Regular followers of mine will know that I am deeply sceptical about the rush by central banks to launch digital currencies.
From my perspective central bank digital currencies, or CBDCs as they have come to be called, are likely to be associated with far more downsides and risks than upsides or solutions. I am mostly concerned about their capacity to centralise monetary power, strip conventional banks of funding and — most importantly — undermine the privacy of users.
Central banks, however, like to contend that if they don’t get involved in issuing digital currencies directly private entities (a la Diem/Libra) will beat them to it. And this, they argue (relatively compellingly) would be counterproductive for everyone, because money should not exist as a private good that sits within a walled garden — which private entities get to dictate who can use and who cannot.
By issuing CBDCs, central banks argue, they can provide the digital public monetary goods that the system requires.
But while that may sound like a noble goal, it doesn’t change the fact that the creation of a CBDC framework — no matter how tiered or limited — brings with it a radical transformation of how central banking and monetary policy is conducted. Nor does it change the fact that it transfers a lot of economic “allocation” power directly to the central bank, turning such institutions increasingly into state-directed banking institutions in their own right.
Finally, it doesn’t change the fact that the central bank is not best positioned to be a customer-facing entity, and would have to outsource most of the management of the CBDC system back to the private banks. Banks, however, would have little incentive to do a good job providing services that house or distribute CBDCs because they would receive little funding advantage from doing so.
A CBDC-issuing central bank also faces a chronic privacy paradox. If it is to remain compliant with anti-money laundering and know-your-customer regulation it must collect data directly on all its CBDC users. That, however, is not a very attractive proposition to users relative to the privacy respecting properties of physical cash or, for that matter, privately-issued stablecoins.
To get around this paradox some central banks have been considering introducing tiered privacy systems (in fact, some like the Nigerian central bank have done so already). In such cases only sums above a ceratin threshold, say $1000, would require KYC or AML filtering. Yet, if the Nigerian case is anything to go by, this too is not a solution, since to control for KYC/AML issues the structure still requires customers to have a legacy bank account to open CBDC accounts. Potential users must also accept the terms and conditions of the service, or as the eNaira.com website puts it “have the requirements for onboarding” in the first place.
These sorts of terms do not compete well with the universality of cash, a true public good, which at end the day does not require a bank account and thus does not discriminate against anyone.
A paradox-breaking solution?
In recent weeks I had grown convinced that the pressures of inflation, the Ukraine war as well rising supply-side shortages, would accelerate the pathway towards a CBDC reality which considered many of these impositions a necessary tradeoff in the greater good of issuing public digital cash.
But it turns out, unbeknown to me, others with similar concerns have been working on an entirely different solution that addresses many of the tradeoffs addressed above.
Key amongst them are United States congressman Stephen F. Lynch, who with the help of advisors like Rohan Grey, an assistant professor of law specialising in monetary matters at the Willamette University, have come up with a challenger system to be issued and managed not by the central bank but the US Treasury.
It comes to market under the paramaters of a new ECash Act proposal, that is being sponsored by Lynch, a Democrat, who is also the chairman of the Task Force on Financial Technology.
It’s a fascinating work around that I haven’t yet been able to find a downside in.
The initial details of the proposal look like this (my emphasis):
In line with these guidance and directives, the ECASH Act would establish a two-stage pilot program led by the U.S. Department of the Treasury to develop and issue an electronic version of the U.S. Dollar that promotes consumer safety and privacy, financial inclusion and equity, and anti-money laundering and counterterrorism compliance. In order to maximize consumer protection and data privacy, the bill requires Treasury to incorporate key security and functionality safeguards into e-cash that are generally associated with the use of physical currency – including anonymity, privacy, and minimal generation of data from transactions. In the interest of expanding financial inclusion, e-cash must also be interoperable with existing financial institution and payment provider systems, capable of executing peer-to-peer offline transactions, and distributed directly to the public via secured hardware devices. Moreover, the bill specifies that e-cash would be regulated similar to physical currency and subject to existing anti-money laundering, counterterrorism, Know Your Customer, and transaction reporting requirements and regulation.
And from the accompanying fact sheet (my emphasis):
E-cash must incorporate key security and functionality safeguards that are generally associated with the use of physical currency – including anonymity, privacy, and minimal generation of data from transactions. E-cash must also be distributed through secure hardware devices that are secured locally via cryptographic encryption or other similar technologies and cannot contain personal identifiable information or be subject to surveillance, transactional data collection, or censorship-enabling features. Establishes a “Monetary Privacy Board” which will review decisions and actions of the ECIP and ensure that the actions are consistent with the Act and commit to preserving the privacy interest of individuals that use e-cash. Moreover, establishes a Monetary Privacy Board to review e-cash development actions and decisions and evaluate the extent to which they preserve individual privacy.
Now, it must be stressed, this is just a legislative proposal at this stage. To become an act the bill still needs to be endorsed and supported by a broad spectrum of representatives from across the political divide.
But as a concept, it’s the first solution that properly tackles the key challenges being posed to the financial system by CBDCs as well as the proposals put forward by the Fed in their white paper in January 2022.
As Rohan explained to me, passing the responsibility of issuing eCash to the US Treasury dodges all the awkward privacy issues usually posed by CBDCs, not least because digital dollars no longer have to become a liability of the Central Bank.*
Instead, the Treasury manufactures eCash the same way it has always printed physical cash: selling the final product to the central bank at cost, and allowing the central bank to redistribute it or sell it onwards at par. The income raised from the price differential is then booked as seigniorage profit in the Treasury’s account at the Fed.
Any profit is thus “internalised” by the US Treasury, meaning the liquidity that comes with it becomes a windfall for the public purse not the central bank. This is important because it can then be redistributed in line with government policy — which is itself accountable to the usual democratic checks and balances. This is quite different to apportioning a big chunk of liquidity to the central bank and having it determine how it should be allocated and invested in the economy, or redistributed back to the banks.
Banks then have to transparently compete with the Treasury for deposit-style funding.
There is no privacy issue, meanwhile, because there is no centralised blockchain or ledger within the system. The digital cash component is issued in the form of a bearer security native to the wallet that resides within your digital device (whether that’s an iphone or a chip-bearing card doesn’t make a difference). Transaction is then device to device.
The model defeats the KYC/AML issue because unlike a bank the Treasury is not subject to the regulation in the same way. The Treasury just issues anonymous cash the way it has always done. It is up to the financial system to ensure the use of the cash complies with AML and KYC legislation. The obligation remains to declare whatever digital cash is deposited into its system in the conventional way.
Devices meanwhile can also be given quotas, meaning those who want to hodl large sums of anonymous cash beyond a key threshold, would have to obtain many devices or cards to do. In that case imagine suitcases full of cards or chips, or mobile phones being smuggled across borders instead of dollar bills — an equal if not greater friction for those intent on operating in the shadows or the fringes of the law.
Yes, I’m sure there are loopholes or problems that haven’t yet been addressed in the system. It’s also the case that I can’t vouch for the efficiency or reliability of the ledger-less technology that underpins the proposal. But, I have to say, from a purely structural perspective I do like this solution, even if (from a central bank independence point of view) it transfers a helluva lot of power to the Treasury. On the face of it at least, it seems an elegant solution that allows for a public digital dollar without any creepy surveillance-state externalities.
What’s more, if foreign ownership remains unrestricted, it could provide the US dollar with a fighting chance of retaining its global supremacy in the international financing game.
*Not all central banks are structured this way. Nor do all central banks subsidise the printing of physical cash. There are many different approaches across the central bank universe. A good (historical) explainer of the differences can be found here.