Towards an Understanding of CBDCs as a Threat to Freedom and Privacy

In one of my previous posts Towards an Understanding of CBDC in the Financial System I discussed the distinction between wholesale and retail Central Bank Digital Currencies (CBDC)s. I took a look at the dialogue being conducted within the European context to clarify certain misconceptions as to the nature of wholesale CBDCs; how the infrastructure that supports wholesale CDBC can be adapted to take advantage of the innovations that are happening in the digital technology.

I concluded that post, with the observation that the trend around the world and in the online media is to investigate how a CBDC can be designed to benefit market economies. It appears that investigations in such economies revolve around the role of a central bank in participation with the private sector in leveraging the potential benefits of CBDC for the financial system.

In this post I will review the general argument posed by those who see CBDCs as a threat to individual freedom, privacy and a form of financial control. I will discuss the main arguments such commentators express in their opposition to CBDCs. Such arguments are based on risks associated with privacy and accessibility, stability and government interference. Given these objections the opponents to CBDCs advocate the decentralised freedoms of cryptocurrencies. I will present arguments that show that there still are risks associated with decentralised cryptocurrencies that need to be addressed through centralised oversight.

Those opposed to CBDCs are doing so on the basis of their political ideology. The opposition is based on liberal values that elevate the primacy of the individual acting in a market free from overbearing government interference. In this ideological perspective freedom and privacy are paramount any security and privacy risks also inherent in their favoured decentralised digital currencies are left unaddressed. Governments however, viewing things from a society wide perspective are trying to mitigate the harmful effects of criminal activity if things were based on a totally free decentralised digital currency world.

I will commence my discussion by presenting the liberal case put by the Cato Institute. I refer you to an article entitled The Risks of CBDCs This was published on February 23, 2023, and authored by Norbert Michel and Nicholas Anthony, henceforth referred to as the CATO authors.

The CATO authors aim to explain “Why Central Bank Digital Currencies Shouldn’t Be Adopted”.

As a “radical departure” from already highly utilised digital currencies, a CBDC as a “digital national currency” does not proffer any comparable advantages to American citizens; rather according to the CATO authors CBDCs pose “serious risks”. These risks, related to “privacy protections” result from the tight coupling that a CBDC digital liability has with a bank customer. This is in contrast to the anonymity associated with paper money. The CATO authors make the following observation: “We don’t know who’s using a $100 bill today and we don’t know who’s using a 1,000 peso bill today.”

So, the CATO authors put forward the case that CBDCs are a serious risk as they will erode existing “financial privacy protections”. Furthermore, according to the CATO authors a central bank has complete management of the regulations that decide how the central bank liability expressed in a CDBC is used. A central bank also controls the technology that compels the observance of these rules.

More generally a CDBC is a “threat to freedom” as such a currency enables government, in a myriad of ways to control and endanger the privacy enjoyed by citizens when conducting their financial activities.  The power to collect and store large amounts of data is the way a CDBC can do this.

The CATO authors pose the question: “How might such FINANCIAL CONTROL occur?” The forms that this government control can take are:

Freezing or seizing assets

A CDBC will facilitate and speedup up the process’s governments use to freeze the financial resources of “citizens” and thereby effectively “to lock them out of society, “. A CBDC facilitates this type of control by tightly linking the citizen, through a “direct line” to government.

Negative interest rates

A CDBC will enable policy makers to put in place negative interest rates, which means that instead of earning interest individuals will be “losing money”. Advocates of CBDC’s contend that would be a way to force individuals to spend their money.

Programmable spending

A key feature of a CBDC is that the government can programme the way a CBDC operates and functions. Being programmable means that a CDBC could be enabled to limit purchasing of certain products or restrict the spending behaviour of people to meet what the government determines to be desirable behaviours. The example cited, by the CATO authors is that in order to curb alcohol consumption a CBDC can be coded to limit the amount spent by an individual. Another example is prohibiting someone buying alcohol when that person has been convicted of an offense associated with alcohol consumption.

In the view of the CATO authors the foundation and future operation of financial markets could also be eroded. By way of example the availability of credit may be restricted. There is also the risk of the removal of intermediaries (“disintermediation”) such as banks.

Regarding this I would like to point out that the disintermediation in the banking sector is common. For example, customers routinely bypass the intermediation of banks when, rather than placing their money in bank accounts directly purchase securities, government bonds or by stocks.

The CATO authors point out another risk in the challenge posed by a CDBC to the increased utilisation of cryptocurrencies. I assume what is meant here is decentralised cryptocurrencies.

There is also the concern that with a CBDC financial information will be centrally stored meaning that the data will be subject to certain risks associated with centralised databases. To illustrate this the case of the US Internal Revenue Service (IRS) where the IRS’s central database of 331 million US citizens was breached. This is contrasted with a breach at a private financial institute which would affect only that institution’s customers. The customers of all the remaining private financial institutions would not suffer.

The CATO authors ask us to reflect on two contrasting scenarios concerning the results of a cyber-attack on two unlike computer networks. The first network we are asked to consider is a bitcoin network based on a decentralised database architecture. In this scenario a hacking operation on one computer would be limited to just that one component and the rest of the distributed network will continue to operate.

The second differing scenario we are asked to consider is one that involves a cyber-attack on a CBDC network. In this case we are told that the vulnerability arises from the fact that all the transactions enter the system through a central authority. If this authority is jeopardized by an attack the rest of that CBDC’s network will be paralysed.

So, we are invited to conclude that a CBDC does not “offer the benefits its proponents suggest…”.

In conclusion the CATO authors declare that a CBDC can “threaten financial privacy and financial freedom….…and undermine the banking and cryptocurrency industries.”

These risks are being taken seriously by governments. The US Federal Reserve acknowledges this in a post entitled The Fed - Security Considerations for a Central Bank Digital Currency

The Federal Reserve states CBDC “security considerations” ought to be a high priority for a central bank. Given that a CBDC should be built on established security frameworks, such as those used for existing payment systems. Such technologies could be adopted for a CBDC.

I will now draw your attention to the views expressed by another person wary of CBDCs. Ron Paul published a piece on his website concerning The Dangers Posed by State-Controlled Digital Currency.

According to Mr. Paul we can choose to eschew the path of the “state monopoly of money” and travel down the path of “…. decentralization, free competition, and individual financial sovereignty.”

Mr. Paul paints an idealistic picture of the unfettered internet unperturbed by government interference where autonomous actors choose amongst “a myriad of different solutions [which] will emerge to serve a myriad of different needs,”. According to Mr. Paul this vision is not a “dream”; we can choose and actually “grasp” the future we want for ourselves. In this world the sovereign individual can elect to place savings in “gold-backed digital currencies”.

As an aside I would like to point out that according to Investopedia a Digital Gold Currency is a type of electronic money guaranteed by gold reserves. These gold reserves are secured in the vaults of private agencies. Individuals that possess a DGC can pay each other in gold or units of currency that represent physical gold held by companies known as exchanges.

Mr. Paul does not mention that at the level of individuals there are also risks associated with a DGC. As Investopedia explains as a form of electronic money, a DGC is not only just offered by private entities but also maintained by these independent entities. This forms an “…. an additional layer of risk to the buyer.” This risk is higher in an “unregulated developing market”.

According to Investopedia:

“Management risk is from an ineffective, destructive or underperforming administration. Lack of transparency, poor oversight, slack security practices, or outright theft all threaten the digital holdings.”

I assume that this does not matter so much to Mr. Paul who in valuing freedom puts the responsibility on the individual buyers of digital currencies back by gold to perform their own risk analysis.

Investopedia points out that according to critics of DGC’s these currencies on a societal level are “…. too independent of a national financial system, and thus cannot be managed by governments in response to financial crisis.” Being directly linked to gold a DGC is not tied to any country’s monetary policies, economic system or political troubles. From the perspective of a national government a DGC is threat to the stability to the financial stability of the economic system.

Mr. Paul writes about the choice offered of gold-backed digital currencies through the tokenisation of real assets “…. to facilitate and secure physical property sales,”.

I refer you to an Economic Co-operation and Development (OECD) paper entitled The Tokenisation of Assets and Potential Implications for Financial Markets. This paper defines asset tokenisation as “….  the process of digitally representing an existing real asset on a distributed ledger…... by linking or embedding by convention the economic value and rights derived from these assets into digital tokens created on the blockchain.”

The OECD paper points out the benefits of tokenisation as well as the ways in which it can disrupt financial markets. The trading, liquidity and pricing implications are discussed. The paper also considers the need for a central authority to govern the “decentralised tokenised world”. The authors of the paper also make a case for a “centralised bank currency or stablecoins in tokenised securities.”

The OECD paper argues that the tokenisation of assets will need to be based on “…. the existence of a trusted and credible central authority that will guarantee the backing of tokens issued by the real assets, as well as hold such assets in custody. This could imply a potential central role for a third party trusted authority, such as custodians, who may be called to act as the trusted party that will guarantee the connection of the off-chain world to the distributed ledger environment.”

One role, amongst others of this suggested “trusted authority” would make sure that the “…. digital representation of the asset on the ledger is unique and that the same asset is not being represented by multiple tokens in multiple platforms.”

Finally, Mr. Paul highlights the advantages of “…. specialized cryptocurrencies can offer privacy and untraceable transactions.” Contrary to what Mr. Paul writes his assertion can be challenged to a certain degree.

CNET asked the following question: Are Cryptocurrency Transactions Actually Anonymous? According to CNET cryptocurrencies do not provide 100% anonymity and transaction are indeed traceable by law enforcement agencies.

Transactions based on the exchange of a cryptocurrency are recorded on a blockchain. There is a degree of anonymity involved as such currencies are not inevitably associated with an individual’s identity. However, there are ways in which the initiator of a transaction can be tracked down. Although there are goods and services can be exchanged directly using bitcoins it is often the case that the expenditure needs to be carried out based on the exchange of say a bitcoin for a local currency such as US dollars. In cases where the currency is heavily regulated by government, like in the USA a clear “paper trail” would be evident to the investigative authorities.

Fergus O’Sullivan writing for Cloudwards has published an article that addresses question: Is Crypto Anonymous 2023 & Is Bitcoin More Traceable Than Cash? Most Cryptocurrencies are not anonymous; they are “pseudonymous” in the sense that an individual’s wallet is identified by a string of numbers and digits that represent the wallet’s address and not the real name of the individual. For example, Bitcoin and Ethereum work in this way.

Mr. O’Sullivan writes that as a “digital space” a wallet can be accessed, and its contents moved about only by a person that has the precise address and access keys. As this address is stored in blockchain the address is basically identifiable.

As the basis of cryptocurrencies, the blockchain digital ledger tracks a token’s creation date and time. The digital ledger also records the token’s movements or changes as well as the entity responsible. The person’s actual name is not recorded on a transaction but the name of the wallet this is the person’s “pseudonym”.  People need to access and retrieve the information stored in the digital ledger. This would not possible if it is anonymous. “Though your real name won’t be there, your pseudonym — the wallet address — will.” It is this characteristic that can thwart fraudulent behaviours.

Mr. O’Sullivan qualifies the notion of a pseudonym by pointing that “there are ways around this, it involves adding an extra layer on top of the blockchain; the basics of the technology remain unchanged.”

Mr. O’Sullivan goes on to ask which cryptocurrencies are anonymous? He begins his answer with the observation that there are those would prefer the anonymity of whatever digital assets they own and the criminal activities they undertake to be “cloaked in secrecy,”.  Then there are those who seek anonymity for “moral principle of privacy.” I would add that the latter group would include our CATO authors and Mr. Ryan.

Mr. O’Sullivan points out that for those who desire anonymity, for whatever reason there are cryptocurrency options that may meet their needs. The examples he cites are Monero, Bytecoin and Zcash. These achieve “offer greater secrecy” by obfuscating through the encryption of transactions on the blockchains of these cryptocurrencies.

As a case in point, I refer you to Monero website where the question What is Monero (XMR)? is asked. Monero believes that transactions with this cryptocurrency are “confidential and untraceable.” They declare that the “…. sender, receiver, and amount of every single transaction are hidden through the use of three important technologies: Stealth Addresses, Ring Signatures, and RingCT.”

These are the kinds of cryptocurrencies are what Mr. Paul means when he writes about the use of “…. specialized cryptocurrencies can offer privacy and untraceable transactions.”

However, governmental authorities in the USA have not been idle in their efforts to find ways to trace Monero transactions. Regarding the risks with cryptocurrencies the Federal Bureau of Investigation (FBI) Internet Crime Centre (IC3) 2021 Internet Crime Report stated:

“In 2021, the IC3 received 34,202 complaints involving the use of some type of cryptocurrency, such as Bitcoin, Ethereum, Litecoin, or Ripple. While that number showed a decrease from 2020’s victim count (35,229), the loss amount reported in IC3 complaints increased nearly seven-fold, from 2020’s reported amount of $246,212,432, to total reported losses in 2021 of more than $1.6 billion.”

With respect to investment scams the IC3 2022 Internet Crime Report revealed that:

“In 2022, investment scams were the costliest scheme reported to the IC3. Investment fraud complaints increased from $1.45 billion in 2021 to $3.31 billion in 2022, which is a 127%. Within those complaints, cryptocurrency investment fraud rose from $907 million in 2021 to $2.57 billion in 2022, an increase of 183%.... Crypto-investment scams saw unprecedented increases in the number of victims and the dollar losses to these investors. Many victims have assumed massive debt to cover losses from these fraudulent”

Mr. Paul and the Cato authors don’t bring to our attention the fact that what they perceive to be many of the evils that make CBDCs risky also challenge the hoped for freedoms of the digital world of decentralised cryptocurrencies as well. These commentators are viewing digital currency technology in terms of how it can benefit an individual economic actor. However, there others who view these technologies in terms of how they can, despite the risks discussed above, through the proper governance of decentralised technologies benefit the economy and society as a whole. Indeed, the case for central control of the cryptocurrency world is strong as well as the case for CDBCs despite the risks as a way to mitigate the anarchic and for that matter criminal tendencies apparent in an unregulated digital currency world.

In many respects the views expressed by the CATO authors and Ron Paul concerning centralised regulatory frameworks and central banks to govern digital currencies are echo the views held in the past by many in the USA concerning the idea of central bank. I leave you with following quote from Roger Lowenstein to ponder on:

“To Americans of the early Twentieth Century, especially farmers, the prospect of a central bank threatened the comfortable Jeffersonian principle of small government. For people for whom local autonomy was sacrosanct, the notion of a powerful bank, joined to the even more powerful federal government, was deeply unnerving.” [1]

References

[1] Lowenstein Roger, Americas Bank. Penguin Books. 2015. p.2