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Finance • Investing

CBDCs and Privacy Concerns: What You Need to Know

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With plans for the introduction of a Central Bank Digital Currency (CBDC) gaining momentum in all major economies, concerns over the impact on privacy are growing. 

During the European Central Bank’s consultation process, 8,200 comments received from the public centered on privacy – that’s 41% of all replies. It’s likely, therefore, that CBDC adoption across the globe, and the success of the digital dollar project, will hinge on consumer trust in the privacy of digital currencies.

We’re already in trust decline, with consumers having far less trust in brands over the misuse of personal data. So, privacy worries are not new. In fact, they are extremely topical, and front of mind for many of us.

More secure transactions or just surveillance?

The big issue with Central Bank Digital Currencies is the threat of surveillance, whereby the authorities have access to unprecedented amounts of personal and spending data. Is the prospect of replacing physical cash, which offers a high degree of privacy, with a digital form, another erosion of basic freedoms?

Will Central Bank Digital Currencies further escalate the dystopian future that technology, digital, and Artificial Intelligence have enabled? 

Or, will regulators recognize privacy challenges and address them in the design of a new digital currency? It all pivots on the competing priorities of transparency and privacy for governments and consumers. Let me explain. 

Balancing privacy and financial crime management 

From fraud to cybercrime and money laundering, financial crimes are on the rise. A 2022 PwC survey found that in the previous two years 51% of organizations surveyed had experienced fraud. While 69% of respondents to Kroll’s 2023 survey expect an increase in financial crime over the next 12 months. 

These crimes are often committed by those that profit from human trafficking, drugs, or terrorism. It’s little wonder that governments want to crack down with more resilient anti money laundering measures.

Central Bank power to control transactions

CBDC is seen as the perfect vehicle to do that because the movement of funds is completely traceable from the time they enter a CBDC platform. 

In effect, governments will have the power to control every transaction made using digital currency. By making transactions traceable through centralized ledger technology, they would be able to scrutinize transaction details, and even stop them. 

Central Bank power to control transactions

Most countries around the world are looking at CBDCs – 11 are now use them, and around 130 are in varying stages of exploration. So, regardless of the precise models adopted, the centralized collection of transaction data looks likely to happen. It’s how that data is used, and for what ends, that really matters. 

Increasing the existing threat to privacy

To detect financial crime, regulators need enough insight to single out suspicious transactions. In many ways, the centralized nature of CBDCs is both an opportunity and a risk for the federal reserve. 

The anti-crime argument for giving central banks more control over the data appears clear, but on the flip side, the sheer scale of sensitive data collected could actually make it vulnerable to cyberattacks. If exploited by bad actors, those vulnerabilities could compromise entire financial systems.

In the absence of proper security protocols, private transaction details could be used to surveil and even steal from citizens. In this way, the introduction of a Central Bank Digital Currency could actually worsen the threats to security and privacy.

It’s not the case, however, that the privacy versus transparency debate is based on polar opposite views. 

Privacy frameworks would be maintained

The Fed, for example, is keen to talk about benefits such as convenience, speed, cost, and expanded access to financial services. Yet it recently stated that any CBDC would need to ‘’strike an appropriate balance between safeguarding the privacy rights of consumers and affording the transparency necessary to deter criminal activity.’’

The Fed’s project, backed by President Biden’s March 2022 executive order, comes with the caveat that existing private sector identity and privacy frameworks would be maintained. Meaning any potential digital currency wallets would be intermediated, just like your bank account is.  

Cautious Canada weighs up the pros and cons

The federal reserve also made reference to the need for an authorizing law if it were to proceed. It’s evident then, that a full appraisal of all the pros and cons is taking place. 

Privacy concerns are also influencing the debate in Canada. In citizen feedback to the Bank of Canada on a digital currency, respondents highlighted political resistance;

  • Concerns were raised by 56% over fraudulent activity. 
  • Apprehension was expressed by 53% about cyberattacks.
  • 51% had confidence in privacy safeguards – 25% were skeptical. 

Privacy anxiety in the digital age

A central issue for the adoption of Central Bank Digital Currency is the power of technology to limit government surveillance and provide anonymous transactions. 

The private sector has made huge advances in financial capabilities around payments apps, e-wallets, and digital assets such as cryptocurrencies. 

For privacy campaigners, the move to CBDCs is a retrograde step, a further decline in our civil liberties and financial freedom. Taking control of the monetary system away from the private sector and handing it to government agencies is the final straw. 

With a centralized ledger, control is exerted from a single source by a single organization – in this case, the central bank. Any third-party processor or intermediary would have to seek permission to operate CBDC digital transactions.

Anonymous digital transactions

On one hand, centralized ledgers, which are permission-based, could make transactions and data more secure by having a single authority control them. On the other hand, the potential for misuse could threaten not only our financial privacy, but our civil liberties. Many critics point to the loss of anonymity and the heightened powers of surveillance, as reasons why CBDCs won’t be adopted. 

Anonymous digital transactions

By eliminating physical currency and replacing it with a digital form of central bank money, governments could control how, where, and what we spend money on. Critics argue that this ‘programmability’ of CBDCs is a very real threat. 

But are they justified in that view?

Seizing the CBDC opportunity

The answer is that we can’t be sure yet because the vast majority of countries are still in the pilot phase. What this presents is an opportunity. It’s a chance for regulators, and governments to address privacy issues in the design of a new digital currency and financial system. 

As major economies like the U.S., Eurozone, and China move towards Central Bank Digital Currency, CBDC opponents claim that currency will be under state control. That a new financial system to combat money laundering or terrorism would be very different, with different objectives. 

Supporters argue that this vision is too simple, and that governments will have to enact appropriate privacy measures that serve their people. 

Fed says no China’s CBDC model 

That said, there isn’t a consistent version of what privacy is around the world. Take China, for example. As far back as 2021, Federal Reserve Chair Jerome Powell said that China’s approach ‘would not work’ in the U.S. because it would allow the government to see every CBDC payment in real time.

While China’s digi-yuan pilot scheme is moving at breakneck speed, already reaching 260 million people. The U.S. is far more measured. 

With CBDCs now possible, Powell is keen to avoid calamitous missteps in the digitization of the globe’s dominant reserve currency. This includes making sure digital currency technology ‘makes sense’ for both the country and its citizens. 

In western societies, there is little evidence to suggest that governments could, or would want to, go on a solo run. Not only would congressional approval be needed to introduce a digital currency, but recent efforts have relied on public-private sector partnership.

Central Bank private sector collaboration

The latest stage of the Digital Dollar Project evaluation for cross-border remittances, was completed in August 2023. Relying as it did on collaboration with Western Union, BDO Unibank, and Accenture, it needed private sector efforts.

It’s very much the case that policymakers need financial institutions and technology partners to fully understand the feasibility of CBDCs for international settlements.

So what does all this mean for privacy concerns?

In simple terms, because governments and central banks are not the only stakeholders, it will be virtually impossible for them to ignore privacy concerns. Consumer trust and public consultation will be essential to make the transition credible. As will working with commercial banks to limit the disruption to financial systems.

Government skin in the CBDC game

This goes back to the opportunity presented by the pilot phase to create a validation architecture that is acceptable for all. If the government in the U.S, Canada, or United Kingdom want to implement a digital currency, it’s clear they have plenty of ‘skin in the game.’ It’s unlikely they would forge ahead and risk their own financial stability, knowing the CBDC project could flounder on the issue of privacy. 

And anyway, there is no single kind of CBDC system, there are many variants that could be used by a central bank. There are possible versions of centralized and distributed ledger technology, or token-based approaches, or combinations of them. Indeed, cybersecurity and privacy risks are paramount in considering the optimal design. 

It’s entirely possible that technology could protect consumer privacy, and prevent cyber crime. For example, encryption could limit access to personal and financial data, and also verify that transactions are legitimate and secure. Concerns over privacy could then be mitigated by allowing each component access to only the information needed for the system to function. 

Need-to-know basis for CBDC payments. 

In this way, anonymous transactions, where data is not directly linked to the identities of actual people, is possible. It’s not just hypothetical. Sweden’s Riksbank’s e-krona is an example of privacy architecture already in use to create a ‘need-to-know’ basis for CBDC digital payments.

Corda, its open source distributed ledger, offers some physical separation between those making transactions and regulatory actors. Only the transactor receives the data. If such a system proves popular, it could mean that government officials would have to seek access to transaction data, if they deem it necessary to obtain. 

Responsibility to serve citizens

The issue is summarized nicely in the key points of a letter to the Financial Times from Jack Fletcher, UK Head of Policy and Government Relations for Digital Currencies. 

In it, he claims that central banks could do more to ease fears over privacy. Countering objections that CBDCs could be used for surveillance purposes, he argues that they can mitigate privacy risks in three ways, by:

  • Maintaining a design framework that upholds data anonymity.
  • Examining novel solutions to create as much “cash-like” privacy as possible.
  • Embracing the responsibility in the design of CBDCs to serve citizens. 

Conclusion

The ability to hold and spend money as we like is a basic human right – one that is largely afforded by paper currency. 

For governments, CBDCs are a strong countermeasure in the fight against money laundering, cybercrime, and terrorist financing. It also could increase financial inclusion, and enhance the power of the federal reserve to dictate monetary policy. For consumers, it also protects against fraud, and promises faster, cheaper, and more secure transactions. 

Any CBDC system would have to allay consumer privacy concerns and the cybersecurity risks of storing huge amounts of data in one place. While these threats are real, governments have the opportunity to choose validation architecture that mitigates them. 

Without the relevant security protocols, CBDCs could magnify the current privacy challenges. However, what is more likely, is that by making the right technology choices, governments and central banks will be able to replicate and even enhance existing privacy measures.

The key issue is trust – do we trust the government to always act in our best interests?

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