Why Fedcoin

Six years ago I wrote a blog post about Fedcoin. Fedcoin is a type of central bank digital currency, or CBDC. (I called it Fedcoin at the time, but it could be any central bank that issues it, not just the Federal Reserve.)

So why Fedcoin?

The rough idea was that it might make sense for the Federal Reserve to create a digital version of the banknotes it issues. To do so it would use a blockchain, much like the blockchains that power Ethereum or Bitcoin. Anonymous users all over the world could download Fedcoin software and run it on their computers. In the same way that anyone can use a U.S. banknote (or bitcoin), anyone could get some Fedcoins and spend them.

Why a blockchain?

Public blockchains have many well-known problems. Because they are decentralized, they rely on work-intensive methods to process transactions. This reduces the throughput they can achieve. Transactions start to lag and they system becomes unusable.

To avoid these capacity issues, people generally advocate an alternative approach to CBDC. If a central bank is going to issue digital money that regular folks can hold, best to do so by providing a basic bank account. Sort of like PayPal, except run by the Fed. It would be faster and more efficient. 

Fedcoin has some benefits that Fed PayPal doesn't, though.

Like I said earlier, Fedcoin would replicate many of the features of a banknote. The banknote system already operates in a decentralized manner. This means that it is fairly robust. If the Fed is hit by a computer virus and has to close down for two weeks, the banknote system will continue to function just fine. That's because we banknote users—individuals, businesses, banks—operate large parts of the cash system, independently of the Fed.

Fedcoin would be similarly decentralized, thanks to its blockchain. And so hopefully it would still function when disasters, hacks, and invasions knock the Fed out of action. At least, more so than a PayPal account hosted on Fed servers.

More controversially, if the U.S. is going to create a digital currency, should it should be an anonymous one?

PayPal-like accounts at the Fed aren't anonymous. I mean, the Fed could allow people to sign up anonymously. Sort of like how egold, the anonymous PayPal that operated in the 2000s, allowed pseudonymous usage. But account holders would never really know what the Fed was doing behind the scenes. Might it be tracing everyone's account activity such that it could build an accurate portrait of each user?

No, if it wants to provide anonymous payments, then the Fed probably needs to give people a means of verifying that its technology is actually doing the job.

With Fedcoin, everyone could download and run the software, poke and prod it, audit it etc. This would allow the public to confirm that no one was operating behind the curtains. What you see is what you get. Sort of like how a $100 banknote is obviously anonymous. Just pull it apart. No surveillance technology. Just cotton, ink, and a security ribbon. I doubt the Fed could provide that sort of transparency with a Fed version of PayPal.

A fully anonymous digital dollar would have some good properties. It would protect us from surveillance by governments and corporations. In a recent article for Coin Center, Matthew Green and Peter Van Valkenburgh explore how this might work.

But anonymity is no panacea.

An anonymous Fedcoin would be the perfect medium for fraudsters and extortionists. Granny extortion schemes are a big business right now. (Head over to Kitboga to see how they work). These boiler-room operations, many of which are run from India, rely on awkward payments methods like Western Union or Walmart gift cards to get granny's money.

But imagine how easy things would be for an extortionist if they could get granny to convert her $100,000 portfolio of savings bonds into sleek & anonymous Fedcoins, and then send them instantly to India.

Or take ransomware. Criminals plant a virus on a corporation's servers and then demand a ransom to free their files. Ransomware operators—most of whom operate from Russia—rely entirely on bitcoin for payment, which is illiquid, volatile, and traceable. But imagine if the criminal could get paid in anonymous digital dollars. That would make the ransom process much easier.

So as you can see, anonymity is messy. It helps good people to avoid harm. But it helps bad people evade good rules.

One way to tidy up this mess might be an anonymity tax. (In my last paper for R3, I explored this idea. And in a previous blog post, I talked about an anonymity tax on banknotes). Briefly, the Fedcoin system would be designed so that anyone can get as much anonymous money as they want, and use it however they like. But they'd have to pay for this privilege. One technique for setting a tax is to charge an hourly fee, or a negative interest rate, on anonymous balances. Another option, which I get from Ilan Benshalom, is to implement a withdrawal fee, say 5%, on anonymous Fedcoins.

By taxing anonymity, the tax revenues from Fedcoin usage might be used by the government to offset the negative effects of payments anonymity. For instance, it could be used to bolster the budgets of fraud departments at the FBI, or to compensate victims of ransomware.

But even this remedy is messy.

An anonymity tax puts regular people and criminals into the same bucket. That hardly seems fair. And it subtly ostracizes licit users of anonymous Fedcoin. We want anonymous payments to be a regular good, not something icky or tainted.

That's where I'll leave it. Sorry, no neatly wrapped and bowed conclusion. With anonymity, there are never clean options. Just kludges. Hopefully some are less kludgy than others.