A central bank digital currency: Challenges and opportunities
Digital national currencies are no longer just a concept. The Bahamian Sand Dollar was issued in October 2020, and other countries, such as Sweden and China, are currently running pilots. Within the next few years, there could be more than a dozen central banks issuing national digital currencies.
These central bank digital currencies (CBDCs) are different from cryptocurrencies like Bitcoin or Ether. CBDCs are issued by national banks. The Sand Dollar, for example is backed by the Bahamian government and one-to-one with the Bahamian dollar, which is itself pegged to the U.S. dollar. They’re also not mined like many cryptocurrencies.
The requirements for CBDCs will differ from country to country, as The Bahamas has different needs than does the USA. Generally speaking, the technical platform should interoperate with other payment platforms and be future proofed so it can integrate new technologies as they emerge to avoid premature obsolescence.
The U.S. Federal Reserve Bank is researching a digital dollar and developing a prototype, though it has not made any additional commitments to a CBDC. Nevertheless, a digital dollar is highly anticipated by the global financial community. Given the dollar’s importance to the international financial system, the decisions the Fed makes about whether to issue a digital dollar and the form the digital dollar would take will have an enormous impact on banks and payments systems around the world. That’s one of the reasons the Fed is being so cautious as there are a number of significant challenges around privacy and security with CBDCs. None of these challenges is impossible to overcome, but addressing these issues may require novel approaches and new technologies.
The Privacy Dilemma
If the Fed is to issue a digital dollar, users need to have privacy. At the same time the Fed needs to be able to prevent fraud and other crimes. Some believe the more privacy there is, the harder it is to prevent illicit activity. In reality, technologies can both protect privacy and address fraud.
To address fraud, investigators should be able to use forensics tools to trace the flow of funds used during a hack or theft. But just as an address does not need to be labeled with a person’s name or made publicly available, a user’s ownership of a particular account can be kept confidential.
To address privacy, CBDCs could help to revolutionize the way people manage their identities, including those that are currently underbanked or unbanked. Today, we use our driver’s license or social security number as proof of identity. As a result, we are unnecessarily sharing private information that, if leaked to the wrong people, could be very harmful. Using zero knowledge proofs, people can validate who they are without having to share their confidential information, and with smart contracts, only the information that needs to be provided for a particular use case would be shared.
Instead of addressing fraud after it’s occurred and when it’s harder to retrieve lost funds, it’s important to look at technologies that prevent fraud. As CBDCs will likely be accessed through mobile applications, mobile application security could help prevent personally identifiable information from getting into the wrong hands. For example, proper security measures will prevent hackers from changing login screens of financial applications that would have enabled them to steal usernames and passwords and risk trillions of dollars' worth of assets.
Security: How Can New Security Challenges Be Addressed?
Security will also pose challenges, as the digital dollar will become an immediate target for criminal organizations and nation states. CBDC platforms will require security that protects the user’s data, application and connection between application and backend server. As a result, the Fed and other central banks are looking carefully at building their build CBDCs on a cryptographic platform.
Fundamentally, digital currencies enable a broader set of people to have choice. Those that want to "be their own bank" and manage their own keys can do so with hardware wallets, paper wallets and online wallets. People have the freedom to choose what type of wallet they want to use to manage their funds and how much they want to put into each wallet. This freedom of choice is no different than how people choose to allocate their funds in savings, checking, investments or cash.
People may also choose to have someone else take care of their private keys and digital assets. Central banks will need to consider the range of choices users will have. Along with those choices come security considerations. As mobile phones will likely be used to manage CBDCs, mobile wallets on smartphones will need to be strongly protected. Mobile application security as well as emerging technologies can prevent tampering of apps that undermine the integrity of financial transactions.
There’s no doubt that digital currencies are coming, and other countries are proving that it can be done. The technology world would do well to pay close attention -- not only will it transform the world of payments and commerce, but there are also enormous opportunities to fill the security and privacy gaps that currently exist.