FX trade, could bring more efficiency to the market.

Researchers found that such a “wholesale” central-bank digital currency could enable “instant” settlement, wherein each party simultaneously receives the proceeds of a transaction, versus the current patchwork system that varies based on which institution is on either side of a transaction.

The New York Fed’s research dovetails with experiments conducted by the Bank of International Settlements on the potential benefits of central bank digital currency and also echoes efforts by the Securities and Exchange Commission to devise ways to shorten the settlement time for equity trades from the current two days to one.

Technological hurdles aren’t the only obstacle, however, to shortening settlement times for cross-border transactions. Competing government policies aimed at combating money laundering and other criminal activity also slow down transactions.

Meanwhile, private creators of digital currency, like USD Coin’s

Circle are also hoping to solve problems related to the slow speed and heightened risk of cross-border payments.

In January, the Board of Governors of the Federal Reserve issued a report examining the benefits and risks of a central bank digital currency that focused on a retail digital dollar that could be used by everyday Americans, versus the wholesale model contemplated in the report issued Friday.

The Federal Reserve Bank of Boston released research in February on a retail-focused digital dollar,  showing that one code base it experimented with was capable of handling 1.7 million transactions per second, much higher than public blockchains like bitcoin

That said, issuing a retail digital dollar could bring with it risks, including the potential for weakening the U.S. banking system by giving Americans an alternative means of saving money, and many Fed officials are skeptical of its utility.

“While [central bank digital currencies] continue to generate enormous interest in the United States and other countries, I remain skeptical that a Federal Reserve CBDC would solve any major problem confronting the U.S. payment system,” Fed Governor Christopher Waller said in a speech on the topic last year.

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