By Angela Yap Siew Peng

Back in 1998, leading American monetary economist Narayana Kocherlakota posited that ‘Money is Memory’, a singular idea that continues to inspire economic thinking.

His paper of the same title, published in the Journal of Economic Theory, argues that money is a primitive form of memory and its circulation in the economy is akin to a “superledger” (as Agustín Carstens of the Bank of International Settlements puts it) that carries within it a history of all transactions – from big kahuna deals of who bought which submarine to mundane affairs of who paid for that bag of lemons, what you still owe the grocer, and if you’ve got enough pennies for a soda on the way home.

This is the central idea behind Kocherlakota’s theory. Money is more than just a medium of exchange; it is intrinsically a source of “high quality information storage and access”. If there were a way to tap into the memory of money, he warned that this could be exploited by parties other than the central bank (the only authorised issuers of money) and “the government’s monopoly on seignorage might be in some jeopardy as information access and storage costs decline”.

For a long time, the theory that ‘money is memory’ was seen more as a philosophical endeavour than practical reality. Today, that has all changed with fintech, specifically distributed ledger technology (DLT), the foremost technology underlying the creation of central bank digital coins (CBDC).

Digital Cash

CBDC, the new electronic currency that most governments are experimenting with, is very much talked about but often misunderstood. The most important misconception that needs to be cleared is that although the idea of a CBDC was inspired by bitcoin, the former is not a cryptocurrency.

Here’s why. As CBDCs are digital fiat currency, its issuance and record-keeping would be centrally controlled and tracked by monetary authorities. Permission to make changes in the digital ledger would be entrusted to authorised individuals (or validators) who each hold a private cryptographic key; a change to the ledger can only be made when consensus is achieved. This mechanism is known as ‘trust by reputation’ or ‘trust by default of a legal contract’.

In contrast, publicly traded cryptocurrencies like bitcoin are permissionless. Changes to the ledgers are done through consensus algorithm, i.e. ‘trust in math’. As long as the numbers and protocols check out, the ledger will record the change.

The countless rallies and crashes of Bitcoin (about eight, at last count) is proof of the underlying volatility in blockchain architecture and reason why cryptocurrencies cannot attain the level of public confidence in CBDCs. The finish line to a global implementation of CBDCs however is still a way off.

Ready, Steady, Go?

Although the majority of central banks are still unlikely to issue CBDCs in the foreseeable future, we must give heed to signals that policy coordination and technical design choices of proposed CBDCs will only intensify in the coming months.

In Ready, steady, go? – Results of the Third BIS Survey on Central Bank Digital Currency, the Bank of International Settlements (BIS) reports this January:

  • Of the 60+ participating central banks, 86% are exploring the benefits and drawbacks of CBDCs.
  • In recent months, major central banks have published a multitude of in-depth assessments of related policy issues and tested a variety of designs for CBDCs.
  • On 20 October 2020, the Bahamas launched its Sand Dollar, the world’s first CBDC which is globally convertible into traditional Bahamian dollars using a prepaid Mastercard.
  • Consequently, central banks collectively representing a fifth of the world’s population are likely to issue a general purpose CBDC in the next three years.

Already, the BIS has followed up with what is perhaps the first economic analysis on using a permissioned DLT as the basis for a new monetary system using CBDCs. In the February 2021 paper, Permissioned Distributed Ledgers and the Governance of Money, authors Raphael Auer and Hyun Song Shin of the BIS and Cyril Monnet of the University of Bern, write:

“While the concept of money as memory has been well-known in theoretical circles, the advance of cryptography and digital technology has opened the possibility of taking the idea of a complete digital ledger more literally, and building a monetary system around such a ledger. However, with a public ledger the issues that loom large are who should have the authority to update the ledger and how. This is all the more so given the incentive problems that arise to misrepresent ownership of funds.

“Under traditional account-based money overseen by an intermediary, for instance a bank, this authority is delegated to intermediaries. The bank updates the ledger by debiting the account of the payer and crediting the account of the receiver.

“However, in monetary systems without a central intermediary, the ledger must be updated by other means, such as a DLT, as exemplified by bitcoin. DLT is a record keeping device in the spirit of Kocherlakota’s analysis of money as memory…Application of permissioned DLT are being explored for securities settlement systems, trade finance solutions, ‘stablecoins’, and CBDCs.”

Proposed Architecture

Although the Bahamas has launched its retail CBDC and China its pilot, regulators are still studying the most appropriate technology for a CBDC.

Attempting to understand the architecture of CBDCs can be confusing as the term ‘blockchain’ and DLT are often used interchangeably. To understand the difference, TradeIX, an award-winning fintech for global trade and supply chains, explains:

“On the surface, distributed ledger sounds exactly how you probably envision a blockchain. However, all blockchains are distributed ledgers, but remember that not all distributed ledgers are blockchains. Whereas a blockchain represents a type of distributed ledger, it is also merely a subset of them.

“Think of blockchain and distributed ledger in the same way you might think of Kleenex and facial tissues. The former is a type of the latter, but it has become so popular that it becomes ingrained in people’s minds as what the product is.

“The most important difference to remember is that blockchain is just one type of distributed ledger…Removing the intermediary party from the equation is what makes the concept of distributed ledger technology so appealing. Unlike blockchain, a distributed ledger does not necessarily need to have a data structure in blocks. A distributed ledger is merely a type of database spread across multiple sites, regions, or participants.”

In fact, there are many options on what the underlying technology of a CBDC should be, however on the basis of security, central banks and other security experts are not in favour of blockchain.

Bruce Schneier, security technologist and lecturer at Harvard Kennedy School, explains why in a recent article by Wired magazine: “What blockchain does is shift some of the trust in people and institutions to trust in technology. You need to trust the cryptography, the protocols, the software, the computers and the network. And you need to trust them absolutely, because they’re often single points of failure.

“When that trust turns out to be misplaced, there is no recourse. If your bitcoin exchange gets hacked, you lose all of your money. If your bitcoin wallet gets hacked, you lose all of your money. If you forget your login credentials, you lose all of your money. If there’s a bug in the code of your smart contract, you lose all of your money. If someone successfully hacks the blockchain security, you lose all of your money.

“In many ways, trusting technology is harder than trusting people. Would you rather trust a human legal system or the details of some computer code you don’t have the expertise to audit?”

Fork in the Road

What then is the optimal technology for a CBDC? Whilst the jury is still out on that, results from the BIS’ Auer-Shin-Monnet study on DLT “suggest that a centralised ledger is likely to be superior, unless weaknesses in the rule of law and contract enforcement necessitate a decentralised ledger”.

The central question is about control over entries into the digital ledger – should the power to make changes to the database vest in a central authority or be designated to a network of validators.

In a centralised ledger, a central authority or administrator (e.g. government, bank, institution) is entrusted with the duty to control the contents of the ledger – what transactions get posted and in what credit/debit amounts. The risk is high when there is a single point of failure.

By contrast, in a decentralised ledger and DLT, such central authority or administrator is absent and the ledger is distributed across several nodes (devices) in a shared network. Updates are done independently as each node contains an identical copy of the ledger. Any modification by one party will be reflected in all other ledgers throughout the network.

Although DLT presents attractive benefits, it is not risk free. It takes time for an update to reflect in all nodes and such a lag can cause severe casualty in financial services, such as high-frequency trades where real-time data is critical down to the nanosecond.

A permissioned DLT also needs to incentivise validators to perform their job of validating transactions properly in order to maintain the integrity of the ledger. This may require a transaction fee as payment for the job, which adds to the cost of using centrally issued digital cash – taking it further away from financial inclusion goals and money’s role as a public good.

But the most crucial is how we strike a balance in the trade-off between user privacy and traceability. Identification is key to ensure the integrity of payment systems, prevent fraud, and AML/CFT efforts. Yet, in a world of increased data hacks and other privacy breaches, what new safeguards must be in place to protect privacy and ensure recourse in the event of a security breach?

Such questions run to the heart of banking stability and financial resilience. As vanguards of their economies, central banks have the Herculean duty of determining if CBDCs will have a role to play in their future economies and, if so, what necessary redesigns must take place in order to preserve the stability of value of all types of money.

Angela Yap Siew Peng is a multiaward-winning entrepreneur, author, and writer. She is Director and Founder of Akasaa, a boutique content development firm with presence in Malaysia, Singapore, and the UK and holds a BSc (Hons) Economics.