Why central bank digital currencies would mean the end of data privacy

There are numerous hurdles banks will need to clear before centralised digital currencies become a reality
The biggest, though, will surely be convincing users to give authorities access to all their transactions, with no option to back out later

Nathan Thompson

Published: 9:30pm, 26 Jun 2022

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As the economies of the world go digital, cash is being left behind in favour of card or mobile payments. This has prompted central banks to consider issuing digital fiat money.

Indeed, 80 per cent of central banks worldwide are looking into digital currencies, while half are already running experiments or pilot schemes, according to a report by the Bank of International Settlements.

One interesting scenario would be the creation of a currency that is “blockchain agnostic”, meaning it can exist on public blockchains such as Ethereum. This would allow it to be traded as a crypto asset that is backed by a central bank.

In the case of a digital Hong Kong dollar, high demand could drive up the price beyond the 1:1 issuance based on the reserves of the Hong Kong Monetary Authority (HKMA). This would create an open market for CBDCs where people could invest and trade based on the fundamentals of each bank. May the best balance sheet win!

As fun as this sounds, it’s an unlikely scenario. Blockchains like Ethereum are decentralised, making them unsuitable for a central bank which is, by its very nature, centralised. As a recent paper published in ICT Express points out, central banks are more likely to opt for a “permissioned” blockchain – one which requires authorisation to use – rather than a “permissionless” one, which anyone can join.

Even then, central bank digital currencies would face the same challenges of scalability and throughput that have dogged Ethereum in recent years.

Signs for Bitcoin and Ethereum outside a cryptocurrency ATM kiosk in Bucharest, Romania, on May 31. Photo: Bloomberg

“Performance and scalability are [the] two main challenges for blockchain-based CBDCs,” says the ICT Express paper. It notes that even with improvements in blockchain ledger technology to speed up transactions from 3,000 to 20,000 per second, Visa can process 76,000 transactions per second.

An additional challenge is that a central bank digital currency would need to function like cash, allowing for exchanges even if both parties are offline. The most obvious solution would be hardware wallets – devices that store crypto keys offline – but how could these be distributed to poor and rural populations? After all, the whole point of central bank currencies is they are available to everyone.

If the banks can surmount these problems, the most likely scenario is that CBDCs are issued alongside normal cash, and would exist on a blockchain only accessible to residents of that country. If this system comes into play, it would not only require some kind of digital identity, but would also give the centralised authority access to every single transaction enacted on the blockchain.

Call me a sceptic, but I think it’s unlikely citizens would want to part with their privacy so easily. Following a Reuters report that Jerome Powell, chairman of the Federal Reserve, had “generally positive remarks” regarding a digital dollar, there was an outcry from Twitter users who saw the comment as an omen of a dystopian future of total government control.

Concerns about privacy are not unfounded. Given that CBDCs would use the aspects of blockchain technology that are immutable and verifiable, the question of who gets access to that information is crucial.

The HKMA is proposing a tiered system where small transactions remain private, and very large transactions are subject to oversight, which is not dissimilar to the current system. However, unlike cash, once you sign on to a permissioned government blockchain, you can’t rescind.

Don’t worry, say the CBDC architects, we will respect users’ privacy and abide by the rules. But what if a new government comes into power?

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Earlier this year, the Canadian government used the financial system to target non-violent protesters. A central bank digital currency would make similar actions ridiculously easy. “At the flip of a switch, we are vulnerable to not being able to take anything out of our wallet,” said Edward Snowdon in a March interview.

The privacy issue is one that should worry us the most. Historically, when governments have been given power over their people, they have ended up using it. Remember the illegal nationwide spying operation undertaken in the US by the National Security Agency in the 2000s?

To have a shot at success, central bank digital currencies would need to trade across borders on decentralised, permissionless blockchains. This situation could be a win for issuing banks and the market. However, the current permissioned designs offer few incentives for citizens to give up their privacy, and if a government still wants to install them, coercion will be their only option.

Nathan Thompson is lead tech writer at Bybit, one of the world’s top-ranked cryptocurrency exchanges. Follow him on Twitter for crypto insights @N_th4n

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