The Risks of Central Bank Digital Currency
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The Risks of Central Bank Digital Currency

With the rise of Bitcoin, central banks all around the world are facing the inevitable digitization of money. Many central banks have started developing their own Central Bank Digital Currency (CBDC), including the European Central Bank, the Bank of the People’s Republic China and the Central Bank of India. In this article, I’ll discuss the risks of Central Bank Digital Currency and how it can be used for nuanced monetary policy and surveillance.

Table of Contents

The War On Cash And Why Banknotes And Coins Have No Future

With the emergence of the internet and personal computers, the use of bank notes and coins is declining and they will completely disappear in the near future.

Central Bank Digital Currency focus group in 2019

(Digital Currency focus group in 2019 by ITU PIctures)

There are several reasons why banknotes and coins will disappear:

Physical cash is the most anonymous form of money. Bitcoin is often falsely criticized for being anonymous while it is only pseudonymous. The only truly anonymous form of money is physical cash. It’s also the preferred way criminals transact.

With the recent Covid-19 pandemic and the possibility of future pandemics, physical cash is increasingly viewed as a safety hazard since viruses and bacteria can survive on the surfaces of banknotes and coins for prolonged periods of time and spread more easily. Many individuals and businesses avoided or completely stopped using cash during the pandemic. Why touch a coin or a banknote that has been in contact with hundreds of other people if you can swipe a card or pay contactless?

Physical cash is easier to counterfeit which is a thorn in the eye of governments. Governments claim the monopoly on money production and if fake coins and banknotes are circulating, it reduces the trust in their currencies. Businesses and banks have to verify that the banknotes they receive are real. This problem doesn’t exist with digital currency.

Another reason why banknotes and coins will disappear is because they don’t allow governments to control and surveil how money is used in a sufficient enough way. As discussed already, physical cash is mostly anonymous, which means governments and central banks don’t have much control over how banknotes and coins are used once they are in circulation.

Finally, printing banknotes and minting coins is a government expense. The government makes a profit from the difference between the cost of producing money and the face value of money. This profit is known as seigniorage.

If it costs the United States government $0.10 to produce a $20 banknote, the seigniorage is $19.90. On the other hand, pushing a button and creating digits on a computer doesn’t cost anything. The seigniorage with digital money is infinity. The government can profit infinitely by having the Federal Reserve create money out of thin air.

These are some of the main reasons why banknotes and coins are inferior to digital money.

Digital Money Trapped in a Slow and Cumbersome Settlement Process

Most of the money in circulation is already digital. Only around 10% of money circulating in the economy exists in the form of physical cash.

If most money is already digital and banknotes and coins are dying out, why is there even a need for Central Bank Digital Currencies? Why not just pull the remaining 10% of physical cash from circulation and convert it into digital currency? To answer this question we have to explore how payments are settled.

The current form of digital money is powered by a cumbersome and slow settlement process that is required to keep track of all bank accounts, balances, deposits, withdrawals and payments.

If you wire money to someone or swipe your Visa card at a store, your bank needs to make sure this same money cannot be spent twice. Let’s say you have a balance of $1,000 and spend $5 on a Starbucks latte. The Starbucks franchise has a balance of $200,000. After swiping your Visa card and spending your $5, your bank account must reflect the credit and show a new balance of $995 and Starbucks must receive the debit and have a balance of $200,005.

Paying for Starbucks with old settlement system

(Final payment settlement when buying a Starbucks coffee by PG.NETO)

While it seems like your money arrived at Starbucks immediately when you swiped your card, the final settlement of the payment only happens several days or weeks later. In the background, this seemingly simple transaction has to be properly accounted for. This means, your bank, Starbucks’ bank and Visa all need to make sure their accounts are in sync.

You can think of it as a ledger that keeps track of every transaction and all account balances. Every bank has its own centralized ledger and needs to make sure it doesn’t deviate from what other banks and financial institutions have in their ledger. And this is incredibly important for one simple reason: In case you spend $5 and your balance remains at $1,000, you could spend the $5 twice.

If this went undetected, you would have discovered an infinite money glitch and could buy an infinite amount of Starbucks lattes for the rest of your life. This would be the equivalent of being able to print money. But in case such an infinite money glitch existed, it would render all other money in circulation useless because trust in the currency would be lost.

This is known as the double spend problem.

How Bitcoin Solved the Double Spend Problem

In the traditional financial system the double spend problem is solved in a centralized way. Final settlement of payments takes long and is cumbersome because it must be ensured that money isn’t spent twice. Account balances and transactions have to be kept in check.

In Europe this is done through the SEPA system, which settles payments. And in the United States it is done through the CHIPS clearing system. It goes without saying that these settlement technologies are outdated and slow.

Then in 2009, Satoshi Nakamoto created Bitcoin, which for the first time in history solved the double spend problem without relying on centralization. Instead of trusting a centralized instance to make sure all transactions and account balances are in sync, Bitcoin relies on a decentralized network of thousands of independent computers that all run a copy of the Bitcoin protocol.

Each of these computers has a complete copy of all transactions that have ever happened on the network and are validating every new transaction that is taking place. Instead of a centralized network, this decentralized network of independent computers is taking care of settling payments.

Rather than taking several days or weeks, final settlement on the base-layer of Bitcoin takes as little as 10 minutes. And with the Lightning Network, a secondary layer that can be used on top of Bitcoin, transactions are almost instantaneous and cost close to nothing.

Given these superior qualities, Bitcoin has received a lot of attention in the past years. And most recently, governments and central banks, witnessing the inevitable and accelerating digitization of money, are scrambling to keep pace with technological advancement.

China’s Cashless Economy and Central Bank Digital Currency Pilot

Of all nations, China has a massive head start when it comes to digital money. The Chinese economy is already completely cashless. Payments aren’t made with banknotes or coins at all, but primarily using QR-codes. The Chinese government granted bank licenses to technology companies such as Tencent, which is behind WeChat, one of the most popular platforms in China. Calling it a social media platform or comparing it to WhatsApp or Facebook wouldn’t be accurate, since it is completely different.

Rather than merely being a social media site or a chat application, almost anything can be done on WeChat. Imagine having Uber, Facebook, WhatsApp, your bank account, your railway tickets and pretty much anything you can think of in one single application that has an almost indefinite number of add-ons.

While traditional banks still exist, most people use apps like WeChat as their bank account. Whenever they have to make a payment, they just open the app, scan the QR-code and make the payment. Settlement, however, takes a lot longer in the background and is centralized.

Person paying cashless using WeChat

(A person paying cashless using WeChat by Nagarjun)

While granting technology companies a banking license has massively accelerated the digitization of money and has led to a completely cashless society, China has taken one step further and started developing its own Central Bank Digital Currency (CBDC).

This CBDC is already being rolled out and tested in China. There is an important difference between the current cashless society and the CBDC though.

And not all CBDCs are created equally.

Retail and Wholesale Central Bank Digital Currencies

Until now, technology companies received banking licenses and simply acted as modern banks with slick interfaces and QR-codes, effectively making physical cash obsolete. But citizens held their account with the technology company and not directly with the Chinese central bank.

China is implementing a retail CBDC, which means the Chinese central bank itself is issuing the digital wallet instead of a bank or a technology company that has a banking license. This means, incumbent banks as well as tech companies that currently act as banks, can be avoided all together and might disappear.

Retail CBDCs give central banks and governments unprecedented control over the economy since all transactions and wallets can be monitored in one centralized place.

Wholesale CBDCs on the other hand work slightly different. In this case only banks hold a digital wallet with the central bank. Citizens continue owning bank accounts at regular banks. While significantly more modern than the current system, wholesale CBDCs are less intrusive than retail CBDCs.

One of the main fears among those watching the space is that most governments and central banks will eventually implement retail CBDCs.

This would significantly increase the risks of Central Bank Digital Currencies becoming instruments of surveillance.

Other Sovereign Nations Are Working On Central Bank Digital Currencies As Well

The European Central Bank announced that it is considering a Central Bank Digital Currency. The Federal Reserve has acknowledged its interest and is currently studying how it could implement a CBDC as well. In order to keep an air of calm and not cause panic, confusion or uncertainty in markets, Jerome Powell said the Federal Reserve wasn’t in a hurry to implement a Central Bank Digital Currency but rather wanted to do it right.

As the world reserve currency, the US dollar has a special privilege and importance. Implementing a CBDC too fast or making mistakes could be detrimental. China, on the other hand, has been able to move faster since it has less to lose.

On the contrary, China has an interest in making the Yuan world reserve currency. Sovereign nations that are being sanctioned by the United States and have a friendlier relationship with China are interested in seeing the Yuan rise to become world reserve currency as well.

Being at the forefront of the CBDC race and having a fully digital currency before the United States is a political statement and a demonstration of technological competitive edge. That being said, it is unlikely that having a CBDC before the United States will threaten the status of the US dollar as world reserve currency. The growing debt mountain and inflationary pressures are more concerning in that regard.

India recently announced it was developing and testing both a retail and wholesale CBDC. In due time, we should expect all sovereign nations to have their own Central Bank Digital Currencies. While some nations will opt for wholesale CBDCs first, most of them will likely switch to retail CBDCs at a later point.

It is just a matter of time since retail CBDCs give central banks more nuanced ways to conduct monetary policy.

Why Do Governments Want A Central Bank Digital Currency?

While most sovereign nations already use digital money, the technology it is based on is outdated and slow. The rise of Bitcoin has sparked interest among venture capitalists and developers, as well as governments and central banks, to figure out how they can use the same or similar technology underlying Bitcoin to create their own digital currencies.

Risks of Central Bank Digital Currency

(The Queen of England, money and control by PhotoGraham)

Bitcoin and Central Bank Digital Currencies are fundamnetally different though.

One of the big innovations of Bitcoin is that the rules, such as the total supply of 21,000,000 bitcoins, have been pre-programmed and cannot be changed by a small group of people.

Bitcoin is like a programmatic, decentralized bank that produces a new block every 10 minutes. Nobody can increase the money supply, change the rules, shut it down or censor transactions.

On the flip side, governments are interested in programmable money. Unlike Bitcoin, they want a form of money for which the rules can be easily and quickly changed by central banks. Instead of a fixed money supply, they are looking for more nuanced and advanced ways to control the money supply.

The two main ways the Federal Reserve can intervene in the economy is by setting short-term interest rates using the Federal Funds Rate and by increasing the money supply by putting assets like government bonds and mortgage-backed securities on its balance sheet — also known as Quantitative Easing.

With a retail Central Bank Digital Currency, where people hold their money in a wallet provided by the central bank instead of a regular bank account, monetary policy becomes more like precision surgery.

This is why in due time most central banks will likely stop using wholesale CBDCs in favor of retail CBDCs which give them more control.

Unprecedented and Fine-Tuned Control Over Monetary and Fiscal Policy

Let’s explore why retail CBDCs will be so powerful for central banks.

With the “Everything Bubble” getting bigger and sovereign debt levels becoming increasingly unsustainable, central banks will have to revert to more and more extreme monetary policy to reflate the bubble in sovereign bonds.

Setting short-term interest rates and deploying Quantitative Easing programs won’t be enough at some point. Retail CBDCs will become an important tool in the toolbox of central banks to implement more direct and advanced forms of monetary policy.

If central banks want to give out stimulus checks, they can airdrop them directly into the digital wallets of citizens. Not only that, but they can give money an expiration date. If the stimulus isn’t spent by a certain date, it simply disappears from the wallet, encouraging people not to hoard money but spend it.

This could also be done with regularly earned money from wages. If central banks want to prevent hoarding, they can give money an expiration date. On the flip side, if inflation is running rampant, they can contract the money supply by simply withdrawing it from digital wallets. These measures might seem completely unthinkable today, but so did negative interest rates in Europe two decades ago.

Fiscal policy can be conducted in a much more direct way with programmable money as well. The retail CBDC protocol could be changed during times of economic turmoil to reflect a carrying tax. This means, people would be punished to hold cash by automatically having a small percentage of money deducted every month that goes to the government.

With enough technological surveillance, filing a tax return or having an institution like the IRS might not even be necessary anymore. Incoming and outgoing payments as well as account balances would all be known to the central bank and the government. Taxation would become programmatic, built into the software. This is why loss of privacy is one of the biggest risks of Central Bank Digital Currency.

Other risks of Central Bank Digital Currency come from merging them with digital identities and social credit systems.

Technological Surveillance With CBDCs, Digital Identities and Social Credit Systems

The dystopian potential of CBDCs gets far greater when they are combined with digital identities and social credit systems. This combination would grant governments an unprecedented level of control and surveillance.

Imagine the following scenario: Instead of receiving a speed ticket if you get caught by a speed trap, your license plate is scanned automatically and then matched with your digital identity. Your digital identity is directly linked to your retail CBDC wallet and the fine is automatically deducted from your wallet. You don’t receive an invoice or have to pay the fine yourself. The next time you check your digital wallet you simply have less money.

This intersection between CBDCs and technological surveillance could also be used to enforce environmental goals.

(Offline surveillance by zigazou76)

People that consume too much meat or have an excessively high carbon footprint as a result of their purchasing behavior could be limited or punished in the future. Imagine walking into a store and buying some steaks, but your payment is blocked because the CBDC is programmed to only permit a certain number of meat related transactions per month.

Or let’s say you fly too frequently and some points are deducted from your social credit system. Moving forward, your retail CBDC wallet temporarily blocks the purchase of plane tickets or gas.

While these scenarios seem dystopian today in Western societies, nobody would have thought that we all have to show a digital vaccine passport to enter restaurants and public transport either two years ago. If anyone had made this prediction in 2019, they would have likely been called crazy. What seemed unthinkable a few years ago became the new normal in a matter of months, with surprisingly little push back from the general public.

This is especially concerning since Klaus Schwab, founder of the World Economic Forum, made it clear that Covid-19 should be instrumentalized as part of the Great Reset to move the world toward Stakeholder Capitalism.

The Antidote to the Risks of Central Bank Digital Currency

We are witnessing two major forces pulling in opposite directions: Centralization and decentralization.

While governments and central banks want to preserve their monopoly on money and keep the fiat standard in tact, Bitcoin adoption is skyrocketing. It is growing at a faster pace than the Internet did and it’s unlikely to stop.

Despite most people getting interest in Bitcoin because the price keeps going up, they are adopting a technology that protects their freedom and privacy. The Bitcoin base layer is pseudonymous but not anonymous or private.

However, with growing adoption it is likely that most payments will happen on the privacy-focused Lightning Network, which acts as a second layer on top of Bitcoin. On the Lightning Network, payments are almost instantaneous with transaction costs close to zero. This is why El Salvador implemented it to power the nation’s bitcoin payments.

With payments taking place on the Lightning Network and final settlement happening on Bitcoin’s base layer, we have a payment network and settlement system that respects freedom, privacy, human rights and savers’ purchasing power.

Transactions on the Bitcoin network are censorship-resistant which means they cannot be stopped by governments or central banks. The money supply of Bitcoin is fixed and set in stone with 21,000,000 bitcoins and each bitcoin divisible into 100,000,000 Satoshis. The rules cannot be changed by a small group of people such as central bankers.

Bitcoin is the antidote to the risks of Central Bank Digital Currencies and the dystopian possibilities they enable. There are applications like Sphinx built on the Lightning Network, bringing the same decentralized, censorship-resistant qualities to messaging applications and social media platforms. Twitter recently announced its Blue Sky project with the goal of completely decentralizing Twitter. It’s hard to ignore all the positive forces, including some of the smartest people in the world, pushing for decentralization.

As Bitcoin adoption grows, hyperbitcoinization as well as the development of truly decentralized applications on the Bitcoin and Lightning Network are the best protection against technological surveillance and financial repression.

January 10, 2022