Note: This is the second of two posts discussing the Atlanta Fed's 2022 Financial Markets Conference. You can read the first part of the conference summary here.
The Atlanta Fed's 2022 Financial Markets Conference, A New Era of Financial Innovation and Disruption: Challenges and Opportunities, featured policy panels, academic paper presentations, and keynote speakers exploring various developments having a significant impact on the financial system. This Policy Hub: Macroblog post covers some of the key takeaways from the discussion of three challenges facing the financial sector: central bank digital currency (CBDC); environmental, social and corporate governance investing; and cybersecurity. All three discussions highlighted how the answers to some seemingly straightforward questions involve a host of complex considerations. (My companion Policy Hub: Macroblog post focused on discussions of the current monetary policy environment, with a focus on shrinking the Fed's balance sheet.) More information on all of the sessions is available at the conference agenda page, which has links to the various sessions' videos, papers, and other presentations.
Which CBDC, If Any, Is Right for the United States?
The issue of whether the central bank should issue a digital currency, and what form such a CBDC should take, is a topic that central banks around the world have been studying with varying degrees of interest, sparked in part by the development of cryptocurrencies. The intensity of that interest increased dramatically with the announcement by Facebook, now renamed Meta, that it was developing a stablecoin called Libra, later changed to Diem. (A stablecoin is a currency that maintains a fixed value relative to some other asset, especially a sovereign currency such as the U.S. dollar.) Meta has since stopped development of Diem and sold its assets. However, the questions surrounding a CBDC remain. The FMC's CBDC panel 
pointed out that this seemingly simple question involves a variety of deep, complex issues for policymakers to consider.
The panel was led off by Nellie Liang, undersecretary for domestic finance at the US Department of the Treasury, who provided broad context for the discussion. Her remarks 
and slides discussed President Biden's executive order for government departments to study the issues associated with digital assets.
Afterward, Charles Kahn, professor emeritus at the University of Illinois, presented his paper on CBDC. The paper makes the important point that a wide variety of choices need be made in the design of a CBDC and that these decisions should be based the intended benefits from adopting a CBDC. Kahn noted that although a CBDC may have many benefits over the existing system, in many cases it is not clear whether a CBDC is the right tool for obtaining the benefits. He then discussed CBDC developments in four of the CBDC leaders: Sweden, Canada, the Bahamas, and the People's Republic of China. These four countries have different priorities and have taken different paths. The two closest to the United States in terms of economic conditions, Sweden and Canada, have both done extensive work but neither has yet implemented a CBDC.
Following Kahn, David Mills from the Federal Reserve Board presented the Federal Reserve's current thinking about CBDC. He noted that the Federal Reserve had recently published a discussion paper, "Money and Payments: The U.S. Dollar in the Age of Digital Transformation ," as a first step in fostering a broad and transparent public dialogue about CBDCs as well as a call for comments on a variety of CBDC-related issues. Mills indicated that the discussion paper raised a wide variety of issues that would need to be considered before adoption of a CBDC. Mills cited support for the US dollar's international role and promotion of financial inclusion as some potential benefits. On the other hand, he noted the potential risks it raises, including consumer privacy and financial system stability.
Paul Kupiec, from the American Enterprise Institute, provided a discussion and an article addressing several issues raised by a CBDC. He concluded that the United States should not adopt a CBDC. Kupiec argued that the issuance of such a currency would likely result in political pressures affecting the type of CBDC issued and, arguably more importantly, could create political pressure on the Fed to manage the rates paid on a CBDC for the benefit of holders rather than for monetary policy purposes. He also noted the risk that a CBDC could lead to a run on banks, with depositors shifting their funds to a CBDC. He offered as an alternative the development of private stablecoins and tokenized bank deposits that could be used for payments.
ESG and Money Management
There can be little doubt that interest in the topic of investing based on environmental, social, and corporate governance—commonly known as ESG—has exploded during the last decade. Participants at FMC considered some issues that ESG investing raises for money managers. The discussions highlighted that this seemingly simple concept in fact raises a variety of complex issues whose answers may legitimately vary among different money managers.
Dissecting Green Returns
Do ESG investors pay a financial penalty when accounting for nonfinancial considerations, or are they being rewarded through "doing well by doing good"? In a session moderated by Paula Tkac of the Atlanta Fed, a paper titled "Dissecting Green Returns" and presented by University of Chicago professor Lubos Pastor addressed these questions. Specifically, Pastor and his coauthors Rob Stambaugh and Luke Taylor looked at the returns associated with environmentally sustainable investments. They note a conflict between theorists and practitioners. Investors, money managers, and some studies suggest that green stocks tend to produce higher returns. However, theory suggests that ex ante expected green returns should be lower than investments that are not environmentally sustainable. Thus, Lubos and his coauthors study the performance of green investments. They find that the past performance was superior, but that this performance reflects the unanticipated increases in the climate concerns of investors and consumers. The superior returns disappear after controlling for changes in investors' level of environmental interest. Their findings imply that the strong historical performance of green assets does not suggest that we should expect higher returns for green assets in the future.
Anna Pavlova, of the London Business School, began her discussion by highlighting the theoretical reason that ESG investing should bring lower returns. She notes that one of the goals of ESG investing is to reduce the cost of capital to green firms, which requires that equilibrium returns on green stocks be below that of the returns on brown stocks (that is, stocks of companies with a large carbon footprint). That said, she also observed that there are a variety of ratings of overall ESG performance and for the environmental component. However, the correlations of these ratings are rather low and sometimes negative for a variety of reasons. Pavlova pointed to a paper she coauthored that offers a possible solution for the variation in ratings.
The panel discussion on ESG investing, moderated by S.P. Kothari from the Massachusetts Institute of Technology, delved more deeply into the issues associated with this type of investing. Laura Starks from the University of Texas presented a paper that raised a number of points on ESG investing. For example, she noted that the number of institutional investors, and the amount of institutionally managed funds devoted to ESG, have grown substantially.
However, Starks devoted a large portion of her presentation to the difference between ESG values (or values-based) investing versus ESG value investing. Some ESG investors avoid supporting (or investing in) companies that engage in activities that violate the ESG principles. Alternatively, some ESG values investors focus on affecting firms' ESG performance, which can mean limiting their supply of capital to firms that are not strong on ESG or through engagement with the management of firms that are not strong on ESG.
In contrast, Starks said that an ESG value investor approaches ESG from the perspective of the value of the firm as an investment. Thus, an ESG value investor is concerned that firms' poor ESG records are likely to have lower earnings or higher risk in the future, or even both. However, similar to ESG values investors, a value investor can implement the ESG value by avoiding firms with poor records, or by engaging with firms' managers in an attempt to improve the firm's ESG performance.
Lukasz Pomorski, head of ESG research at AQR Capital Management, built on Starks's discussion of ESG value versus values investing. He notes that up to a point, ESG can be valuable for risk management, but at a certain point it becomes a constraint that can have an adverse impact on a portfolio's financial performance. In response to a question from Kothari, Pomorski explained that binding restrictions not only affect portfolio diversification but also the ability of active money managers to exploit their skill. A money manager may have above-average ability to evaluate firms in some disfavored industries, but an excluded industry precludes that money manager from using that skill to benefit investors.
Pomorski also addressed a point that Starks's presentation touched on. Firms can be influenced in two ways: the cost of capital and voting stock ownership. Pomorski emphasized that these mechanisms sit in opposition to each other. The only way to raise the cost of capital is to sell the stock, but only shareholders own votes.
The final panelist, Mikhaelle Schiappacasse from Dechert LLP, reviewed the evolving ESG rules in Europe, especially those related to green finance. She observed that the European Commission has set a goal of net zero carbon emissions by 2050 and is intent on using regulations on investment to support that goal. Thus, the European rules are pushing firms and investors to divest activities with big carbon footprints and invest in those with smaller carbon footprints. However, Schiappacasse also discussed some complications in implementing these goals. One major issue is often called "greenwashing"—firms and investment managers creating only the appearance, but not the reality, of being green. Another complication she discussed is that ESG money managers can get a good rating only by investing in green assets, so they can't work with brown firms in an attempt to shrink their carbon footprint.
Cyber Risk in the Financial Sector
Finance and cyber risk management often have a hard time understanding each other, according to Patricia Mosser of Columbia University, the moderator of the FMC's cyber risk panel . In part, the lack of understanding arises from having different goals. Cyber risk is about avoiding adverse shocks, but adverse shocks are unavoidable in finance, so finance's goal is resiliency to those shocks. Another important difference is the nature of the shocks. Cyber risks, and their resulting theft or disruption, are the intention of whoever created them. Moreover, cyber shocks are not random but happen at moments of increased vulnerability. The occurrence and timing of financial shocks, on the other hand, are not intentional.
The presentation , by Jason Healey from Columbia University, noted that the nature of the cybersecurity problem has increased considerably from the early years. Then, it was simply a matter of controlling access to the computer room, but more recently anyone connected to the internet is conceivably a threat. In some respects, however, the problem has not changed much since the mid-1990s, and many of the risks remain the same. What has changed is our capacity to respond. For example, in response to an audience question, Healey noted the development of cloud computing, which allows individual firms to reduce their individual exposure to cyber risk but at the expense of increased systemic risk by concentrating risk in relatively few vendors. Healy also listed the ways that cyber risks could become a financial issue, and then he listed some ways a cyber-driven financial issue could become a financial stability issue.
Stacey Schreft, of the US Department of Treasury's Office of Financial Research and currently on assignment at the Federal Reserve Board, discussed some issues and responses to cyber risk. Schreft's presentation included figures showing some of the parties in the financial sector who are vulnerable to cyber risk and linking these to concerns about traditional financial sector risk. Among the responses she mentioned is the mitigation of vulnerabilities through the supervision of financial firms from the grassroots level. Another response has been increased collaboration across the financial sector, both within the United States and globally. These responses are attempts to strengthen vulnerabilities in the financial system's stability and improve the way we measure cyber risk.
By Larry Wall, research center executive director of the Atlanta Fed's Center for Financial Innovation and Stability, and