The U.S. Federal Reserve is expected to publish a report about its work on a retail central bank digital currency (CBDC) or digital dollar in the coming days or weeks. We believe one of the design avenues being explored is a kind of digital cash. Not only does the design robustly address one of the most challenging issues with CBDC, privacy, but because it doesn’t use blockchain, it potentially leaves room for private payment innovation through stablecoins and bank-issued settlement tokens.
There’s a possibility that this solution could simultaneously address the financial inclusion aims which dominate the Democratic agenda and competition issues that concern Republicans when it comes to digital currency. However, the strongest feature is its ability to provide payment anonymity similar to physical 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 cash” was a research topic. MIT is working with the Boston Federal Reserve on CBDC research.
The evolution of digital cash
During the dot-com boom, the technology contender for e-money was eCash from DigiCash, 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 were rumors of interest from Goldman Sachs, Visa, Microsoft and Netscape.
The potential digital cash CBDC solution is outlined in a working paper published in March by the Swiss National Bank (SNB), which is not planning a retail CBDC itself. It’s authored by Chaum, SNB Alternative Board Member Thomas Moser, and Christian Grothoff, a Professor at the University of Bern.
The CBDC is a software-based digital token that does not use blockchain or distributed ledger and is a bearer instrument providing anonymity. It’s designed for payments, not as a store of value, and tokens will have expiry dates.
How it works
The solution is centralized, so the central bank is the sole 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 into a private software wallet that works on a smartphone. This addresses KYC processes. Neither the central or commercial bank see the money’s serial number at the point of withdrawal.
Chaum invented a cryptographic concept called blind signatures, which is about as technical as we’ll get. Once the CBDC is in the software wallet, the money is “blinded” effectively becoming anonymous. Much like for cryptocurrencies, users have private keys.
When a consumer makes a payment, the retailer does not know their identity. And one coin owned by a consumer cannot be linked with another, so there’s no digital trail. The retailer automatically verifies that the signature associated with the CBDC public key belongs to the central bank to ensure the cash is real. And the retailer has to deposit the digital cash at a bank, which prevents double-spending.
Because the retailer has to deposit the money, they don’t get the same anonymity as the consumer. So it ticks the box for addressing tax evasion. Privacy is still supported when consumers receive change for a particular currency denomination and if the retailer issues a refund.
A common issue 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 all their future money could be compromised.
What’s the catch?
Every solution has strengths and weaknesses, and this one is no different. The first one is that a country’s CBDC depends on the central bank’s private keys. If these are compromised, the solution enables the central bank to revoke the keys and also allow consumers to get their money back.
A key driver of CBDC in many countries, including the U.S., is financial inclusion. So far, we’ve mentioned the digital currency needs to use a smartphone and a bank account, both of which could be inclusion challenges. According to Pew Research, 29% of U.S. residents over 65 don’t own a smartphone.
However, the wallet can run on a computer and apparently, it’s feasible to develop lower cost specialist devices for a mass market.
Regarding bank account requirements, what’s really needed is someone to execute KYC. So that role could be performed by a government office for refugees or social welfare recipients.
Consumer KYC combined with retailers depositing the CBDC in a bank account sort of addresses anti-money laundering procedures but not in a conventional way. That could prove even more challenging 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 would not be anonymous.
Perhaps the biggest weakness is the need to be online. It’s no coincidence that Japan, with its recent Tsunami experience, was one of the first countries to explore offline payments for a CBDC.
Another paper explores offline use of this software design for a digital euro. It highlights that only the payee or payer needs to be online for the transaction and that offline could be allowed as a fallback, although there would be counterparty risks. That’s similar to credit cards that are accepted for in-flight purchases. The paper argues against a dedicated hardware solution.
And the final fallback in case of disaster is physical cash which governments would invest in precisely for this purpose.
Circling back to the main benefit of this solution, it’s privacy. People don’t like the idea of governments or private companies having access to their data.
However, in this day and age, KYC is seen as a must. But it’s worth bearing in mind that KYC is not required to get your hands on physical cash. This requirement for digital cash means that a not-so-benevolent government could use a CBDC as a tool to discriminate or lock out foes.
There’s a quote attributed to Chaum in 1996 that we were unable to verify: “The difference between a bad electronic cash system and well-developed digital cash will determine whether we will have a dictatorship or a real democracy.”