Monday, November 27, 2017

Central banks shouldn't ignore their duty to provide anonymity

Cross section of a banknote with a cotton paper core surrounded by two layers of polymer [Source]
 
Central bankers are at their most comfortable when engaging in technical debates over the finer points of monetary policy. But over the next few years they may be forced out of their comfort zone into a thorny philosophical debate over anonymity and financial censorship. They are poorly equipped for such a debate.

When central bankers monopolized the issuance of banknotes in the 1800s and early 1900s, little did they know that a hundred years later anonymity would become an important public good. And because banknotes are the only generally-accepted way for law-abiding citizens to make uncensored anonymous payments, central bankers effectively became—by accident rather than design—the sole purveyors of these vital services.*

Banknotes are anonymous because it is very difficult to link banknotes to identities, say by monitoring usage of notes via a note's serial number. As for 'uncensored', this means that banknotes are available for anyone to use—i.e. they are highly resistant to censorship. There are no gateways involved, no need to get permission ahead of time by opening an account or installing some sort of proprietary software or hardware, and no way for the issuer to halt a payment while it is being made.

If you glance through the research papers that central banks typically publish, they're almost all on monetary policy. And why not? A stable medium of exchange is one of the most important services provided by a central bank, so they need to do their homework. But if you try to find research on the topics of anonymity and censorship resistance, good luck. What this tells me is that central bankers know very little about the unique set of services they are providing to the cash-using public, despite being the world's only suppliers. Not only have they blundered into their role of monopoly provider of anonymity and uncensored payments, they are trying their best to pretend the role isn't theirs.

Take for instance the European Central Bank's decision to stop printing the €500 note, which was motivated by the desire to cut down on crime. No doubt a significant chunk of €500 notes are used by criminals, but the ECB seems to have made no effort to quantify the anonymity services lost by the tax-paying non-criminal public. Because the ECB has never officially admitted its role as Europe's sole provider of uncensored payments anonymity, it lacks the sorts of datasets and institutional wisdom that are necessary for formally approaching problems about anonymity and censorship-resistance. So while their decision about the €500 wasn't necessarily wrong, it was surely uninformed.

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Related to all this is Tyler Cowen's recent article criticizing central banks that take an active role in developing their own cryptocurrencies. His critique includes the Fedcoin idea, or a public cryptocurrency available to anyone that is pegged by the central bank to the national unit of account. Cowen says that this "new and potentially risky responsibility" might tax central bankers' resources. The problem with this is that the responsibility of delivering anonymous and censorship resistant cash is an old one. In this context blockchain technology isn't anything special, it's just another technology among many that central bankers might use to upgrade the quality of the public services that they are already providing.

Banknote technology has been constantly improving over the decades. For instance, anti-counterfeiting technology began with serial numbers and elaborate engravings on notes in the 18th and 19th centuries. Even after banknote production was monopolized by governments, improvements continued into the 20th and 21st centuries with security threads, watermarks, holography, raised images, clear windows, latent images, microprinting, and luminescent ink. The substrate on which notes are printed has evolved from cotton and/or linen to polymer, or a hybrid of the two (see image at top). If central bankers had applied Cowen's advice to avoid new technology, banknotes would still be printed on cotton and lack modern anti-counterfeiting devices.

So think of encoding banknotes onto a public blockchain—the Fedcoin idea—as just another change in substrates. In the same way that the anonymity and censorship resistance embedded on a cotton substrate was replicated on a polymer one, why not test out the idea of replicating these features on a blockchain? Along with anonymity and censorship resistance, a public blockchain would capture the decentralization of banknote systems, and thus their robustness in the face of disasters, a feature I wrote about here.**

The advantage to digitally delivering these services rather than physically delivering them on polymer or cotton is that a payment no longer requires face-to-face meetings; it can occur over the internet. This would constitute a dramatic upgrade to the quality and breadth of the anonymity and censorship resistance services that are currently being provided by our central bank monopolists.

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With the emergence of bitcoin and the slowly percolating Fedcoin debate, central bankers are thinking for the first time in ages about designing cash-like systems from scratch. And since these systems may eventually replace the physical stuff, central bankers will have to accept the fact that they are the only providers of anonymity and censorship resistant payments services, and that maybe they should get their act together and think hard about the value of these services to the public. A great start can be found in former Fed policy maker Narayana Kocherlakota's Monetary Mystery Tour, which ends with the exhortation: "Need more economists working on these issues!"

Bringing this back to Cowen's article, I don't agree that central bankers should refuse to test the idea of a central bank-issued cryptocurrency because this represents a new and risky technology. That would be shirking their duty as a monopolist provider of the unique services embedded in paper cash. Central bankers should only say no to Fedcoin because they've done a rigourous cost-benefit calculus that takes into account the social value of anonymity and censorship resistance to the public, and that effort has resulted in a conclusion that the status quo—the provision of these public services on a polymer or cotton substrate—is the best option. 

Having blundered into their role as monopoly provider of anonymous payments, here's hoping that the cryptocurrency revolution means that central bank's finally take that role more seriously. If they don't, maybe they should just give up their monopoly.




*Can bitcoin serve as a suitable replacement for cash? Unlike cash, bitcoin can't be used to make anonymous payments. Bitcoin payments are pseudonymous—so they don't quite make it over the line. The other problem is that bitcoin is not pegged to national units of account. Thanks to its terrific volatility, bitcoin has failed emerged as a genuine medium of exchange, so it can't take on the responsibility of providing law-abiding citizens with a generally-accepted anonymous and censorship-resistant medium for making payments.
**I am by no means wedded to blockchains as a way to digitally capture anonymity,censorship resistance, and robustness. There are other ways to go about this that do not involve blockchains.

24 comments:

  1. The implied assumption is that owners of a banknote cannot change the denomination or double spend. That is the counterfeit proof premise, an assumption in the theory.

    The CB should continue improving the banknote concept, change the substrate a bit.

    Move from passive polymer to active to just light up a small LCD display to show the denomination.
    Add an NFC interface so the denomination can just be passed securely from note to note, honestly. Then the polymer layer displays the remaining cash available.

    Now, you have converted the bank not into an intelligent banknote. It is an advanced debit card with an intelligent chip or a very cheap smart phone with tamper proof protected messaging. No matter what angle you arrive, it is the smart cash card and is a natural outcome of all three technologies.

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  2. "In the same way that the anonymity and censorship resistance embedded on a cotton substrate was replicated on a polymer one, why not test out the idea of replicating these features on a blockchain?"

    This is an elementary question, but are you saying that it is not possible for ANY third party to trace the identity of a payor in a cryptocurrency transaction using blockchain?

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    1. It depends on the blockchain. In the case of bitcoin, all transaction records between addresses are publicly available. So even though the owners of addresses are anonymous, it may be possible to get enough information about transaction flows to flush out who they are.

      With blockchains like Monero, however, transactions information is mixed up so there is no way to associate transactions with addresses. So it is almost impossible to trace identities of payors.

      https://www.monero.how/how-does-monero-work-details-in-plain-english

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  3. As much as I understand blockchain and cryptocurrencies, I don't think a blockchain based crypto-currency, a quasi-bitcoin, can serve the needs.

    Nevertheless, with digital currency we will never have complete anonymity - so pseudonymity is a valid goal that is plausible. There will always be possibility of "lifting the veil" under court orders following due process of law.

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    1. As I pointed out to JKH, bitcoin gets us to pseudonymity. But other blockchain technologies get us much closer to a cash-like level of anonymity, say Monero or Zcash. A central bank-issued cryptocurrency would have to follow along of the lines of Zcash/Monero rather than bitcoin if it is to be a decent digital replication of banknotes.

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  4. “And because banknotes are the only generally-accepted way for law-abiding citizens to make uncensored anonymous payments, central bankers effectively became—by accident rather than design—the sole purveyors of these vital services.”

    I’m puzzled by the overall argument.

    Surely the primary service provided by bank notes is convenience rather than anonymity, and that anonymity is a coincidental by-product of the payment mode. If the same convenience can now be digitized, what exactly is the argument for force designing that by-product of anonymity into a digital mode?

    Conversely, what is the primary argument for digitization if not an increase in convenience? Surely the primary argument is not a replication of anonymity. And if anonymity is not the primary argument, again what is the argument for replicating it?

    I see anonymity as a coincidental feature – not the essential service. What would be the argument for it being an essential service?

    Does a citizen actually have the right to shield certain transactions from the tax authorities? What is the proof that tax evasion has or hasn’t occurred in that case?

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    1. There's no point in creating digital cash for the sake of convenience. If an individual is not concerned about anonymity but only wants to buy stuff quickly on the internet, then bank-issued digital payments options like credit cards are an excellent option.

      But if law-abiding citizens are concerned about anonymity, and want to transact over the internet or some other remote manner, there are currently no options. That's the argument for digitizing cash.

      Here is one of my favorite arguments in favor of anonymous payments:

      https://www.frbatlanta.org/-/media/Documents/research/publications/wp/2004/wp0418.pdf

      I see it as being an essential service because the private sector is precluded from providing it.

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    2. I still don’t see the logic of the overall argument.

      “There's no point in creating digital cash for the sake of convenience. If an individual is not concerned about anonymity but only wants to buy stuff quickly on the internet, then bank-issued digital payments options like credit cards are an excellent option.”

      I’m referring to the potential to replace Fed note payment with payment by Fedcoin. Surely that’s a function of convenience. Why else would somebody switch?

      “But if law-abiding citizens are concerned about anonymity, and want to transact over the internet or some other remote manner, there are currently no options. That's the argument for digitizing cash.”

      I don’t understand the presumed non-illegal concern with anonymity for the consumer, or why a central bank should be concerned about it. (In my own case, the referenced paper doesn’t help). I see anonymity as a legal by-product characteristic of central bank notes, not a proactive objective behind the original idea. So I’m not surprised that central banks would not have researched this aspect more generally.

      I suppose I see a potential concern on the part of the CB, if its notes start to be redeemed as a result of some nominally anchored version of private sector crypto currency. But I’m not sure why this would happen to any great degree more than what already happens as a result of normal debit and credit card transactions, and we know that the note attrition in that case is generally slow, at least in North America. I see all digital forms, including those which have been existence for a long time, rather than crypto digital per se as determining the residual demand for bank notes. In any event, central banks don’t need to issue banknotes in order to set interest rates, so I’m not sure why it matters. And obviously a CB will set the design of bank settlement accounts in such a way as to ensure that the essential interest rate setting process continues.

      “I see it as being an essential service because the private sector is precluded from providing it.”

      I don’t understand. What’s that got to do with the argument in favor of Fedcoin? Unless Fedcoin is more convenient than Fed notes?

      Sorry if my comments seems contentious, or askew. I plead ignorance in my attempt to put of this into a coherent story (in general – not necessarily your specific post).

      For me, it starts with the rotten story of bitcoin value as an absurdly speculative bubble, extended by a Rube Goldberg machine of conceptual rationalization for anonymous crypto currency demand in general. I see the cryptocurrency demand story as a scam of leveraged persuasion, undertaken by real world crypto hustlers.

      This could just be the result of my own lack of understanding.

      But I don’t get ‘it’ from anything I’ve read or heard so far.

      Perhaps this will all dawn on me down the road sometime – when I realize what everybody else seems to know already – that block chain is the greatest idea since the internet itself.

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    3. JKH, will get back to you in a bit. Gotta get some stuff done first.

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    4. "I’m referring to the potential to replace Fed note payment with payment by Fedcoin. Surely that’s a function of convenience. Why else would somebody switch?"

      People would switch because Fedcoin would be cheaper to handle and store. You could withdraw it from you bank account using your phone, without having to walk or drive to a bank. And instead of having to drive over to a store to make an anonymous cash payment, you could just do it from your computer at home using the company's website.

      The benefit isn't purely in switching, but in realizing all the transactions that never get made. Cash can't be used over long distances, and many people are wary of using non-anonymous alternatives. So they don't spend. Fedcoin fills this void.

      "I see anonymity as a legal by-product characteristic of central bank notes, not a proactive objective behind the original idea. So I’m not surprised that central banks would not have researched this aspect more generally."

      Yep. Likewise, the lender of last resort function was never a part of the original idea behind central banking. The bungled themselves into the role. The same with the provision of payments anonymity. It's time they recognized their duties.

      "Sorry if my comments seems contentious, or askew. I plead ignorance in my attempt to put of this into a coherent story (in general – not necessarily your specific post)."

      No problem, you're making me think harder about what I've written!

      "For me, it starts with the rotten story of bitcoin value as an absurdly speculative bubble, extended by a Rube Goldberg machine of conceptual rationalization for anonymous crypto currency demand in general. I see the cryptocurrency demand story as a scam of leveraged persuasion, undertaken by real world crypto hustlers."

      I too am a bit grossed out by bitcoin, especially the huckster elements. While I got the Fedcoin idea from watching bitcoin, but they are distinct ideas. Don't let your negativity about the one flow to the other. Remember, Fedcoin would just be like cash, pegged to the unit of account; so no one would be speculating in the stuff.

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  5. Time for reductio absurdum.

    If I configured an android phone with spending keys for $20, and no pass code, then I give it to you. What have I created?

    The exact duplication of the $20 banknote in digital form. It is square, made of plastic, shows the denomination, it counterfeit proof and delivers $20 in spending authority,. I can give you a $20 digital spending android, and you can give me a $5 version in change, works exactly like a banknotes, real actual paper cash.

    Material costs are enormous. The material costs are enormous not because of counterfeiting, or double spending, we have solved that by making the keys counterfeit proof. Tim Cook says he an do that.

    The costs are enormous because I give you the phone itself. But, instead, I can make one small change, why not just give you the keys by tapping my digital bill against yours. The bills can safely make change to each other by passing keys, no blockchain required, we are back to the counterfeit proof problem, easily solved.

    And we have a precursor, the debit card with the dumb chip, just make that chip smart, add the NFC interface, a denomination display and a four position entry button. My point. How did duplicating the banknote in digital form involve a blockchain? There is no justification, not even a regulation arbitrage justifies blockchain. It is a puzzle.

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    1. As I said in my post: "I am by no means wedded to blockchains as a way to digitally capture anonymity,censorship resistance, and robustness. There are other ways to go about this that do not involve blockchains."

      So if your version of digital cash can get us anonymity, censorship resistance, and robustness, then great. I don't care what the substrate is, as long as it replicates these features while at the same time allowing us to transact over the internet.

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  6. "While it may look odd for a central bank to issue a cryptocurrency that provides anonymity, this is precisely what it does with physical currency, ie cash. Perhaps a key difference is that, with a retail CBCC, the provision of anonymity becomes a conscious decision. It is worth recalling that the anonymity properties of cash are likely to have emerged out of convenience or historical happenstance rather than intent."

    https://www.bis.org/publ/qtrpdf/r_qt1709f.pdf

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    1. Yep, I was thinking about that exact quote from Rodney Garratt when I was writing this post.

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  7. I think this is fairly good framing:

    “While these digital currencies may not pose major concerns at their current levels of use, more serious financial stability issues may result if they achieve wide-scale usage. Risk management can act as a mitigant, but if the central asset in a payment system cannot be predictably redeemed for the U.S. dollar at a stable exchange rate in times of adversity, the resulting price risk and potential liquidity and credit risk pose a large challenge for the system. During times of crisis, the demand for liquidity can increase significantly, including the demand for the central asset used in settling payments. Even private-sector banks and certainly non-banks can have a hard time meeting large-scale demands for extra liquidity at the very time when their balance sheets may be in question. Moreover, this inability to meet the demand for extra liquidity can have spillover effects to other areas of the financial system.”

    And:

    “Given that privately developed digital currencies may raise important financial stability issues tied to the value of the asset, some have argued that central banks should begin to issue their own digital currency as a 21st century analogue to paper currency. I would urge caution, particularly for countries like the United States with highly developed banking systems and ongoing robust demand for physical cash… For the United States, the alternative to privately issued digital currency is not necessarily a publicly issued digital currency. Instead, the near-term alternative is to build on the trusted foundations of the existing payment system and work to improve private-sector payment services … Privately developed digital currencies as currently configured would raise concerns about the effect on financial stability if they take on more prominence in the payments and overall financial system. Central bank digital currencies are also not immune to a large range of risks and could even adversely affect financial stability. As such, central banks should tread cautiously as they contemplate issuing them.”

    From:

    https://www.federalreserve.gov/newsevents/speech/quarles20171130a.htm

    That's a Fed speech released just today.

    Obviously a regulatory view and arguably biased against the wild west crypto culture.

    I just say - thank goodness for adult supervision.

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    1. The Bank of Canada also just released a paper on the topic of Fedcoin/CBDC:

      http://www.bankofcanada.ca/wp-content/uploads/2017/11/sdp2017-16.pdf

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    2. Thanks.

      Good paper. I found section 5.4 relating to banking system 'equilibrium' particularly interesting.

      Also, the closing remarks:

      “An interesting question is whether a central bank liability that is accessible to the general public, like cash or CBDC, is desirable from a social-welfare perspective. Is it sufficient for a central bank to supply only reserves to qualified financial institutions? Put differently, is a “cashless society” a sound outcome.”

      I still think the anonymity perspective needs further fleshing out. The article suggests pure anonymity would not be advisable, most particularly in the case of taxable interest income on I-CBDC. There would seem to be advantages in avoiding certain kinds of fraud risk compared to credit and debit cards, but there is also the risk of losing computer records with DC.

      As of right now, I’m not sure whether the overall concept is over its skis, or if I’m over my skis in trying to figure it out.

      : )

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    3. "The article suggests pure anonymity would not be advisable, most particularly in the case of taxable interest income on I-CBDC."

      The problem of combining anonymity and interest payments is an interesting one, I hadn't thought about it until I read this article. A major advantage of digital currency over cash (from the perspective of a central banker) is that it can pay both negative and positive interest. So no zero lower bound plus it implements the Friedman rule.

      But as the article says, for tax reasons the BoC needs to provide information about the identity of the receivers of interest to the tax authorities. And in the case of negative interest rates, many people may want to claim that as an expense for tax purposes. And that would require associating identities with the money being used.

      So the twin benefits of a cash product that is anonymous and pays interest clash with each other.

      I like one solution they propose in a footnote:

      " A central bank could consider issuing both an anonymous benchmark CBDC (with a cap on the maximum amount that could be held) along with an I-CBDC (with no cap on balances). Analysis of such an approach is for future research."

      So basically, if you want to get positive interest (or claim negative interest as an expense) you need to use unshielded CBDC. Otherwise you continue to shield yourself, but lose out on these benefits. It's elegant. You're basically paying to get the benefits of anonymity. (I disagree with the cap part of the idea. Impossible to implement anyways since you can't prevent anonymous individuals from breaching a cap).

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  8. some interesting contrasts:

    https://www.bloomberg.com/amp/news/articles/2017-11-26/what-the-world-s-central-banks-are-saying-about-cryptocurrencies

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  9. Regarding the “Money is Memory” paper, which I think you referenced somewhere:

    https://www.minneapolisfed.org/research/sr/sr218.pdf

    This strikes me on the surface as written at a level of abstraction that lies somewhere between formidably brilliant and awesomely useless.

    I didn’t get a whole lot out of it. Except that it reminded me that I’ve long forgotten anything that I might once have only slightly understood about Lebesgue measure theory.

    Care to take a shot at an intuitive translation of the paper?

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    1. sorry - I see the reference to the paper is actually from David Andolfatto's blog:

      http://andolfatto.blogspot.ca/2017/11/tyler-cowen-on-central-bank.html

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  10. Crypto means watermark, as in watermark on papercash. Bitcoin is blockchain, not cryoto, The web accounts are encrypted, all the new coins are blockchain. Crypto is cash because any party can verify the watermark with a known algorithm, and the watermark is counterfeit proof. The definitionshave been fouled bynthe bitcoiners.

    Also, digital watermarks need not be anonymous to the parties, its an option. Software can verify both valid cash and the owner, if you choose. The something you cannot do with cash is clear the transaction with a central clearing house at each transaction.

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  11. This is excellent:

    https://www.moneyandbanking.com/commentary/2017/12/3/bitcoin-and-fundamentals

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