CBDCs and Privacy

Whether CBDCs are designed as token- or account-based, regulations such as those governing money laundering and the funding of terrorism mean total anonymity/privacy is not possible. Given that while privacy is highly valued in principle, the public take little to no action to safeguard their privacy in practice, is it so important? Whatever the answer, when it comes to the design of CBDCs, privacy is much discussed. Casual media reports of using CBDCs to control spending (stopping the purchase of alcohol for example) raises fears and highlights that ultimately digital privacy only extends as far as people trust their governments. In some parts of the world, not very far.

The Centre for Economic Policy Research (CEPR) has recently published an article ‘Central bank digital currencies, cryptocurrencies, and privacy: What experiments tell us’ by Emanuele Borgonovo, Stefano Caselli, Alessandra Cillo, Donato Masciandaro, Giovanni Rabitti. To address the problem some innovative experiments were run. The experiments assessed the role played and relationship between the different functions of cash (unit of account, medium of exchange, store of value) with privacy as a variable. Privacy was defined as anonymity in this work. It is this exploration of the importance of privacy which is novel in the research.

Those taking part in the experiment assigned a value 1.44% greater on average to an anonymous medium of exchange compared with one that was not anonymous. It also assessed the importance of the attitude to risk in that preference. Risk-prone subjects had a risk premium which was 30% greater for at least 50% of their choices. Why could be because they did not want others to know that they like risk because risk aversion is the social norm. Or risk-prone subjects are more likely to make illegal deals and so value anonymity more. Finally, the experiments investigated the relative importance of anonymity compared with illiquidity risks and the expected return. The finding was that these attributes tend to be more influential than anonymity and that expected returns have a greater influence than illiquidity risk.

For the anonymous mediums of exchange, people required a more-than-proportional increase in the expected return in order to accept a higher illiquidity risk. The paper suggests this might explain the initial interest in bitcoin. It offered high returns sufficient to justify the illiquidity risk of bitcoin, and other cryptocurrency offerings.

A CBDC should have a low illiquidity risk. The denominator in the ‘return/illiquidity’ ratio is small. Mathematically as soon as the return moves beyond negligible, the ratio becomes high. Theoretically a CBDC could be made a highly attractive currency relatively easily and cheaply.

The findings of this work show:

  • Anonymity matters;

  • The opportunity cost is the more relevant property of money;

  • A combination of the three properties of money is likely to increase interest in a medium of exchange;

  • Risk-prone individuals like anonymity even more;

  • Given the level of anonymity, to accept higher illiquidity risks, individuals require a more than proportional increase in the expected return.

Given that the experiments confirm that anonymity matters, cash can maintain its appeal as an anonymous medium of exchange. However, if a CBDC can be trusted to offer anonymity while balancing illiquidity risk and expected return, then they could be an attractive alternative to cash.

If cryptocurrencies can decrease their illiquidity risks, increase their expected rate of return and offer credible anonymity, then they can be an attractive medium of exchange. If CBDCs lack anonymity and/or have low expected returns, then cryptocurrencies, which have these attributes, may be more attractive. This has policy implications for all suppliers of mediums of exchange, whether banks, central bankers, and private firms. Although CBDCs are unique, combining being electronic mediums of exchange as well as being a public currency, their attractiveness will depend on their design in terms of their level of privacy and interest-bearing mechanisms. Given that in theory the illiquidity risk of a CBDC is low and it seems unlikely that individuals will view it as offering the same anonymity as cash, the experimental results in this paper suggest that offering a yield could help increase its overall appeal.