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Finance

CBDCs and the Fight Against Financial Crimes

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The adoption of the Central Bank Digital Currency (CBDC) is heralded by many as the beginning of a new global financial era. Despite the fact that 130 countries are exploring CBDCs, including all of the world’s major economies, the topic is contentious.

In an increasingly cashless world, digital transactions and the holding of digital assets is gaining broad traction. Digital currencies are a way for central banks and governments to regain control of unregulated cryptocurrencies and maintain monetary sovereignty.

They are a means to improve financial inclusions, promote greater fiscal stability, and increase the transparency and efficiency of transactions. That’s the theory, anyway. 

Critics argue that the centralized nature of this new programmable fiat currency offers the state excessive control, with impacts on privacy and civil liberties. It’s clear that CBDC offers benefits and risks for both central banks and consumers. 

Combating financial crime with digital currency

The term describes a range of activities that use financial systems, or instruments to generate illicit profits for criminals. Money laundering, cybercrime, identity fraud, and terrorist financing are something of a scourge in the digital world. According to research by Deloitte, almost €1.87 trillion, up to 5% of the globe’s GDP, is laundered each year.

The specific feature that helps central banks monitor and trace these transactions is distributed ledger technology. Instead of the public, shared ledgers used for cryptocurrencies like bitcoin, and stable coins, central bank digital currencies run on private, encrypted blockchains. 

Restricting access to financial data

While permissionless distributed ledgers are accessed by multiple participants who can access transaction data, permission-based ledgers would restrict access to a single party. In this case, central banks would effectively control all CBDC transactions, and be able to view every transaction from the time it enters the system. 

CBDCs could then provide a variety of benefits in the fight against financial crime, like:

  • Improved traceability. 
  • Greater transparency. 
  • Automated transaction monitoring.
  • Fraud and money laundering detection capabilities. 

Making it harder for criminals to operate

Digital CBDC transactions could be tracked using blockchain technology that offers an irrevocable record of fiat currency transactions. The reporting and analytical functions of a centralized system will foster improved anti-money laundering capabilities.

It will help central banks and governments cooperate internationally to promote collective mechanisms and regulatory frameworks. By being programmable, where governments could monitor or even stop transactions.  

CBDCs may stop money being received by criminals and sanctioned groups. And even in instances where it does fall into the wrong hands, digital currencies could be programmed to be useless, or seized by the authorities. 

If it makes the digital financial systems harder for criminals to operate on, it takes away one of their current advantages. The level of sophistication that bad actors can have in the current system knows no bounds. This, it is argued, would force criminals to use physical currency, at a time when it is becoming more redundant.

Controlling the financial crime risks

If CBDCs prove popular and are accepted by the public, the move away from physical money to a digital version will throw a brighter spotlight on the shadow ‘cash-only’ economy. This has big implications for tax evasion, and could bring untold sums, previously untraceable, back into the tax authority’s net. 

By allowing the federal reserve to progress systemic financial objectives around money laundering and fraud, fiat currencies create a new platform to address financial crime. 

That is one school of thought. The other, is that precisely what makes it secure, is what could undermine the digital currency and expose it to new risks.

New terrorist financing and money laundering risks

Critics argue that by storing massive volumes of currency and data in a single place, CBDCs would invite the kind of cyber attacks that could completely undermine them. The potential that the system could be hacked and exploited by criminals who develop fresh methods, would threaten monetary and financial stability.  

It’s worth remembering, however, that most of the decisions about what form CBDC will take are still being made. Aside from the eleven nations where CBDCs are now in use, very little has been decided. Fundamental questions remain, such as about the:

  • The nature of public-private cooperation and the role of commercial banks in a new arrangement.
  • Technology capabilities are needed, and the extent of their interoperability with traditional financial systems.
  • Choices between tokenized or account-based CBDC designs. 
  • Decision to use in consumer retail and business settings, or for wholesale use by financial institutions, or both. 
  • CBDC ecosystem needed to allow people to spend digital currencies as they wish. 
  • How CBDC would improve cross border payments.
  • The regulatory framework that would need to apply around the world.
  • Validity of a purely digital currency for citizens. The European Central Bank, for example, views the digital euro as part of a hybrid solution with existing physical notes.
  • How privacy would be maintained in legitimate transactions.

Privacy and legitimate cash transactions

At present, much of the debate around CBDC is polarized about the competing aims of transparency versus privacy. This, too, is something that will only be borne out when adoption takes place. In reality, the objectives of citizen privacy and transparency need not compete.  

In a recent statement, The Fed’s Jerome Powell, emphasized how a digital dollar would have to strike a balance between privacy safeguards for consumers and the ‘‘transparency necessary to deter criminal activity.’’ 

In fact, the digital dollar project comes with the condition that current privacy frameworks be maintained. CBDC could indeed protect individual privacy by encrypting access to financial data while verifying that transactions are legal and trustworthy. 

There is also a possibility that transactions could still be anonymous with transaction data not linked to identifiable individuals. 

Vulnerability of Central Bank Digital Currencies to cyberattacks

The privacy architecture that allows this is already used in Sweden’s pilot e-krona. Separation between transactors and regulators is afforded by an open-source distributed ledger that limits government access to data on a need-to-know basis. 

If we assume that privacy safeguards can coexist with heightened powers to fight financial crime, we remove a sizable roadblock to CBCD adoption. We’re not finished yet though – for some, the vulnerability of CBDC to cyberattacks is very much its Achilles heel. 

But, are those concerns justified? Are central banks just placing all their virtual eggs in one basket, for criminals to target more easily? Will the threat of financial crime be worse as cyber criminals evolve for new ways to outfox law enforcement? 

Are we going enough to fight financial crime?

Digital currencies are evolving at a time of growing doubt that current financial systems are doing enough to tackle financial crime. 

Open banking is a concept that’s been around since the 1980’s, but came into effect in 2019 in the UK, and is being introduced in the U.S.. It gives third-party payment interface providers access to transaction data from banks and other financial institutions. 

It relies on an Application Programming Interface that gives the software used by different companies a gateway to access and share information. By sharing data, it enables secure interoperability between banks to speed up payments and generally make them more efficient. 

Revolut, for example, is an open banking application that offers personalized banking experiences by allowing consumers to manage all their banking needs in one place. Using Revolut, consumers can link all their accounts in one place for full visibility, and interrogate their own data in innovative ways. 

Public access to financial data

By giving people choices about how they use their own data, it offers an array of previously unimagined innovation in financial services; banking, foreign exchange, peer-to-peer payments, debit cards, small loans, budgeting tools, stocks and crypto exchange. 

Where once traditional banks held all customer data on a closed system, open banking has increased the number of players and products in the financial space.

Despite efforts to make it more secure with two factor authentication and any money laundering checks, open banking introduces more access points for criminals to steal customer data.

The chief concern is that open data sharing increases the likelihood it will fall prey to skilled criminals who can target frailties and exploit them to steal personal data. The longer the chain is, the more likely it will contain weak links. 

Better collaboration and intelligence sharing

With far more parties involved in financial transactions, the volume that traditional banks are processing is rapidly decreasing. Many of these transactions happen outside the auspices of traditional banks, hindering their view of customer activity and, ultimately, making suspicious behavior more difficult to monitor. 

Without a holistic view, and with financial institutions more siloed than ever, inadequate monitoring offers criminals the ideal setting to disguise their activities. 

The solution to all this, experts argue, is to foster better collaboration and intelligence sharing across the financial ecosystem. In this way, the pooling of transaction data would create the conditions to identify, track and share knowledge of financial crime activities.

In this scenario, critics of the crime fighting capabilities of open banking espouse greater public-private partnership. From a technology standpoint, they propose distributed ledger blockchains to strengthen power around digital identity verification.

This is a very different dynamic to the one proposed under current plans for CBDCs. Creating a single point of financial data control for a central bank would certainly change the current role of third-parties and intermediaries. 

Potential benefits of Central Bank Digital Currencies

CBDCs, if accepted by consumers, would give control back to the central bank, and would not require them to give access to commercial banks, or anyone, for that matter. It’s certainly possible that controlling access to transaction data by hosting CBDC on secure, private blockchains could obstruct some financial crime techniques:

  • Transactions would be more transparent and easier to track.
  • The recording of transactions would offer stronger audit capabilities. 
  • Monitoring transitions in real-time using data analytics would uncover financial crime trends. 

Financial crime is not limited to national borders

There’s little doubt that CBDCs will be better than physical currency for improving anti-money laundering capabilities. There is, however, a growing body of evidence that digital currencies will attract new cyber security risks. 

Key features like programmable wallets and the ability to disguise larger volumes under a penny are just a few. It all adds to the view that Central Bank Digital Currencies could be an easy target for financial criminals. That AML regulation would have to catch up globally, nationally and regionally to prevent unlawful use of CBDC. 

Key concerns include:

  • The borderless quality of CBDC would make detection harder.
  • Countries differ in their approach to AML and know your customer compliance with CBDCs.
  • How international settlements would be regulated.
  • Cooperation between countries who are developing CBDCs for their own ends, like Russia and China’s digital yuan, would hinder efforts for consistency. 
  • At the current rate of development, the West is not in a position to influence global CBDC legal and regulatory standards. 

Conclusion

For the authorities, the proposed adoption of CBDC presents both risks and rewards in the fight against financial crime. 

By extending their powers of control, and placing them back at the heart of the financial system, CBDCs increase the overall relevance of central banks and help them to dictate monetary policy. In doing so, they gain new powers and technological measures to fight crime.  

On the flip side, digital currencies, critics argue, could make the financial system more susceptible to the very thing this initiative is trying to prevent. By placing vast amounts of financial data on a single central system, it would be open to new forms of exploitation by criminals. 

Of particular concern is the global nature of CBDC, and the need for a cross-border regulatory framework around the world. In that case, do the conditions for global cooperation on a digital currency exist? Maybe, but regulation will have to catch up in what is a fraught and unstable period for the world. 

For the CBDC project to work, and stop money launderers who channel illicit profits through legitimate structures, governments will need the private sector and the global legal community to play a key role.

For now, in the exploration and pilot phase, the need for governments to make careful choices is paramount. Perhaps that’s why, in the democratic west, at least, progress is stalling. 

When it comes to internationalizing your business and life, nothing works alone. Nomad Capitalist is the only firm of its kind that combines tax, immigration, asset protection, and investment strategy, all under one roof to create a plan as unique as you are.

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