Welcome to another issue of CTPI Weekly, your premium newsletter on tech design and policy.

Today we'll cover:

The Brazilian CBDC (Drex) pilot launch,
and a brief history of cryptocurrencies.

We defend that there are always better tech alternatives to any use of blockchain, but the CBDC movement is quite interesting on its own. Instead of banning blockchain, it leverages the current financial infrastructure to control cryptocurrencies’ risks. If successful, it will be another example of regulators intervening in a market through technology instead of only through regulation.

Now let's get to it.

M. and J.

What we know so far about Drex

The Brazilian Central Bank (BCB) has launched a pilot of Drex, its Central Bank Digital Currency (CBDC). It is similar to Bitcoin and Ethereum, but instead of being a new currency, it represents an existing currency, the Brazilian Real (BRL).

At first glance, it may make little sense for a Central Bank to invest time and effort into creating a new cryptocurrency, especially since so many cryptocurrencies and stablecoins exist today. But Brazil is not alone in this effort. From the Atlantic Council CBDC tracker:

130 countries, representing 98 percent of global GDP, are exploring a CBDC. In May 2020, only 35 countries were considering a CBDC. A new high of 64 countries are in an advanced phase of exploration (development, pilot, or launch).

Most countries worldwide are considering building their own CBDC, and while we'll focus on the Drex pilot, most of the analysis also applies to the others.

A brief overview of cryptocurrencies

From the launch of the first cryptocurrency, Bitcoin, in January 2009 until today, the history of cryptocurrencies is filled to the brim with undelivered promises, financial losses, fraud, and crime facilitation.

Bitcoin, Ethereum, and other cryptocurrencies were created to build a payment system that would not rely on central authorities, such as banks or governments. From NerdWallet:

Bitcoin is a form of digital currency that aims to eliminate the need for central authorities such as banks or governments. Instead, Bitcoin uses blockchain technology to support peer-to-peer transactions between users on a decentralized network.

This is a promise that is definitely not delivered. While many cryptocurrencies don't require a wallet or exchange, the big exchanges centralize most cryptocurrencies today. Intermediating financial activities is the whole point of a bank, though. So exchanges with wallets behave as unregulated financial institutions. They make it easier for certain crimes to happen, such as the one involving FTX, which caused USD 8 billion in losses. One of the reasons for so much regulation in the financial industry is to prevent crimes like these.

The FTX crash is the most recent in a sequence of value destruction, although the type of damage changed over time. In the early days of Bitcoin, one of the biggest reasons to lose money was forgetting your password. Then, with Ethereum and smart contracts, there was the first large-scale theft of cryptocurrencies. Around USD 150 million were stolen because of a bug in the contract. Up to this moment, the damage was contained in the cryptocurrency and its users. Now, one of the growing concerns is the role of cryptocurrencies in facilitating crimes against society in general, even against people that have never used cryptocurrencies.

While crime facilitation has always been a big part of the cryptocurrencies’ history, the rise of ransomware to 20% of all online crime is directly attributed to the existence of cryptocurrencies. This type of crime only works if it is easy to move money worldwide anonymously. Again, in comparison to the financial system, much of the financial industry regulation is there precisely to prevent this type of money movement.

It is important to realize that the financial system also suffers losses from cyber attacks and fraud, but there is a crucial difference. In the financial system, most of these losses are absorbed by the banks because that is one of their functions. In cryptocurrency, society directly suffers the impact, such as the people who lost their savings in the FTX crash.

Back to Central Banks

With the previous context on cryptocurrencies, one could think that forbidding the use of cryptocurrencies in a country could help reduce the damage. Some countries tried the ban approach, but as we wrote about technology bans in the past:

These measures achieve their goal in the short term by disrupting the service. But they have more unintended consequences in the long term. In Brazil, people learned to use VPN to bypass app bans.

There is too much interest in cryptocurrencies for a ban to be effective. People will find a way to use it. And the risks cryptocurrencies currently pose to financial stability are even greater than what we've seen so far. From the Financial Stability Board:

Crypto-assets markets are fast evolving and could reach a point where they represent a threat to global financial stability due to their scale, structural vulnerabilities and increasing interconnectedness with the traditional financial system. The rapid evolution and international nature of these markets also raise the potential for regulatory gaps, fragmentation or arbitrage. Although the extent and nature of use of crypto-assets varies somewhat across jurisdictions, financial stability risks could rapidly escalate, underscoring the need for timely and pre-emptive evaluation of possible policy responses.

Financial and economic stability is one of the main goals of Central Banks and is one of the main drivers for the CBDC movement. CBDCs attempt to use the current financial infrastructure to control the risks cryptocurrencies can pose and, at the same time, enable possible innovations that may come from this technology. While we disagree that cryptocurrencies or their backing technology, the blockchain, have any practical value whatsoever, we agree with the movement for CBDCs as damage control.

Enter Drex

Drex is a no-compromises approach to the creation of a cryptocurrency. Current cryptocurrency implementations have mostly ignored money laundering, privacy, fraud, security, and stability concerns. Drex needs to address every single one of these concerns before going live.

In Drex, the stability risk is solved because Drex will not be a new currency. It will be a different representation of the Brazilian Real (BRL) in the same way that all forms of electronic representation of the BRL work: a financial institution (FI) has an account with BCB that effectively holds the amount of BRL that the institution can use on the rail. Unless a critical failure drives people away from Drex and they are willing to exchange Drex for less than BRL, Drex stability should follow that of the BRL. And even in such a catastrophic event, BCB can just shut Drex off and mandate that financial institutions move the money to other rails.

Security, fraud, and money laundry prevention (AML) is addressed in the same way the current financial system does: BCB delegates this responsibility to the FIs, and they are supervised to ensure the controls are working as expected. In Brazil, the BCB has enough power to punish misbehaving institutions, and historically it has been enough to deter and remediate bad behavior. Any FI willing to join Drex must detail how it plans to implement these controls properly and monitor that everything behaves well.

This brings us to privacy. Brazil has a privacy framework similar to the European GDPR, the LGPD. There is also a law that protects financial information as privileged in the country. And this is where things get substantially harder for Drex. Apart from KYC information, the bank secrecy regulation does not allow for sharing financial information without the customer's consent. On all payment and transfer rails, the payee FI also receives information about the payer, and there is clear implicit consent that the payee FI will receive this information.

Due to how blockchains work, though, all FIs will receive all information about all payments and transfers done in the country. It is not reasonable to assume such implicit consent in this case. Pseudonymization also does not solve this because the payee FI needs to know the origin of the funds for AML prevention. Even with fancy key exchanging and derivation protocols, all FIs will be away from a single key compromise to a possible massive violation of bank secrecy. One can argue that the FIs would never use a compromised key to access the information of transactions outside of the ones done by them. Still, internal security violations do happen from time to time in any FI. That is an awful position for FIs to put themselves into. The group working on the Drex pilot will dedicate the next six months to researching a solution for problems such as this one. From our expertise in cryptography, it does not look promising, though.

A last-resort privacy-preserving alternative would be to solve this problem at the root cause: not sharing the blockchain. Only the BCB would have the blockchain, and the FIs would send the transactions through APIs. In this case, would Drex be a cryptocurrency? Technically yes, but it would be the least performant clearing house in the world. So not much reason to go through all this since Brazil already has an exceptionally performant and secure clearing house, the SPI, which clears Pix transactions.