The U.S. Federal Reserve is expected to release a report on its work on a central bank digital currency (CBDC) or retail digital dollar in the coming days or weeks. We believe that one of the design avenues explored is some sort of digital money. Not only does the design robustly address one of the most difficult issues with CBDC, privacy, but because it doesn’t use a blockchain, it potentially leaves room for private payment innovation. via stable coins and settlement tokens issued by banks.
It is possible that this solution simultaneously addresses the financial inclusion goals that dominate the Democratic agenda and the competition concerns that concern Republicans when it comes to digital currency. Its strongest feature, however, is its ability to provide payment anonymity similar to cash, but also comply with Know Your Customer (KYC) rules.
In a recent video conference, Neha Narula, director of the MIT Digital Currency Initiative, mentioned that the concept of “digital currency” was a topic of research. MIT is working with the Boston Federal Reserve on CBDC research.
The evolution of digital currency
During the dot-com boom, the technological competitor for electronic money was DigiCash’s eCash, and this CBDC design is based on the ideas of its founder David Chaum and the successor to eCash, the open source GNU Taler. During the 1990s, DigiCash was piloted by Deutsche Bank and there was rumors of interest from Goldman Sachs, Visa, Microsoft and Netscape.
The potential digital silver CBDC solution is described in a work document published in March by the Swiss National Bank (SNB), which itself does not plan a retail CBDC. It is written by Chaum, Thomas Moser, member of the board of directors of SNB Alternative, and Christian Grothoff, professor at the University of Bern.
The CBDC is a software-based digital token that does not use a blockchain or distributed ledger and is a bearer instrument ensuring anonymity. It is designed for payments, not as a store of value, and tokens will have expiration dates.
How it works
The solution is centralized, so the central bank is the only issuer and has a database of all money issued. Banks act as intermediaries providing the digital equivalent of ATMs.
A consumer can withdraw the CBDC from their account in a private software wallet that runs on a smartphone. This concerns KYC processes. Neither the central bank nor the commercial bank see the serial number of the money at the point of withdrawal.
Chaum invented a cryptographic concept called blind signatures, which is about as technical as it gets. Once the CBDC is in the software wallet, the money is “blind” and effectively becomes anonymous. Just like with cryptocurrencies, users have private keys.
When a consumer makes a payment, the retailer does not know their identity. And a part owned by a consumer cannot be linked to another, so there is no digital track. The retailer automatically verifies that the signature associated with the CBDC public key belongs to the central bank to ensure that the money is real. And the retailer has to deposit the digital money in a bank, which avoids double spending.
Because the retailer has to deposit the money, he does not have the same anonymity as the consumer. He therefore ticks the box to fight tax evasion. Privacy is always taken care of when consumers receive change for a particular currency and the retailer issues a refund.
A common problem with money laundering and bank accounts is that criminals pay people to open bank accounts on their behalf. In this case, if someone allowed a third party to use their digital wallet, that third party would need their keys. Which means that all of their future money could be in jeopardy.
What’s the catch?
Every solution has strengths and weaknesses, and this one is no different. The first is that a country’s CBDC depends on the private keys of the central bank. If these are compromised, the solution allows the central bank to revoke the keys and also allows consumers to get their money back.
Financial inclusion is one of the main drivers of the CBDC in many countries, including the United States. So far we’ve mentioned that digital currency has to use smartphone and bank account, both of which could be challenges for inclusion. According to Pew Research, 29% of US residents over 65 do not own a smartphone.
However, the wallet can run on a computer, and apparently it is possible to develop specialized devices inexpensively for a mass market.
When it comes to bank account requirements, what is really needed is someone to run KYC. This role could therefore be played by a government office for refugees or social assistance recipients.
Consumer KYC combined with retailers depositing the CBDC to a bank account somewhat addresses anti-money laundering procedures, but not in a conventional manner. This could prove to be even more difficult with person-to-person (P2P) payments.
GNU Taler, the technology on which the concept is based, is designed for consumer-to-retailer use instead of P2P payments. However, it could be adapted for P2P use, although the recipient is not anonymous.
Perhaps the biggest weakness is the need to be online. It is no coincidence that Japan, with its recent tsunami experience, was one of the first countries to explore offline payments for a CBDC.
Another paper explore offline use of this software design for a digital euro. He points out that only the payee or payer needs to be online for the transaction and that offline could be allowed as a fallback, although there are counterparty risks. It’s similar to credit cards that are accepted for in-flight purchases. The document opposes a dedicated hardware solution.
And the last resort in the event of a disaster is the physical money that governments would invest in precisely that purpose.
Coming back to the main advantage of this solution, it is confidentiality. People don’t like the idea of governments or private companies having access to their data.
However, nowadays KYC is considered a must. But it should be borne in mind that KYC does not have to get your hands on physical money. This digital money requirement means that a not-so-benevolent government could use a CBDC as a tool to discriminate or lock down enemies.
There is a quote attributed to Chaum in 1996 that we have not been able to verify: “The difference between a bad electronic money system and a well developed digital currency will determine whether we will have a dictatorship or a true democracy.