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Friday, May 27, 2022

International Security Implications of Central Bank Digital Currencies

International Security Implications of Central Bank Digital Currencies

Cryptocurrencies like Bitcoin and Monero have been the subject of much debate and consternation in international security and financial crime circles. These digital payment systems enable illicit financing through their uneven regulation, transaction speed and anonymity.

To date, the development and implementation of cryptocurrencies has largely been the purview of private actors. Few states have adopted cryptocurrency as a common (or replacement) currency. Globally, cryptocurrency is proving increasingly popular both as an investment vehicle and as a payment mechanism, so much so that many central banks are researching and piloting the creation of their own versions: central bank digital currencies (CBDCs). CBDCs present a range of risks and opportunities for the international community, and mitigating the worst possible effects of CBDCs will be difficult due to sovereign national monetary policies. In authoritarian regimes, CBDCs are likely to be embraced for their utility in mass surveillance and for illicit financing opportunities. Understanding the international security risks of CBDCs is a first step toward developing norms and regulations governing their use, although some of the worst excesses are likely to be difficult to avoid and will need to be mitigated instead.

How CBDCs Work

CBDCs are digital currencies backed by a government’s central bank. They are a form of state-backed currency, just like a bank note. These currencies differ from existing digital currencies (like Bitcoin, or Facebook’s Diem, or stablecoins like Tether) because they are backed by states, not corporations, or, in the case of Bitcoin, the blockchain. Since they are tied to a state’s currency, CBDCs will fluctuate along with the traditional currency. Most models of CBDCs are fully regulated under a central authority.

China has become the first major economy to pilot a CBDC. Other countries with pilots underway include Sweden, Ukraine, Saudi Arabia, the United Arab Emirates, South Korea and Thailand. The Bahamas has also implemented a CBDC pegged to the U.S. dollar, and Russia is expecting to have a prototype of its “digital ruble” available in late 2021. Canada has also launched a proof of concept, Project Jasper, for interbank settlements, and has partnered with the Monetary Authority of Singapore and the Bank of England to work on an international settlement system, and the European Central Bank is developing a digital euro.

There are different types of CBDCs in development. Some can be used for interbank settlements, some can be held at the central bank by the general public, and some are being developed as a form of digital cash that can be used for retail payments. There are a number of potential benefits of CBDCs for states and consumers, including lower (or nonexistent) banking fees, reduced costs associated with producing and managing cash, and greater financial inclusion. But there are also a fair number of risks, as well. CBDCs could facilitate illicit financing—such as proliferation financing, corruption, sanctions evasion, money laundering and terrorist financing—by providing illicit actors (in this case, states) with greater control and autonomy over their domestic or regional financial systems. All forms of CBDCs have various illicit financing risks; however, the type of CBDC most widely in development is the digital cash version, which poses some of the most clear-cut risks from an illicit financing perspective.

Digital cash CBDCs are easiest to think of as digital banknotes. Some CBDCs will use intermediaries to facilitate their use (likely banks or payment processors, similar to how payments are made today), while others may provide their own platforms that negate or reduce the need for retail banking. This has obvious implications for market disruption but also shifts many of the anti-money laundering/counterterrorist financing (AML/CTF) requirements to the issuer of the currency: the central bank. This, in turn, means that the issuer of the CBDC will need to implement identity-verification and other AML/CTF regulations.

International Security and CBDCs

Requiring that banks verify the identity of participants in a transaction is a cornerstone of AML/CTF policies, but when applied to CBDCs, this policy could essentially force the creation of a national identity system that might include personal data, credit history, financial transactions and other sensitive information. This presents obvious opportunities for intelligence collection and surveillance by states and would remove the existing barrier between states and personal finance. Financial intelligence has an important role to play in countering illicit finance; it provides critical information for pattern of life and social network analysis, and can assist in threat assessment. In authoritarian regimes, though, this would create the opportunity for states to more effectively and fully surveil their populations, with notable impacts on opposition and protest groups. Combining financial intelligence with other forms of digital information technology creates a digital authoritarian state, like the one that China’s Uighur population is now experiencing firsthand. While the Financial Action Task Force (FATF) has long trumpeted the creation of financial intelligence units and the exploitation of financial intelligence for counterterrorism and anti-money laundering, the international community has yet to fully grapple with the human rights and privacy impacts of financial intelligence and the AML/CTF regime. CBDCs will only exacerbate this.


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