by Anthony Accurso
Bitcoin is rapidly changing the way we function as individuals in a global and interconnected economy. Even though any individual person may not own or use it directly, it is reshaping economics across the planet. It is, in many ways, the best solution to a unique problem in banking enabled by the digital age.
The rise of Bitcoin and other cryptocurrencies has shaken many governments out of their complacent view with regards to the prevailing economic order, and they are reacting in varying ways to the threat. Many countries and economic zones are now considering creating their own digital currencies to compete, both with Bitcoin and each other.
The choices made by government producers of Central Bank Digital Currencies (“CBDCs”), in the forms these new monies will take, have the potential to irrevocably disrupt the relationship between governments and their citizens. To understand the implications of this seismic shift in technology and policy, we have to understand what purposes money serves in society and the conditions that led to the proliferation of cryptocurrencies.
Money as a Tool
Tools are things that people use to solve problems. Money is a tool, and understanding money requires understanding the problems it is meant to solve.
First, it serves as a store of value. You can save money until you have enough to buy something you need or want, or you can save enough so that you no longer need to work (much) to earn enough to be comfortable. Without this tool, we would have the problem of our resources being insufficient to meet our needs or desires at any given moment.
Second, money solves the “problem of coincidence of wants—what you want to acquire is produced by someone who doesn’t want what you have to sell.” When it solves this problem by standing in for bartered goods, it is functioning as a medium of exchange.
Third, once money is commonly used in place of barter, it solves the efficiency problems that arise when economies get larger than a small village by functioning as a unit of account. This means that goods are priced compared to denominations of the money rather than to each other. Instead of a cow costing 20 chickens, it instead costs 100 shekels.
Short of a magic lamp that grants infinite wishes, all tools are imperfect, and people constantly assess their usefulness while considering better alternatives. Money is like this as well. It has taken many forms throughout the history of mankind and continues to evolve to this day.
For instance, in West Africa for centuries prior to the massive influx of Europeans in the 1600s, Aggry beads (decorated glass bead) were used as a common form of money, employed by a diverse set of social groups. The origins of the beads are debated by historians—whether they were made from meteorite stones or passed on from Egyptian and Phoenician traders—but they were rare in an area where glass making technology was expensive and uncommon.
Aggry beads were easily transported in bags or sewn on to loops. They were mostly blue and uniform in shape. And though there were enough in circulation to function as money, they were difficult enough to make or obtain that the ratio of the stock of beads to the influx of beads in the market was high. This last factor changed after Europeans got involved in the West African market in the 1500s.
The Venice was the lone hub of glass making skill prior to the Renaissance; this changed after the Turks took Constantinople in 1453 CE. Venetian glassmakers then spread throughout Europe, setting up production shops in multiple areas simultaneously. This diaspora made glass production far more accessible to Europeans.
Once Europeans traveling to Africa realized glass beads were used as money there, they began to have large quantities of beads produced. Before Africans understood what was happening, Europeans had purchased vast quantities of valuable land and goods with what was literally nothing more than glass beads to the Europeans, which were relatively cheap to produce.
Imagine if someone offered to buy your car for twice its listed value and wanted to pay in cash. A great many people would sell their car, go buy another one, and use the excess to go on vacation to celebrate their good luck. However, a drastic increase in the stock of a commodity in a market will lower the value of it. When the flow of a commodity being used for money drastically increases, the stock-to-flow (see below) ratio plummets, debasing the value of the money, meaning it takes more of the money to obtain the same quantity of goods than it did prior to the influx of the additional money.
The proliferation of cheaply produced European beads, indistinguishable from true Aggry beads, completely undermined the value of beads as a useful currency. And this lesson can be applied to nearly any commodity used as money; a change in politics or technology can completely reshape an economy dependent on one form of money.
For our purposes, the stock-to-flow ratio is simply a model that attempts to measure the scarcity or abundance of a commodity, especially something used as a form of money such as gold. The “stock” is the amount of the commodity that currently exists in the marketplace. The “flow” is the new supply of the commodity that is introduced into the marketplace each year. Comparing “stock” to “flow” helps determine a commodity’s relative scarcity or abundance. Stock-to-flow is calculated by dividing the “stock” by the “flow,” i.e., Stock / Flow = number of years it would take to produce the total amount of the commodity currently in the marketplace.
Throughout the history of money, gold has maintained the highest stock-to-flow ratio of any commodity. It’s current stock-to-flow ratio is approximately 62.3 (about 187,000 metric tons of gold have been mined throughout history and about 3,000 tons mined each year). It is chemically stable such that it does not rust or decay, nor is it consumed by production or use. Thus, all the gold that has ever been mined from the ground is still available for collection, trade, or use. This large number dwarfs the annual influx of new gold supplies into the market.
Mining gold is difficult, involving ecological destruction and the use of chemicals that are toxic to most life. Even as technology evolves, we will continue to mine for the ever decreasing and finite amount of gold left in the ground. This will likely remain the situation until we wrangle gold comets back to Earth or devise a method of synthesizing gold using electricity alone.
Some of the first coins in recorded history were made of electrum—a naturally occurring mix of gold and silver—and gold was used as money in a great many areas of the world. While its stock-to-flow ratio makes it an excellent store of value, its current value makes it unsuitable for use in daily transactions. One troy ounce of gold is about the size of a six-sided die, but it is worth almost $1,800. Making change at a convenience store would thus involve handling gold flakes.
Traders faced a similar problem in 9th century China under the Tang Dynasty. Rather than carry around piles of valuable metals, they began writing IOUs on paper to each other in place of exchanging coins or other valuables. They traded these IOUs amongst themselves, largely trusting in the reputation of each traitor in the group.
Wherever paper printing technology flourished, people would eventually begin printing paper currencies. Like the IOUs of Tang Dynasty traders, these notes were issued by individuals or associations and, at least in theory, backed by deposits of gold or other valuable commodities. In the early days of paper money in Europe, a many unscrupulous persons would print money they could not support with goods of value. Some printed paper of such low quality that they intended it to degrade before it could be exchanged for gold at its source. Such shenanigans were so common that when the government of Sweden issued its first paper currency in 1661, the signatures of 16 persons adorned each note, attesting to its value and backing.
During the 1800s, countries and currency zones across North America, Europe, and Japan had adopted the gold standard such that every note of currency issued was redeemable for its value in gold. It seemed that the technology of money had reached its zenith. Paper currency was easy to carry and exchange, and since it was backed by gold, the commodity’s use as a store of value could not be surpassed—bearers of such currency could amass it in the same way dragons would hoard piles of gold in fantasy novels.
Fiat Currencies Inspire a New Money
The gold standard had its failings. “While the gold standard helped protect the currency from the vagaries of politicians, linking the quantity of money to a finite commodity meant the money supply did not adjust appropriately to the size of the economy and left it vulnerable to changes in gold supply,” according to worldfinance.com. Inflation and deflation occurred as a result of changes in the stock of gold, leading to politically unpopular recessions.
In the U.S., war debt also posed a problem. The country sold U.S. dollars to other countries, like Great Britain, to finance wars. At any time, a representative of any one of these governments could show up at the “gold window” of the U.S. Treasury to demand gold in exchange for dollars. This was not a hypothetical: “in the second week of August 1971, the British ambassador turned up at the Treasury Department to request that $3 billion be converted into gold,” according to pbs.org.
Exercising the power granted him by Congress, President Nixon ended the gold standard in the U.S. on August 15th, 1971, officially closing the gold window at the Treasury while simultaneously imposing wage and price controls in an attempt to slow inflation and rising unemployment.
At the time Nixon made his move, gold was trading at roughly $43 per troy ounce. Since that time, “the dollar has lost over 96% of its value to gold bullion to date,” according to sdbullion.com.
Even though the switch from the gold standard to a so-called “fiat currency” lessened the constant roller-coaster of gold fluctuations, it has caused rapid deterioration of the value of the wealth of U.S. citizens. And though recessions may happen less often, they still occur with alarming frequency.
Citizens of some other countries have learned the hard way that their country mismanages its currency and have relied on a heterogeneous marketplace of money to protect their wealth.
“In Argentina … while the peso was used as a medium of exchange—for daily purchases—no one used it as a store of value. Keeping savings in the peso was equivalent to throwing away money. So, people exchanged any pesos they wanted to save for dollars, which kept their value better than the peso. Because the peso was so volatile, people usually remembered prices in dollars, which provided a more reliable unit of measure over time.” Boyapati, V., The Bullish Case for Bitcoin.
It was during the great recession of 2007-2009 that people began rethinking our relationship to money. A person or persons who went by the pseudonym of Satoshi Nakamoto sent an email on October 31, 2008, to a cryptography mailing list announcing that he had produced a “new electronic cash system that’s fully peer-to-peer, with no trusted third party.” Though Nakamoto’s identity has never been conclusively determined, it is clear that Bitcoin’s creation was inspired by the mismanagement of fiat currencies. (Note: when referring to the Bitcoin protocol, it’s capital “B,” and when referring to a unit of account on the blockchain, it’s lower case “b”)
The genesis block is the first block in any blockchain, and the genesis block for Bitcoin contains the text, “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.” This is a reference to an article in Britain’s The Times newspaper announcing the possibility of further bank bailouts, an action often cited as an example of the government choosing to prop up a system that favors the transfer of value to corporations and the wealthy at the expense of wage earners.
This is, of course, a gross simplification of economics in general, and politics too. But to truly understand the purpose of Bitcoin, we have to look at its two most salient features: absolute scarcity and direct trustless transfers.
Bitcoin is a protocol run on millions of computers around the world. All are running essentially the same algorithm of code originally published by Nakamoto. Part of this algorithm mandates that only 21 million bitcoins will ever be created. No new technology will allow for the creation of more bitcoins. Also, only a portion of the 21 million are currently available, accounting for those that have been “mined” since its creation and not lost forever as several million have been.
The rate at which new bitcoins are mined is fixed and is reduced about every four years in what is commonly referred to as the “halving” when the reward for mining a block on the Bitcoin protocol is reduced by half. Bitcoin is the first absolutely scare commodity because no amount of extra effort or market demand will mine them faster or increase the total fixed supply of 21 million. The first halving occurred on November 28, 2012, and the block reward at that time was 50 bitcoins. The second halving occurred on July 9, 2016, with a reduced block reward of 25 bitcoins. The third halving took place on May 11, 2020, and the block reward was cut in half once again to 12.5 bitcoins per block reward. The fourth halving is projected to occur on May 9, 2024, with the block reward reduced to 6.25 bitcoins. Each subsequent halving will reduce the number of bitcoins issued as block rewards in half until the final bitcoin is mined some time in 2140.
Remember that gold has been a superior store of value due to its high stock-to-flow ratio. Bitcoin was designed to have an even higher, and more predictable, stock-to-flow ratio than gold, enforced by its algorithm’s programming. The longer the network is in operation, the greater its utility as a store of value as its stock-to-flow ratio constantly increases over the years.
This design is reminiscent of the gold standard in its emulation of scarcity. No government can mandate the creation of new bitcoins to debase it, and attempting to purchase bitcoins, only makes them more scarce and therefore more valuable. This design allows people to trade-in fiat currencies for bitcoins, thus stabilizing the value of their wealth.
Direct payment is the second salient feature of the Bitcoin network. If Alice wants to pay Bob $1, she can give him a dollar bill. Alice can hand the bill directly to him without the assistance of a third party. However, if Alice and Bob are separated by some amount of physical distance, or if they don’t want to have to carry cash on their person and prefer to conduct a digital transaction, they must depend on and trust a third party.
Before digital payments were possible, Alice would deposit her dollars into a bank, which would take those dollars and exchange them for their equivalent in bank money. She would then write a check to Bob and send it to him, usually by mail. Bob would take the check to his bank, which would confirm the funds with Alice’s bank and (eventually) credit Bob’s account with the appropriate amount of bank money, which could be exchanged by Bob for cash.
Digital payment networks have made such transactions quicker and more reliable, from Visa and MasterCard to systems like Zelle, Venmo, and Cash App, bank money can be exchanged between the accounts of Alice and Bob practically instantaneously over any distance.
But all of these transactions depend on one or more trusted third parties between Alice and Bob. The banks and digital payment network providers involved in each transaction have their own policies, and all are beholden to government requirements such as know your customer (“KYC”) laws and regulations ostensibly promulgated to prevent money laundering and to counter the funding of terrorism (“AML/CFT”). These regulations can also significantly increase the friction for international transfers, making them difficult and slow, even in our digital age.
Bitcoin disintermediates such transfers. Any two persons can operate their own network nodes, regardless of whether they choose to mine bitcoins. Alice can send Bob any number of bitcoins, or fractions thereof (called satoshis or “sats” with each whole bitcoin comprised of 100 million sats), she possesses, without any limits, verification, or charge-back risk, and can do so relatively quickly and inexpensively—ranging from about 10 minutes to a couple of hours depending on various network factors.
Further, Alice need not know Bob’s true identity to make this transaction. She need only know his wallet address, a long set of letters and numbers that identifies his wallet. This does not mean that Bitcoin transactions are anonymous, as it is possible and sometimes trivially easy for third parties to establish with a reasonably high confidence the identity of a wallet holder. But it does mean that Alice does not need to know anything about Bob besides his wallet address.
Before Bitcoin, Bob had to reveal at least some physical characteristics to Alice to obtain funds from her. For indirect payments, she would need his name and maybe his physical address. More recently, she would need some of Bob’s information such as a username or KYC verification.
This disintermediation means that Bitcoin behaves like cash, but it is superior in that it can be exchanged anonymously over great distances. Ideally, in conjunction with its true scarcity, Bitcoin is thus a better money tool than either gold or fiat currencies like the U.S. dollar. It is unsurprising then that governments have expressed concern over Bitcoin’s rise in popularity and are considering issuing their own cryptocurrencies.
Bitcoin Is a Threat to Governments
All commodities used as money are valued beyond their utility value. Gold, for instance, costs more per ounce than can be justified in its superior utility over other metals for use in electronics or jewelry. Bitcoin is the same in that it is overvalued in relation to the costs necessary to obtain one bitcoin. Though bitcoins were originally priced at an amount that reflected the cost of the electricity required to mine one coin, their price has risen beyond this amount. This overvaluation is known as a monetary premium.
However, like all technologies, the value of a commodity used for money largely follows a repetitive S-curve known as a Gartner hype cycle, named after an American technology research firm. Bitcoin is no exception, though possibly due to its relatively young age, these curves have been fairly volatile.
The S-curve of a hype cycle has four features. It begins with the “innovation trigger,” a rise in value which increases relative to its evangelism until it reaches a “peak of inflated expectations.” Its value then descends, usually after some negative event, towards its nadir to the “trough of disillusionment.” Its value will rise again, though more slowly as longer-term investors recognize its usefulness, in a “slope of enlightenment.” The final stage involves a relatively stable valuation for a period known as the “plateau of productivity.” The nature of this cycle is that the plateau will eventually give way to another sharp rise fueled by renewed expectations.
The value of each bitcoin has increased dramatically during its relatively short time in existence. The first recorded transaction giving monetary value to bitcoins occurred in October 2009, when a Finnish computer science student named Martti Malmi sold 5,050 bitcoins for $5.02, thus giving each bitcoin a value of $0.0009. In November 2021, it reached an all-time high of approximately $68,789, as reported by the U.S. cryptocurrency exchange Coinbase. Reflecting its volatility, the price has settled in the $27,000 to $28,000 range as this article is being finalized in early June 2023.
As government regulators begin supervising exchanges in a more active manner—as there have been calls to do following the collapse of several cryptocurrency exchanges and platforms in 2022 and 2023—expect institutional investors to have more confidence in Bitcoin as it matures as an asset and regulatory clarity emerges, which will drive the price up above the $60,000 range again. During some later cycle, governments may also purchase bitcoins like they currently purchase gold for reserves, driving the price even higher.
Should it reach such a valuation and remain relatively steady, it could possibly become useful as a de facto global reserve currency, a status currently held by the U.S. dollar but perhaps not for much longer. This means that other countries purchase dollars, usually in the form of government bonds, as an investment. It also means that international transactions and trade are denominated in dollars, which lowers the exchange risk for U.S. entities while also making such transactions cheaper. Were Bitcoin or some other digital currency to take the dollar’s place as the dominant reserve currency, these benefits to the U.S. economy would be negated.
Even more threatening than eclipsing the dollar as the dominant reserve currency is the lack of control governments have over Bitcoin. The U.S. government has spent decades developing an infrastructure of national and international laws and regulations for the purpose of denying funding to individuals and entities it deems terrorists or criminals (or simply disfavored), which is made possible because of the dollar’s status as the global reserve currency. These policies prevent expeditious international wire transfers and are used to seize any pile of cash government agents even suspect is being used for illicit purposes (known as civil asset forfeitures).
Following the attack on the U.S. on September 11, 2001, the U.S. government has forced financial institutions and any payment processor who handles more than a few thousand dollars to verify the identity of their customers, known as KYC laws. It has used its political clout to incentivize dozens of other countries to do the same. This results in persistent government surveillance of all transactions greater than a specified amount or meeting other triggering criteria.
But such measures have their critics, and not everyone agrees with them. Critics cite the lack of regulations on insider trading by politicians, massive wealth transfers to corporations, and the ineffectual punishments for corporate theft as reasons to view such regulations as only truly existing to hamper wealth collection and transfer by wage earners and laborers. They see such controls as a violation of privacy and individual sovereignty, or they disagree with classifying marijuana businesses in the same category as violent religious extremists.
Governments have attempted to impose these laws on Bitcoin users by linking individuals to their digital wallets and then tracking the flows of bitcoins to and from individuals suspected or convicted of criminal activity. Though the Bitcoin blockchain contains the record of billions of transactions, the distributed nature of its ledger means that any government or corporation with sufficient will and resources can track all transfers of bitcoins back to the very first coins.
Users have responded with various technologies to counter such blockchain analysis attempts. Some people run mixing services for bitcoins. Let’s say Alice wants to conceal the provenance of bitcoins she receives from Bob. He sends those bitcoins to “Trent’s Tumbler,” which receives coins from Bob, Carol, and Dan and redistributes them after they have been mixed. Alice would then have the mixed bitcoins deposited in her wallet. With enough participants in any mixing, none of Bob’s coins need actually make it into Alice’s wallet, and the transfer to Alice would be complete (less Trent’s fee for his service).
Other cryptocurrencies have implemented anti-analysis tools such as mixers as part of their original or adopted algorithms and may include other features such as one-time use sub-wallets and the need for additional cryptographic keys to view transactions on the blockchain. Well known cryptocurrencies which have implemented such tools include Zcash, Verge, Monero, Dash, and Desire.
In its technical report on the regulatory challenges present in the operation of a digital currency by a central bank, the International Telecommunications Union – a United Nations agency which proposes standards and publishes research – explained how the ecosystem of altcoins, each with their own anti-analysis features, might be used to launder bitcoins in defiance of government regulation. This largely involves some combination of mixing services as well as using bitcoins to buy other privacy-oriented altcoins such as Zcash and then buying bitcoins again, all while utilizing IP address obfuscation methods such as VPN services or TOR. These transactions can be made to look more like cryptocurrency speculation than money laundering.
The final reason why governments fear Bitcoin is its apparent durability. Bitcoin was the first digital currency that used proof of work calculations of cryptographic problems to achieve what is now commonly known as a cryptocurrency.
The Architecture of Big Brother
Governments and central bank administrators have been monitoring these developments with a mixture of fear, awe, and jealousy. On one hand, the wealthy and political classes have a vested interest in maintaining a system that preserves their power and wealth. On the other hand, government-sponsored digital currencies could have significant benefits for economically marginalized segments of the population, generally increase GDP by improving efficiency, and provide a long-awaited shakeup of the financial services industry.
One interesting development in this area is that, although “105 countries, representing 95% of global GDP” are exploring or have implemented some form of government digital money, the proposed or actual implementations are far from homogeneous. Understanding differences in implementations involves an explanation of terms.
Central bank digital currency (“CBDC”), digital base money, and digital fiat currency are the most common terms for government issued currencies, and “CBDC” is the one that will be used for the rest of this article.
Wholesale and retail CBDCs refer to two different purposes of a CBDC. Wholesale involves the use of a CBDC solely for the purposes of managing deposits and reserves of private banks that are held by a central bank. All banks in the U.S. and U.K. are required to hold some percentage of their deposits as reserves with the central bank system, and central banks facilitate transfers from one bank to another. According to the Atlantic Council’s CBDC Tracker, at least eight countries are considering or have implemented wholesale CBDCs only. Such systems have the potential to improve efficiency for central bank accounting systems and are expected to provide efficiency returns in the long-term, lowering costs.
Retail CBDCs are what most people think about when they hear the term CBDC. Central banks, like the Federal Reserve in the U.S., print or mint money for use by the public for direct exchanges or in person payments. A retail CBDC would be issued by the same institution, have the same value as physical currency, and have the benefit of enabling exchanges digitally, similar to existing electronic payment systems.
Another distinction often made is between account-based and tokenized systems. Account-based models link a digital wallet to an account in a central bank’s ledger, and the money is merely a number in the ledger. Tokenized systems mean that, although users may have accounts where token currency units are stored, these units can exist separately from an account in a mobile wallet. Though transactions from account wallets to mobile wallets are still reported on the blockchain (else they would eventually be double spent), they are not technologically linked to a particular account.
Distributed ledger technology (“DLT”) is a term used to describe a system where multiple participants in a network each hold identical copies of the ledger, also known as the blockchain. In the vast majority of private cryptocurrencies, DLT is used in a way that enables all network participants to inspect and interact with the blockchain. This access, coupled with the availability of software that allows anyone to operate their own node, decentralizes control over the network.
However, simply because a blockchain uses DLT does not make it inherently democratic. In a hypothetical use case, each of the 12 Federal Reserve banks in the U.S. would participate in a digital dollar system, with each maintaining a copy of the ledger. Yet, private individuals would not be allowed to operate nodes and would have to instead clear all transactions on the blockchain through the 12 nodes operated by the central bank system. This would technically be a DLT system, but its limited access would make it centralized and decidedly less democratic.
Also, even in the unlikely scenario where a central bank used DLT and individuals outside the bank had access to the blockchain, that doesn’t mean that all transactions would be visible to the public. Some blockchains, like Bitcoin, are permissionless systems, so that any interested party can inspect the record of transfers to and from all wallets, back to its inception.
Other systems, like Monero, are permissioned. This means that any one person can use the cryptographic key from their wallet to view any transactions to or from their own wallet but only their own wallet. To view the transactions from another person’s wallet, that person would have to share their key. It is technically possible for a central bank to create a permissioned DLT system such that, while users cannot see the transactions of others, the central bank holds a “skeleton key” that allows the bank or government agents to view all transactions on the network.
When designing its digital currency and electronic payments system (“DC/EP”) known as the digital yuan, China initially tested a DLT system but scrapped it in favor of a single, centrally operated traditional database system, because these are less resource-intensive and easier to mine for user data, which, despite protestations to the contrary by governments, is one of the primary motivations for adopting CBDCs.
Intermediated or disintermediated systems denote which institution a wallet holder interacts with when processing transactions. The Central Bank of Iceland is one of a few central banks seriously considering operating a disintermediated system to provide digital wallet services directly to its citizens. All other countries that have launched, or are considering, a retail CBDC have chosen to operate an intermediated system where private banks or financial technology (fintech) companies interact directly with citizens and operate the digital wallets, while the companies themselves interact with central banks.
While a disintermediated system might sound like the more simple and efficient choice, central banks have little experience (or interest) in interacting directly with the public for their daily transactional needs, and private banks already have such infrastructure in place (i.e., customer service call-centers). Also, central banks see intermediation as an opportunity for private banks and fintech companies to provide additional services, which ideally encourages competition and innovation.
With these terms in mind, let’s look at how some currently implemented or proposed systems for CBDCs are constructed and the resulting implications for both monetary policy and especially human rights.
First, consider China’s digital yuan, alternatively called the DC/EP or e-CNY. This system is centrally operated with no DLT, and it is intermediated by Chinese private banks. Any Chinese citizen can go into a bank and open an e-CNY account, or one can be created through an online fintech firm like Tencent, after verification of identity.
The Center for a New American Security published a report in January 2021 explaining “the concept of privacy for DC/EP as ‘controlled anonymity,’ which upon elaboration was explained as a ‘front-end voluntary, back end real name’ system.” This means that though wallet-holders must provide their real identity to the Chinese government via the financial institution or fintech provider, they can transact anonymously amongst each other. Alice can send Bob money without Bob knowing it came from Alice, but Gary, a government agent, will know she sent the money. Whichever form any country’s CBDC takes, there’s no doubt that it will allow the government complete transparency to see everyone’s transactions.
According to the Atlantic Council, by October 2021, “123 million individual wallets and 9.2 million corporate wallets had been opened with transaction volume of 142 million and transaction value of RMB fifty-six billion.”
China also now allows tourists who provide their passport information (prove their identity) to create an e-CNY wallet. Visitors for the Olympic games in February 2022 “were able to use the software e-CNY application and the hardware e-CNY card, and daily transactions during the games were around ‘a couple of million RMB.’”
The ease of use of the e-CNY is likely to eventually improve banking access to individuals who do not currently use banking services and instead only rely on physical money. Over time, as users prefer e-CNY to physical cash, costs inherent in maintaining physical cash will be reduced. According to Jonathan Dharmapalan, founder of e-currency company eCM, “minting and distributing digital currency would cost 10% of what it costs to print and distribute an equivalent physical currency note while allowing the government to retain the revenue it gets from issuing currency, known as seigniorage.”
Having most of its population participating in the e-CNY system also provides more fine-grained control over a nation’s money supply allowing for precision modifications.
“A CBDC could have several advantages from a central bank’s perspective. One is winning back more direct control over money supply, to use as a monetary policy lever. In the fractional reserve banking system, banks make the money, and central banks control its supply only indirectly, through adjusting banks’ incentives. In a CBDC system, the central bank could bypass banks and influence customers directly,” explained Vili Lehdonvirta, a senior research fellow at the University of Oxford.
Such direct influence could involve a negative interest rate during economic downturns. While banks currently incentivize customers to make deposits by paying them interest on savings accounts, the Chinese Central Bank could “incentivize” consumers to spend their money using monetary penalties such as negative interest rates. Imagine an announcement by the government that mandates holders of the CBDC to spend at least 1% of their account balance within 30 days or have their digital wallets reduced by 1%. It should start to become clear why governments are so enamored with the idea of CBDCs – they provide the possibility of unprecedented control and surveillance over the population.
Lehdonvirta continued, “another advantage would be data, or to put it more bluntly, surveillance. If all citizens had an account with the central bank and used those accounts to pay for all kinds of purchases, then obviously the bank would have a lot of visibility into what goes on in the economy. This would be useful for economic research but also for law enforcement. In a country where the rule of law is less than perfect, this comes with concerns.”
During times of political unrest, China could use its system to track dissident networks and temporarily disable their e-CNY accounts. Or a more precision approach might prevent known dissidents from using public transportation or taxis, hindering their ability to travel to or from protests.
An even more dystopian outcome could be envisioned where it concerns systemic oppression. China has been criticized for its systemic oppression of minority Muslim Uyhgers in its Xinjiang province. Further oppression could take the form of preventing the e-CNY accounts of Uyghers from functioning anywhere outside of Xinjiang or disallowing payments to businesses like restaurants or grocery stores where they are deemed unwelcome.
It is easy then to imagine how a central bank could implement a digital currency, increasing reliance on digital payments while decreasing the availability of physical money, and then deny access to accounts for any politically unpopular minority group for the purpose of making ethnic or ideological cleansing easier.
But there is nothing to limit such control measures to the political unpopular. They can be used against any disfavored group or individual based on any reason and certainly not limited political views and action. CBDCs’ use as a tool for control and surveillance is literally limited only by the imagination of those in power.
Contrast the foregoing scenario with Sweden’s pilot for its e-krona network. Swedish citizens currently conduct approximately 90% of a transaction digitally and only 10% using physical currency, the latter mostly by senior citizens who distrust digital technologies. This has the Riksbank (Sweden’s central bank) concerned about the availability of physical cash during market downturns, and it is running pilot programs to test the viability of issuing a CBDC.
Though Sweden is part of the European Union—sharing its legal framework and many social values—Sweden does not use the euro for currency. The Riksbank is responsible for issuing its currency, the kronor, and would be responsible for any eventual CBDC issued in Sweden.
The Riksbank published a report in April 2022 about the second phase of its e-krona test network, including some technical aspects of the system, as well as its requirements for a fully functioning CBDC. Other than its use of a blockchain to enable offline payments, its system looks very much like the CBDC in use in China.
Like in China, it would be an intermediated retail system where citizens create digital wallets at their participating bank after passing KYC checks. Both individuals and businesses can operate wallets and interact with them using an app (for electronic payments or smart contracts) and a debit card.
Designs for the e-krona network include an alias service for anonymous transfers between wallet holders and businesses. This is in keeping with the EU’s general data protection regulation (“GDPR”), and prevents individuals and businesses from obtaining private data about a person’s spending habits.
Unlike China’s e-CNY, the e-krona would utilize a distributed ledger, but the net effect would be no different than in China. Only the Riksbank and approved financial institutions would be permitted to operate nodes that maintain a copy of the whole blockchain, and individual users can only view transactions in which they themselves have participated, including any of their aliases (similar to a permissioned ledger like Monero’s). The sole purpose of using a DLT-based system would be improved efficiency by operating redundant notary nodes on the network and allowing for a more resilient and efficient network than a monolithic system would be, mitigating risks from cyber and physical attacks on the network.
Also different from e-CNY so far is the ability to transfer e-krona offline between users. Smart phones running the e-krona app can hold digital tokens that represent kronor in a person’s digital wallet, and these can be transferred to another person using NFC technology.
For example, Alice wants to give Bob 10 kronor but is outside of range of a cellular network. As long as Bob is nearby with his phone, she can make the transfer without the app first consulting the network. The next time that Alice or Bob is online, their app can sync the transfer with the network, updating both of their accounts.
The Riksbank identified the following questions and risks associated with offline use of e-krona: “How much money should one be allowed to store off-line? What size transactions should be accepted? Should there be different rules for different users (e.g., consumers and merchants)? How many consecutive step-by-step off-line transactions can be allowed before an on-line synchronization is needed? How long should a user be allowed to remain off-line? How should risks be shared when making off-line payments?”
Yet, offline payments are still linked to a wallet, as e-kronor cannot exist without being tied to an account verified to a user’s identity. Thus, the only real difference between the CBDC systems in place or proposed in China and Sweden is the legal framework that prevents collection and analysis of user transaction data and the abuse of this information.
If the reports of trial projects published by the federal reserve banks in Boston and New York are any indication of the ultimate architecture of a U.S. CBDC, we can expect something very similar, if not practically identical to the Swedish and Chinese systems. In fact, according to Augustin Carstens, General Manager at the Bank for International Settlements, the “[l]ikelihood of CBDC issuance is increasing, with account-based access preferred.”
For instance, Federal Reserve Bank of Boston published its Project Hamilton report in February 2022 and had this to say about the feasibility of using DLT: “Despite using ideas from blockchain technology, we found that a distributed ledger operating under the jurisdiction of different actors was not needed to achieve our goals. Specifically, a distributed ledger does not match the trust assumptions in Project Hamilton’s approach, which assumes that the platform would be administered by a central actor. We found that even when run under the control of a single actor, a distributed ledger architecture has downsides. For example, it creates performance bottlenecks, and requires the central transaction processor to maintain transaction history, which one of our designs does not, resulting in significantly improved transaction throughout scalability properties.”
The summary here is that any proposed U.S. CBDC is assumed to be centrally administered and will likely be account-based rather than tokenized. It will probably avoid using a distributed ledger the same way China has, or if DLT is utilized, it will be limited to federal reserve banks and participating financial institutions only, like Sweden’s system is. While these systems might be more convenient than using cash or other current electronic payment systems, they will be subject to all of the AML/CFT policies which hinder transfers, infringe on privacy, and reduce individual monetary sovereignty.
CBDCs Versus Bitcoin
When CBDCs are more widely available, they will compete with other cryptocurrencies and forms of money in the same way that other commodities have competed in the past. As of June 2023, Bitcoin is the dominant cryptocurrency. Bitcoin was the first true cryptocurrency, and as such its popularity is partly due to the effect of path dependence. As long as there are no fatal flaws with the first implementation to market of a new technology, it will enjoy a competitive advantage simply for being the first.
Yet while Bitcoin was the first cryptocurrency, it was the newcomer compared to other types of money. Its market capitalization is, as of June 2023, approximately $525 billion dollars. Compare that to the total amount of U.S. dollars in circulation, which is approximately $2.337 trillion. The total market capitalization of gold is somewhere between $9.5 and $14.3 trillion (depending on who is doing the estimating).
Gold has been around as money and as a store of value since about 700 B.C., and the U.S. dollar has been in existence since 1792. In contrast, Bitcoin has been around only since 2009.
Like every money, Bitcoin has its pros and cons. It cannot be controlled by any central authority, provides for absolute scarcity, and enables direct transfers without the involvement of a trusted third party.
But it is also relatively slow, and many wallet apps and programs assume a level of education and sophistication beyond the average consumer. While it is resistant to censorship and control, governments have found ways to interfere with Bitcoin markets. For instance, many online exchanges that run custodial wallet services for the trading of cryptocurrencies pay blockchain analysis companies to rate the provenance of bitcoins. If Coinbase believes your bitcoins were once involved in illicit activities, they will refuse deposit or segregate them afterwards. Exchanges that do not employ analysis companies run the risk of being prosecuted and fined for knowingly enabling money laundering or terrorism.
A 2009 study showed that “90% of paper money circulating in U.S. cities contains traces of cocaine.” The anonymity and tracking difficulty of physical dollars makes it difficult, if not impossible, for governments to determine the flows of cash through illicit businesses and AML/CFT regulations on individual dollar bills in the way they are currently trying to do with bitcoins and will definitely be able to do with CBDCs.
Instead, most AML/CFT regulations are enforced on electronic payment systems involving bank money denominated in dollars. These regulations introduce significant friction into person-to-person exchanges and cross-border payments. These regulations are so onerous that many payment providers take extremely conservative actions in lieu of actual regulations to avoid the possibility of arbitrary agency enforcement actions.
In 2013, several banks and payment networks refused services for businesses which regulatory agencies had deemed “morally corrupt.” Though these businesses were engaging in legal endeavors, they were denied payment and banking services including having their funds frozen. The Justice Department ended this program, known as Operation Chokepoint, in 2017 after pressure from Congress, but such controls would not have been possible to enforce on peer-to-peer Bitcoin users.
CBDCs, including a digital dollar, are likely to spur innovation in the fintech industry and make sending money between individuals, and payments to businesses, more convenient, especially over long distances. But these systems will have the obvious burdens of AML/CFT regulations, including KYC requirements, transfer limits, and arbitrary seizures.
In the longer term, the true cost of shifting most transactions to digital dollars will be hidden from its users until after they have been lulled into complacency. Many of the dystopian scenarios listed earlier when discussing China’s CBDC are not the kind of events that would occur around the time of a CBDC debut. Such events would take place later, after citizens had largely divested themselves of physical cash.
Currently, when law enforcement wants to know where a person has been in the recent past, they subpoena that information from Google, the company that collects more data points on user location than nearly any other entity. When the U.S. Treasury can amass similar information and more on citizens in the country, there will be fewer hurdles to the abuse of this data.
Once digital dollars are commonplace and physical cash transactions drop below 10% of all transactions, we can reasonably expect to see law enforcement exacerbate the current trend of treating uncommon occurrences—such as cash transactions—with unwarranted suspicion. Expect to see law enforcement agents testifying in courts about how traders of cryptocurrencies are actually criminals attempting to circumvent banking regulations.
Many crypto exchanges like Binance and Coinbase voluntarily adhere to KYC laws to forestall the risk of facing sanctions, seizures, and investigations. E.U. regulators have proposed additions to AML/CFT rules to prevent exchanges from transacting privacy-respecting altcoins like Zcash and Monero.
China banned businesses from accepting cryptocurrency payments in 2013 and followed that in 2021 with a blanket ban on mining or transacting with all cryptocurrencies except the e-CNY. The Russian Federation has been considering banning the purchase of crypto assets but will still allow people to mine coins and sell them to non-Russians considering it’s need to maintain exports of anything in the face of sanctions over its invasion of Ukraine. It is not a coincidence that Russia is on the verge of issuing its own CBDC, the digital ruble.
American and European legislators will likely shy away from total ban on crypto-asset competition for their own CBDCs and instead will continue to attempt to regulate away any altcoins they have difficulty tracking or that compete too well against their own eventual CBDCs.
Sadly, governments have the resources to create the most rights respecting, tokenized digital currency that could be backed by a robust largely free market, but they almost certainly never will. In order for it to be these things, they would have to relinquish control of a thing that undermines their own systems of control.
Keep in mind that with the implementation of a CBDC as a nation’s official currency, the government has virtually complete control over you by literally being able to control what you spend your money on, when you can spend it, where you can spend it, how much of it you can spend, and with whom you can spend and receive it. The government will know every aspect of your life because it has complete transparency into how, where, and when you spend every cent as well as where each cent you receive comes from.
Couple that degree of granular information about you with advanced artificial intelligence capabilities, and one can only shudder at the “predictive” models the government will dream up. Additionally, the mechanism for total surveillance and control is complete when a CBDC is coupled with a social credit score system, especially if it includes a carbon credit and electronic “health passport” component.
Behaviors, or even views, that are not criminal but disfavored by those in charge can lead to draconian restrictions on your ability to use your own funds. Going to an out-of-town protest that’s frowned upon by the government, and it can easily restrict the use of your funds for any form of transportation, lodging, and food as well as bar the use of your funds within, say, a 100-mile radius of the protest location. Similarly, maybe you’ve run your home’s air conditioner “too much,” so when you go to the gas station to fill up your car, you discover that your funds don’t work anymore to buy gas because you’ve exceeded your allotted carbon credits. Or maybe you refused the latest vaccine rolled out to the public without going through the standard multi-year clinical trials and discover that your funds have been completely frozen until you comply.
Here’s another “benefit” of a CBDC – it provides the government the ability to directly collect fines, fees, and taxes from your account. But obviously, that’s not a benefit for
you or the public.
The current messaging by the government, media collaborators, and various henchmen about why CBDCs are preferable to decentralized cryptos such as Bitcoin is but a trickle compared to the torrent of propaganda that will be unleashed in the near future to prepare the battlefield of public opinion in accepting the implementation of an official CBDC. The demonizing of Bitcoin has already begun in earnest with sitting members of Congress ridiculously and baselessly blaming it for the recent collapse of several regional banks, exacerbating the “climate crisis,” serving as a critical funder of terrorism, and practically anything else they can conjure up that they believe may have traction as an accepted legitimate criticism of Bitcoin.
A CBDC is a wolf in sheep’s clothing. It will be sold to the American public as an unmitigated benefit for the people, but in reality, the only ones who will genuinely benefit from a CBDC are those in power and their associates. Keep this in mind as you’re bombarded with the inevitable exhaustive messaging of the many virtues of a CBDC and the many sins of Bitcoin.
There is a famous quote often attributed to Henry Kissinger that serves as an apropos final thought on this topic: “Who controls the food supply controls the people; who controls the energy can control whole continents; who controls money can control the world.”
Sources: Ammous, Saifedean, The Bitcoin Standard: The Decentralized Alternative to Centralized Banking; International Telecommunications Union (ITU); Bitter, Lea, Banking Crises Under a Central Bank Digital Currency; Werner, Richard, Can Banks Individually Create Money Out of Nothing? Britannica.org; historycooperative.org; sdbullion.com; investopedia.com; worldfinance.com; pbs,org; nakamotoinstitute.org; news.bitcoin.com; vijayboyapati.medium.com; forbes.com; atlanticcouncil.org; wsj.com; riksbank.se; qz.com; bostonfed.org; companiesmarketcap.com; uscurrency.gov; cnn.com; politico.com; markets.businessinsider.com; worldcoin.org; fxstreet.com; breedlove22.medium.com; wikipedia.org; youtube.com; suerf.org; ecb.europa.eu; papers.ssrn.com; bis.org; bankofcanada.ca; federal reserve.gov; theguardian.com; bankofengland.co.uk.
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