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Modern Money Meets SCA: Crypto & Central Bank Digital Currencies

First published: 10/11/2022

updated: 21/11/2022


If you’re part of the finance world, you live in exciting times. The news is flooded with new regulatory initiatives, technology and challenges. But, from a birds-eye perspective, even larger trends that have to do with the nature of “money” should be notably observed. In this lengthy post, we look into how cryptocurrencies and central bank digital currencies differ from today’s money and their impact on security requirements.

Money - what is it?

Money is a generally consented-to commodity that serves as a medium of economic exchange. It circulates from person to person and country to country, facilitating trade and is the principal measure of wealth. Money started as objects (commodities), but through history, it has made its way onto coins (metallic), paper, credit, plastic, and digital currencies.

The financial world as we know it today has slowly moved away from paper money towards credit cards and bank accounts. Relatively recently, it moved into the cryptocurrency space. And now, we are seeing the possibility of central bank-issued digital currencies.

With each new money-related technology, many challenges related to securing transactions and identifying/authenticating the payer or payee remain the same. However, on a more fundamental level, another question remains: how does this technology change the concept of “money”?

If the money-related technology at hand fundamentally changes how “money” is implemented, what will be the impact? Will ordinary consumers even notice any difference? Let’s take a look.

Today’s trends: Cryptocurrencies & Central Bank Digital Currencies (CBDCs)

The cryptocurrency space that grew out of the initial 2008 Bitcoin whitepaper by Satoshi Nakamoto has been almost entirely unregulated. Moreso, avoiding third parties from validating transactions was one of the initial motivations for Bitcoin. But taking into account the enormous amounts of fraud in the cryptocurrency space, there have been growing calls for regulation and consumer protection, particularly in the EU (we will get into this later).

But now, with regulation on the rise, another money-related trend has been showing up on the radar: central bank-issued digital currencies. CBDCs are an alternative to cash (and banks) in an increasingly cashless world. But perhaps more importantly, as an answer to the challenges raised by cryptocurrencies. Because CBDCs are issued and backed by a central bank, they likely won’t need a distributed ledger (such as the blockchain). But, at the same time, because central banks back them, there are many more questions about privacy and tracking.

CBDCs to the rescue...?

There are some apparent issues with cryptocurrencies, such as fraud, environmental impact, and the complexity of the protocols and solutions involved. As such, central bank digital currencies have been considered both a response and an alternative to cryptocurrencies.

While a cryptocurrency is based on a distributed ledger with some proof to avoid double-pay, implementing a CBDC would most likely use a database run by the central bank (or some approved private entities). The database would record the amount of money held by every entity, where the value is directly linked to the currency’s value, much like a bank does today. In addition, since the government basically runs the database, the entities and people can be authenticated by the government.

An important question regarding CBDCs is, “what problem are they solving”. Is it to reach the unbanked? Is it to provide a faster, more efficient, cheaper, and more law-abiding alternative to existing banks? Or is it to provide an official alternative to cash?

A central bank can provide better terms for deposits than any private bank if they want to. But should central banks be allowed to out-compete private payment initiatives if they can? This could also impact the amount of CBDCs issued to not compete with existing banks. And that alternative to the cash question: if a CBDC is a central bank run with a slightly more modern interface than a current bank, it will not offer the benefit of anonymity you get with cash. Alas, these are complex political issues.

Anti-money laundering rules (for Europe)

Just this summer, The European Union agreed on rules for regulating the cryptocurrency industry in the wake of the Terra meltdown and Bitcoin plunge. The rules “will ensure a harmonised market, provide legal certainty for crypto-asset issuers, guarantee a level playing field for service providers, and ensure high standards for consumer protection.” The announcement is essentially a provisional agreement on enforcing the “transparency of crypto asset transfers”, extending anti-money laundering regulation to cover transfers of cryptocurrencies.

While not explicitly stated, such transfers will likely be required to implement Know Your Customer (KYC) and Strong Customer Authentication (SCA) for customers. In addition, they’ll only be allowed to transfer to known recipients who also are authenticated. This will make exchanges more responsible when doing anti-money-laundering checks on incoming transfers. However, it will also make it much more inconvenient if you want to use cryptocurrency as a payment for a service or to transfer it out of the regulated system, particularly if you’re hosting your wallet and not using an exchange.

Getting back to the EU, the Council also announced that they reached a general agreement on crypto-asset regulation. Known as (MiCA), service providers will be liable if they lose an investor’s crypto assets, require liquidity reserves for stablecoins, and ensure that a cryptocurrency’s climate footprint is declared. The last part is particularly important, as Ethereum had an infamous power requirement for maintenance equal to the electricity usage of the entire nation of the Netherlands (even though they only reached a peak of 22 transactions per second)!

The challenge of privacy rights for “money”

Cash, bank account balances, cryptocurrencies in a digital wallet, or CBDCs all have one thing in common: they represent some form of value backed by the trust you have in the entity that issued it or is keeping it for you. For many of us, cash and banking are easy to conceptualise, even if fractional reserve banking is a bit hard to grasp. But if you’re curious about how banks create money, there is a good page on Wikipedia for money creation.

When comparing cash and traditional banking, there are two significant differences: cash lets you make payments with at least some expectation of anonymity, while bank transfers and card payments allow for safe payments by authenticating both the recipient and payer. While the safety aspects of banking are beneficial, there is something to be said about not having all your transactions tracked by a bank or the government. 

In my view, the issue of privacy mostly comes down to privacy versus anonymity. While it is obvious that consumers are (mostly) not criminals and have a fundamental right to privacy, many criminals want total anonymity for their transactions. So, in a way, avoiding fraud often comes down to preventing the criminal’s right to anonymity. To me, it is not clear how we can both offer anonymity and protection against fraud simultaneously. Perhaps the best we can hope for is a reasonable right to privacy, which would still require authenticated transactions.

A media theme on cryptocurrencies is how criminals use them to avoid government tracking. Some currencies, such as Monero, are created with privacy in mind. But for the most common cryptocurrencies, such as Bitcoin and Ethereum, tracking is built into the distributed ledger that is fundamental to the technology. As such, as long as you can associate a wallet address with a person, the transactions registered on the blockchain can also be linked to the person. 

Making this connection between a wallet address and a person when a crime happens can be extremely hard. This is partly why the EU has started legislating how cryptocurrency transactions can occur.

Where will future payments occur?

When was the last time you saw someone use a paper cheque? If new payment systems can offer services which are cheaper, faster, or more convenient than existing solutions, there is a chance that they will take over the payment flows. 

From a consumer perspective, the underlying technology couldn’t be any less interesting. After all, “consumers care about shopping, not payments”. So, for most people, this is primarily an academic question. Still, there is one crucial factor: for money to have value, people need to trust financial services and the institutions that guarantee their funds can be used to buy goods and services in the future. 

Regardless of whether or not we base future payments on cryptocurrencies, central bank digital currencies, open banking, or existing card rails, future payments will demand strong customer authentication to authenticate the sender and recipient. In addition, security will indeed only become more critical over time. Therefore, a strong focus on security is essential to build trust. Still, whatever is used as a future solution, I hope it’s implementation will have privacy and consumer protection in mind, as well as authentication that is as frictionless as possible.

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