Traditional money market funds and other kinds of cash investments could be disrupted by the introduction of a digital dollar in the U.S., Fitch Ratings says in a new report.

Earlier this year, the United States Federal Reserve Board issued a white paper on a potential central bank digital currency (CBDC). Last week, President Joe Biden issued an executive order that directs government agencies and the U.S. Treasury to explore the introduction of a digital dollar.

That executive order, “elevates the urgency for the U.S. to explore developing a CBDC, echoing the concerns of some Federal Reserve officials who think that the U.S. is falling behind global peers in developing a digital currency,” said Moody’s Investors Service in a separate report.

“A well-designed CBDC would be a faster, easily accessible form of public money that is free from credit and liquidity risk, has potential cost efficiencies in payment systems and could spur innovation in digital money,” Moody’s noted.

At the same time, it warned that the advent of a digital dollar could be a negative for banks, as it could reduce the availability of deposits for funding, and could eat into banks’ revenues from payments.

Moody’s also suggested that a CBDC could introduce new risks to the financial system, such as increasingly centralized cyber risks.

In its report, Fitch said that such a move also has potential implications for the money market sector. These include the risk of fund outflows being aggravated during periods of market stress.

For instance, at the onset of the pandemic in early 2020, U.S. institutional prime money market funds had outflows of around US$95 billion, representing approximately 15% of assets under management, “driven by investors’ increasing appetite for lower risk assets amid the pandemic fallout.”

Fitch reported that much of this cash moved to government money market funds at the time, adding that an eventual CBDC could potentially serve as an alternative destination.  A CBDC “could even challenge U.S. Treasuries as the ultimate ‘risk free’ asset, particularly in a period of potential future volatility,” Fitch warned.

“This could lead to elevated redemptions for money market funds and exacerbate market illiquidity in times of financial stress if investors move cash to assets perceived to be less risky, such as CBDC,” it said.

The Fed’s paper suggested that the risks stemming from assets shifting to a CBDC could be managed by limiting the digital dollar’s relative yield, along with potential limits on how much CBDC can be owned by one entity, and how quickly it can be accumulated.

Ultimately, the implications of introducing a CBDC will depend on its final design, the rating agencies concluded.