CBDC: A Mandate for Digital Property

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To evaluate a potential central bank digital currency (CBDC), the Board of Governors of the Federal Reserve System published a paper in January 2022 titled Money and Payments: The U.S. Dollar in the Age of Digital Transformation (the Paper). — In its executive summary, the Fed’s Paper states:

“For a nation’s economy to function effectively, its citizens must have confidence in its money and payment services. The Federal Reserve, as the nation’s central bank, works to maintain the public’s confidence by fostering monetary stability, financial stability, and a safe and efficient payment system.”

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However, a first-principles approach demands recognition that ‘money’ and payment services – while no doubt important – are merely tools facilitating economic transactions toward a specific outcome. Simply speaking, citizens do not require confidence or even want money for its own sake, but for its utility and what it represents: a store of value, and a reliable placeholder for current and future use, including most importantly, property rights. — As such, our response adopted the following framing instead: For a nation’s economy to function effectively, its citizens must have strong, and enforceable property rights, as these are the foundation of economic prosperity, as guaranteed by the Fifth and Fourteenth Amendment of the U.S. Constitution.

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The executive agency responsible for promoting economic prosperity and ensuring the financial security of its citizens is the Treasury Department, with the assistance of the country’s central bank, currently responsible for managing the people’s primary system for property exchange: its currency.

Background

Despite the charitable assessment of the Paper, payment technologies offered by the Federal Reserve have indeed not evolved alongside today’s network technologies. As of now, the central bank provides currency to the public only in the form of Federal Reserve Notes (Cash) printed on a cotton and linen-blend fabric, available in seven denominations: $1, $2, $5, $10, $50, and $100. While legally classified as IOUs, these bills – and smaller denominations in coinage – provide citizens and non-citizens strong protection akin to property rights, enabling its bearer to settle transactions without a third party by transferring the note.

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However, as the precipitous drop in velocity of the physical Cash reported by the Federal Reserve Bank of St. Louis shows, a Federal Reserve Note (“cash”) is on average used less than five times a year to purchase domestically- produced goods and services. And since cash is almost entirely unsuitable to the functions of an effective economy, citizens are forced to use commercial bank, and nonbank currencies which are burdened with an ever-growing number of frictions, including censorship, time delays and fees. The latter amounts to more than 1.9% of all currency transferred – in other words:

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After moving any amount of currency fifty-times, almost its entire value has been absorbed by middlemen!

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Putting these number into a wider context: The global financial services market grew from $20.5 trillion in 2020 to $22.5 trillion in 2021 at a compound annual growth rate (CAGR) of 9.9%. This number should be contemplated in conjunction with the International Monetary Fund reported global gross domestic product at $94.9 trillion.

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The contributors to this response have studied global CBDC efforts, and private market currency solutions for several decades, guided by an understanding that any U.S. CBDC must, among other things:

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·        secure the property rights of citizens better than the legacy currency systems,

·        provide benefits to households, businesses, and the overall economy that significantly reduces the costs and risks associated with the legacy currency systems;

·        protect consumers’ rights of freedom of expression, self-determination, and privacy;

·        protect consumers and businesses from criminal activity;

·        have broad support from citizens holding or using U.S. currency today.

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The Paper defines a CBDC as a digital liability of a central bank that is widely available to the general public, and analogous to a digital form of paper money. The following response will make use of that definition while differentiating between the function of current “paper money”, and its uses cases – i.e., as a form of payment, with the understanding that currencies are technologies that systematize agreements over money. The latter is legally a contract between parties choosing a unit of account and a medium of exchange for their transaction. To illustrate this point, one might imagine a pedestrian picking up a $100 Federal Reserve Note of a New York City sidewalk, consequently using the note as money to pay for his dinner at a restaurant. A tribesman finding the same $100 bill in the sand of the Kalahari Desert might not consider it, and use it to kindle his fire that night. — CBDCs can a) mitigate against the loss of purchasing power, b) end wholesale surveillance of private financial transactions, c) provide financial inclusion, d) globally promote US values, e) offer faster and more efficient disaster response, f) secure the global dominance of the US Dollar.

Loss of Purchasing Power

Today, the central bank provides currency to the public in form of Federal Reserve Notes printed on cotton and linen-blend fabrics, available in seven denominations: $1, $2, $5, $10, $50, and $100. While legally classified as IOUs, these bills – and smaller denominations in coinage – offer users strong protections akin to property rights, enabling the bearer to settle transactions without a third party by transferring the note. However, with the introduction of digital technologies into the economy, ‘cash’ as it is commonly referred to, has become a niche application, settling only 19% of all transactions in the United States as of the end of 2021, and accounting for less than 5% of the value being transferred. Currently, the US central bank provides currency in digital form only to commercial banks, while consumers are reliant on commercial banks, and nonbanks for all digital forms of currency storage, transfer, and overall control.

Ending Wholesale Surveillance of Private Financial Transactions

To date, with few exceptions, financial transactions involving digital forms of fiat currencies involve the disclosure of personal, identifiable data of the recipient and sender, regularly sharing this information with a number of intermediaries and retaining copies – often for undisclosed purposes. This wholesale surveillance of financial transactions is at the core an externality of regulation purportedly aimed at bad actors wanting to use the financial system for the purpose of money laundering or other nefarious activities. However, as extensively documented and widely reported (see this Economist article) AML measures have largely failed to mitigate the illicit financial activity, while intermediaries keep exposing sensitive information to a wide variety of data brokers, and their often outdated networks and systems are susceptible to criminals gaining access to slews of poorly secured databases.

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47% of Americans experienced financial identity theft in 2020.

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While the paper mentions of the necessity of privacy-preserving features, they are followed up by remarks that AML regulations will still need to be followed. These concerns fail to position AML regulations as an exemption from the prohibition of warrantless surveillance, as an externality of legacy financial systems such as account-based architecture, and its underlying database structure. With the latter being addressed by technology, the former exception can no longer be used.

More egregious though is the weaponization of fiat financial systems by totalitarian governments which persecute their own citizens, including for such ‘crimes’ as publicly disagreeing with the party line in social media. A problem that US Federal Reserve Notes currently provide a partial solution to.

Digital privacy – including financial privacy – is readily available via encrypted communication, and peer-to-peer value transfer solutions.

Financial Inclusion

While the paper stresses the importance of the inclusion of the ‘unbanked’ in the financial system, they regularly fail to address the true reasons why citizens do not maintain bank accounts. Despite the fact that legal tender laws point to the obviously public nature of fiat currencies, governments regularly deputize commercial entities to administrate and intermediate the use of national financial systems.

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This extension of government powers to otherwise commercial entities have in some cases led to the outright confiscation of funds custodied by banks. These ‘bank bail-ins’ have been used in Cyprus, depositors with more than 100,000 euros to write off a portion of their holdings. Although the action prevented bank failures, it has led to unease among the financial markets in Europe over the possibility that these bail-ins may become more widespread, while eroding consumer trust in banks in general.

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Setting these extreme examples aside, the fact that financial institutions are empowered to impose their own conditions on the use of the banking system has led to systemic discrimination against consumers that are deemed to be unprofitable, and in some cases do not conform with the moral framework of banking executives.

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The largest group of unbanked, however, is comprised of individuals unable or unwilling to pass stringent anti-money laundering procedures often charitably labeled as ‘know-you-customer’ requirements.

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Tellingly, that term even appears in quotations within the secretly extended legal requirements for – what must otherwise be considered – an invasion of financial privacy. CBDCs discussions offer little hope for the two billion unbanked citizens, most of which do not even possess government credentials.

Promote US Values

Cash issued by any country has largely the same properties – namely the ability to act as a recognizable medium of exchange, without the need for a middleman, while settling transactions in real-time with finality. As such the historical success of Federal Reserve Notes is its ability to serve as a medium of exchange, a unit of account, and a pricing function when local currencies could no longer provide these functions.

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While legally considered IOUs, Federal Reserve Notes have de-facto long been the most successful and profitable technology exported by the United States. It costs the federal government around 14 cents to produce a $100 bill, and a few more cents to send it overseas. In exchange for each of those bills, the issuer receives a permanent interest-free loan of $100.

Faster, more Efficient Disaster Response

The Fed’s Paper alludes to recent improvements to the U.S. payment system, claiming that its efforts in “payments have been a particularly active field of private- and public-sector innovation.” However, the U.S. Government Accountability Office, an independent investigative agency that reports to Congress, issued a comprehensive report on the nearly $3 trillion in funds dedicated to mitigating against externalities from the government’s unprecedented shutdown of large parts of the US economy. The report uncovered disturbing deficiencies in the federal payment system, with many citizens waiting weeks for checks to arrive in the mail, with some funds never arriving at their reported destination.

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In 2020 the federal government sent stimulus payments to almost 1.1 million dead people totaling nearly $1.4 billion.

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Securing the Global Dominance of U.S. Dollar

As of today, the U.S. Dollar is the world’s reserve currency, awarding enormous privileges to the issuer of the currency. However, several countries have ambitions to subvert the Dollars positions in the global economy.  These nations have long done away with checks, provide e-money solutions to their citizens, and enabled large parts of their merchants to utilize ubiquitous mobile payments solutions using QR codes with sub one percent or no fees at all. As some of these applications already have more users than the United States has citizens, it is easy to see how these solutions might be adopted by a growing global population, should a U.S. digital bearer instrument not be available in the near future.

Policy Considerations

As of today, the goals of U.S. central banks monetary policy are to promote maximum employment, stable prices, and moderate long-term interest rates.

For the nation’s economy to function effectively, human capital must be allocated efficiently. However, legacy technologies frequently lead to misallocation of human capital. In particular obsolete network technologies – such as systems of money (currencies), using data siloes, require human intervention akin to dispatchers in legacy phone networks. Keeping citizens occupied with non-productive labor, prevents these individuals from acquiring skills in demand by the free market.

Internet technologies have proven to be the largest contributor to employment opportunities over the past twenty years. Decentralized software solutions – such as blockchains – are now extending the capabilities of this global network over pure information distribution to a new network layer of value distribution. The latter already enables a myriad of employment options. However, a climate of “regulation by enforcement” has driven much of the development of this promising new economy out of the United States. A U.S. CBDC designed as digital bearer instrument, allowing for “programmable money” solutions can reverse the trend, and ensure viable employment options in the space within the United States.

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P.S. Some of these thoughts will find its way in our book Streaming Money to be published later this year. You can pre-order it here.

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