The Marshall Islands SOV Deconstructed

In 2018, the Republic of Marshall Islands (RMI) parliament passed the Sovereign Currency Act 2018 (the SOV Act), which established the digital currency Sovereign (SOV) as second legal tender in addition to the US dollar based. As legal tender, the SOV would be able to be used for any purchases as well as all payments of debt and tax obligations. Pursuant to this law, the SOV would be issued by the Ministry of Finance and would be non-redeemable. It was to be introduced via an initial coin offering (ICO), which the appointed organizer – SFB Technologies was tasked to perform. The law also requires transparency over the identity of the SOV users. The SOV would be issued on the Algorand blockchain.

One main purpose of the SOV is to generate revenue for the government. Additional motivations expand financial inclusion and improve RMI’s access to the global digital financial system.

After the initial issuance through an ICO, the number of SOV units would grow by 4 percent per year coded into the blockchain independently of the demand for the currency. Half of the revenue from the initial issuance (24 million SOVs) would be allocated to SFB Technologies and the other half to the RMI government. SFB technologies is tasked with developing and implementing the SOV and would bear all the necessary costs to issue the SOV and perform the ICO.

SFB technologies was planning on organizing a pre-sale of rights to future SOV units, with an eye to “test the markets and technology” and to gather additional information that could inform the government’s decision whether to proceed with the launch of the SOV. The pre-sale as currently conceived is independent of the RMI government and is designed as a private sale.

At a first glance, this arrangement sounds great, but a closer look reveals that it sounds too good to be true. Let us deconstruct the statements above to figure out where the SOV’s fatal flaws lie.

First, introducing the SOV would imply that the RMI would move to a dual currency system. In the absence of a monetary policy framework and a central bank this would impose significant risks to macroeconomic, monetary, and financial stability. The fixed annual growth rate of 4 percent irrespective of the demand for the currency would lead to large fluctuations in the value of the SOV against other currencies, including the U.S. dollar, the primary legal tender. These fluctuations, in turn, could create incentives for households, firms, and visitors to hoard the more stable/appreciating legal tender, while discharging debts and other obligations, including tax obligations, in the depreciating legal tender. This could have serious adverse consequences for the RMI’s public finances. Also, given that the RMI does not have a central bank, the country would effectively outsource its monetary policy to a private sector party creating a strong dependency.

Second, SFB technologies is foreign start-up with limited financial sector experience. The company’s intention was to seek financial support from potential investors to finalize the design of the SOV highlighting the immaturity of their technical concept. Also, SFB technologies’ dual role of issuer and private investor may create the appearance of a conflict of interest.

Third, based on the SOV’s issuance through an ICO as a way of raising revenue can be considered a securities offering. As there is no securities regulation governing either the pre-sale or the actual issuance, the RMI exposes itself to a regulatory vacuum unable to thwart or respond to potential fraud and manipulation.

Fourth, the identity of SOV users is expected to be verified through licensed international exchanges. However, licensing exchanges that will list the SOV is a mammoth task that may exceed this small country’s existing regulatory capacities. Moreover, although the exchanges are responsible for identity verification and establishing white and black lists for financial integrity purposes, the RMI government would still have to manage those lists as well as monitor and enforce compliance. Given the weakness of the country’s anti-money laundering (AML) and counter-terrorism financing (CFT) regime and capacity constraints within the regulatory and supervisory agencies, it remains questionable whether financial integrity risks can be mitigated adequately. The Digital Economic Zone for the exchange of virtual assets would only exacerbate the financial integrity issues.

Fifth, the stated goal behind the SOV is to raise revenue for the government to offset the fallout from revenue from the reduction of the U.S. Compact grants after 2023. However, there is no indication how much revenue the SOV issuance would generate. For revenue to be sizeable, there would need to be strong demand for SOV by foreigners. This seems difficult given the strong competition from existing crypto assets. In addition, through the SOV issuance, the small economy’s revenues would be subject to global crypto market price volatility.

Finally, the country’s frequent power and network outages could hamper the issuance and wide-spread use of the SOV, obstructing the goal to achieve financial inclusion and impeding the country’s access to the global digital financial system. More importantly, the SOV issuance could jeopardize the country’s last U.S. corresponding banking relationship with First Hawaiian Bank exacerbating the RMI’s access to global financial networks.

It is easy to get blinded by the promise of enormous revenue from a state-backed crypto-asset like the SOV especially considering impending revenue fallouts. But issuing, managing and sustainably maintaining a crypto-asset designated as legal tender is a complex endeavor and requires important prerequisites such as an adequate legal and regulatory framework, sufficient capacity to supervise and regulate the SOV as well as the security of the underlying system and a viable digital infrastructure. Rather than embarking on a project of this magnitude and complexity, the Marshallese could consider other options such as rationalizing public spending which is the highest in the Pacific region to unlock extra revenue, lean on regulated stablecoin or e-money providers to expand access to finance, work with development partners such as the World Bank or the Asian Development Bank to expand the country’s core infrastructure and request technical assistance to enhance the country’s legal and regulatory regime.

The government is now considering to repeal the SOV Act and a bill on establishing a Digital Economic Zone was submitted to the Parliament recently.

Central Bank Digital Currency (CBDC) Privacy and Transparency: Not So Black and White

In designing central bank digital currency (CBDC), central banks face a trade-off between satisfying legitimate user preferences for privacy and mitigating financial integrity risk. Physical cash protects privacy because it is anonymous, but it also facilitates criminal financial transactions such as money laundering, financing of terrorism, corruption, and tax evasion.

A CBDC that gives authorities access to user identity and their transaction data would provide obvious financial integrity oversight benefits. However, such fully transparent CBDC might raise concerns around digital surveillance with CBDC potentially being instrumentalized against users, especially in jurisdictions where trust in public institutions is low. Also, such CBDC might disadvantage those without access to identification, which could impair financial inclusion efforts.

On the other hand, a fully opaque CBDC that hides users and their transactions from authorities, could introduce significant financial integrity risks, notably due to the ease and speed with which transactions can be performed and their potential global reach. Privacy preferences are not driven only by the desire to conduct illicit transactions but also to mitigate spamming and identity theft, and of being stalked or robbed (Kahn and others, 2005).

But there are many dimensions of anonymity and privacy with different CBDC design implications.

Dimensions of CBDC Anonymity and Privacy

Brookings (2020) and R3 (2021) specify two dimensions of privacy – anonymity and transaction privacy. Anonymity means that it is impossible to link transactions or activity to the sender or recipient. Under the EU General Data Protection Regulation (GDPR) identity data is considered personal data, i.e., any piece of information that relates to an identifiable person. This can range from pseudonymous keys or metadata (e.g., location data or online identifier) to personally identifiable information, like government ID numbers. A transaction is private if related metadata (e.g., whether it occurred, its amount, between who and when, whether the two parties have transacted before) is not revealed.

Then there is the question of who and how identity and transaction data is shared with. Bech and Garratt (2017) specify two types of financial anonymity – counterparty and third-party anonymity. Counterparty anonymity means that a payor need not reveal their identity to the recipient. Third-party anonymity means that the payor’s identity is invisible to all other parties, including the operator of the payment system.

Digital Currency Design Considerations

The Financial Action Task Force (FATF) has issued standards that countries should implement to prevent money laundering and terrorist financing that will impact CBDC design considerations. In most instances, to comply with FATF standards, some information on CBDC users and transactions would need to be collected and, on a when-necessary basis, made available to competent authorities. However, some form of proportionality could be applied to reduce data requirements on low value transactions to foster adoption and usability, provide a more ubiquitous access to CBDC, and assuage data privacy concerns. For example:

Brookings (2020) suggests that the central bank could delegate account and identity management to one or more payment service providers (PSPs) who verify and record specific identity information, while the central bank sees only pseudonymous public keys. In this business model, individuals are at least pseudonymous with respect to the central bank and the transactions it processes if the PSPs adequately protect this identity information. However, the PSP can disclose the identity associated with a suspicious account to address regulatory compliance and anti-money laundering. See the table below for three examples of this type of business model in action.
The European Central Bank tested out “anonymity vouchers” in a proof of concept (ECB, 2019). These non-transferrable vouchers allow users to anonymously transfer a limited amount of CBDC over a defined period whereby a user’s identity and transaction history cannot be seen by the central bank or counterparties other than those chosen by the user. Hence, anonymous CBDC transfers can be enforced without recording the amount of CBDC that a user has spent, thereby protecting users’ privacy.
China’s eCNY design includes “controllable anonymity” in its design. Although the central bank will be privy to the identity of its users and their transaction data, users will have the ability to control what information they expose to counterparties (Qian, 2018). It aims to keep the degree of anonymity within a controllable range by requiring the disclosure of transaction data only to the central bank (Fan, 2020).
A stored value CBDC hardware solution that takes the form of a card or a mobile wallet app on which prepaid values are stored locally opens the possibility of almost complete anonymity. Such a wallet could conceivably be as anonymous and private as physical cash, although the central bank may require identification to enforce a one wallet per person policy or holding and/or transaction size limits to mitigate financial integrity risk. A couple of vendors (BitMint and WhisperCash) offer this CBDC platform option.

	Holding/Transaction Limit Structures	Data Access
Central Bank of the Bahamas Sand Dollar	Physical/email address, phone number and photo for low-limit access (B$500 holding and B$1,500/month transaction). Plus, government-issued photo ID for higher limits (B$8,000 holding and B$10,000/month).	Transaction transparency to enable CB to monitor suspicious transactions and stop accounts. Pseudonyms ensure user anonymity. CB maintains ledger and server is encrypted.
Eastern Caribbean Central Bank DCash	Physical/email address, phone number, photo and birth date/place for low limit access (EC$1,000 to EC$2,700/month transaction depending on risk profile). Plus, full name and bank account for higher limits (EC$3,000 to EC$20,000/day).	CB can see anonymized transaction data and outstanding CBDC in each digital wallet. Registered financial institutions can fully observe the identity of payers and payees and the purpose of transactions.
Central Bank of Uruguay e-Peso	Physical/email address, SIM card and national ID for low limit access (UYU30,000 wallet maximum). No higher limits except for businesses (UYU200,000).	User data is segregated across different databases. Transaction data per (anonymous) digital wallet can be decrypted to reveal the user’s identity under very restrictive conditions – e.g., a competent authority prosecuting someone that has probable cause to access the transaction data.
People’s Bank of China eCNY	SIM card for low limit access (¥10,000 holding, ¥2,000/transaction and ¥5,000/day). Plus, full name, address, phone number and bank account for higher limits (¥500,000 holding, ¥50,000/transaction and ¥100,000/day).	Controllable anonymity: The PBOC will be privy to the identity of its users as they are required to provide their real identities when they first sign up. However, users will have the ability to control what information they expose to counterparties

Digital currency privacy tradeoffs have sparked intense debate with seemingly irreconcilable differences of opinion. On the one hand, authorities do not want to allow anonymous CBDC because of potential financial integrity risks. Others don’t believe it’s possible to design a fully anonymous currency that’s resistant to double spending attacks. On the other hand, law-abiding users consider privacy an intrinsic non-negotiable right and nobody should have full oversight over their transactions. However, the choice between user anonymity and transparency doesn’t need to be black and white. For example, the recent digital euro public consultation found that, although potential users place a high value on transaction privacy, they don’t support full anonymity. Ultimate design choices will depend on the motivation for CBDC issuance, country specific circumstances and user preferences.

This post was co-written by Sonja Davidovic and the Kiffmeister

The Best of the Centralized and Decentralized Worlds

There is a perception that decentralized finance (DeFi) and central banks are worlds apart. However, these two worlds should explore common ground that can unlock the best possible solution for the end-consumer – the transparency and efficiency of the DeFi space paired with safe and reliable liquidity and reduced compliance burden provided by central banks. After all, it should be about working towards one common goal – to provide the safest, most efficient, and reliable user experience in payments.

A lot of existing and prospective initiatives are looking into enabling faster, cheaper, more transparent and more inclusive cross-border payment services, while maintaining their safety and security. Improved cross-border payments translate into widespread benefits such as supporting economic growth, international trade, global development and financial inclusion. Cross-border payments are particularly relevant for emerging and developing economies given the central role of remittances and the large number of unbanked citizens in these countries.

The emergence of distributed ledger technology (DLT) has added new momentum to efforts to improve cross-border payments initiated both by the private and public sector. While the private sector has focused on developing decentralized peer-to-peer (P2P) solutions in the retail domain, the public sector has aimed at enabling direct exchanges between participating financial institutions through centrally operated DLT-based networks in the wholesale domain.

For the private sector, the use of DLT eliminates the need for trusted third parties and intermediaries like commercial banks for processing, clearing and settlement. DLT has spurred the growth of DeFi that recreates traditional functions of financial systems using smart contracts in place of middlemen. DeFi operates via decentralized, permissionless DLT-enabled applications called DApps. Currently, the primary DeFi platform is Ethereum, but in principle these ideas can be implemented on any smart contract platform. The main building blocks of DeFi are fiat currency-pegged stablecoins that can be exchanged seamlessly and most DApps are designed to fully interoperate with each other.

Public sector activity in the cross-border domain has focused on exploring DLT-enabled private permissioned wholesale CBDC networks as an alternative to existing real-time gross settlement (RTGS) systems. The broadcast of transactions in real-time across the network of participants eliminates the need for reconciliation or intermediation, allowing designated financial institutions to transact directly without relying on correspondent banks. The Inthanon-LionRock research project carried out in collaboration between the Hong-Kong Monetary Authority and the Bank of Thailand in 2019 created a Thai Bhat and Hong-Kong Dollar cross-border corridor network prototype, which allowed participating banks in Hong Kong and Thailand to conduct funds transfers and foreign exchange transactions on a P2P basis reducing settlement layers.

At a first glance, these two types of initiatives appear worlds apart. But the potential convergence holds promises for the best of two worlds in cross-border payments – a robust solution leveraging the competitive advantage of both. For example, DeFi relies on liquidity pools to meet its liquidity needs. Liquidity pools are crypto-assets that facilitate trading on decentralized exchanges. The tokens are locked into smart contracts and serve to provide liquidity in decentralized exchanges. Those exchange typically make use of an automatic market maker, which obviates the need for an order book and a counterparty in the traditional sense. For the buyer to compete a transaction, there does not need to be an available seller, only sufficient liquidity in the pool against which the trade is executed.

However, these pools can put the deposited funds at serious risk such as impermanent losses, smart contract exploits or malicious actions by pool administrators. Given their decentralized nature, there is no recourse when funds or data is lost as the counterparty is not easily identifiable. Instead of relying on crypto-assets in the liquidity pool, stablecoin providers could purchase central bank reserves issued “on-chain”. These reserves can be used to back the issuance of their coins in different currencies. Another advantage of linking up with central banks is that it could ease the regulatory and compliance burden of DeFi providers and participants which can be particularly heavy when working across different sectors and jurisdictions. Central banks, on the other hand, would have more regulatory oversight over DeFi providers holding their reserves.

Also, rather than having to venture out in the retail space to operate and manage their own networks, which can be time and resource intensive, central banks could benefit from the continuous enhancements of decentralized public networks. In addition, central banks would not need to run consumer-facing operations, like hosting wallets, handling consumer complaints, maintaining superior user experience and integrating with other functional applications beyond payments, which are traditionally outside their mandates. Plus, central banks would have real-time insights into how DeFi providers are using these on-chain reserves and whether they are achieving desired policy goals.

The oracle middleware of decentralized data systems provides a unique opportunity for central banks (or international regulatory and standard setting bodies) to impose technical and regulatory standards that govern the interaction with external DeFi providers. Oracles are third-party services that enable data and transaction sharing between disparate environments in a secure and authoritative manner. Information shared by oracles is digitally signed and hence is considered non‑repudiable (assurance that the signature cannot be denied by the party who signed it). For example, only parties that have completed required financial integrity checks would be authorized to purchase the central bank liability discussed above. Oracles can transmit real-time exchange rate data for DeFi cross-border payments systems and continuously validate and monitor data usage in the downstream applications. Oracles can also be used to achieve interoperability with private enterprise blockchain networks and existing legacy payment systems.

The marriage of the decentralized P2P solutions and centrally governed and organized networks can catalyze mutual benefits beyond cross-border payments. Linking central platforms with decentralized marketplaces would allow for a better integration of the retail and wholesale domains thereby unlocking a variety of use cases for DeFi providers that could be aligned with a country’s strategic policy objectives such as expanding financial inclusion. At the same time, central banks can rely on the continuous improvement of the public networks underlying DeFi while ensuring access to liquidity and regulatory compliance.

Blockchain Service Network – Key to Digital Currency Interoperability?

As central banks advance their work on central bank digital currency (CBDC), they are faced with questions on how to ensure interoperability with other digital assets. To unravel the interoperability conundrum and provide a robust digital ecosystem for the economy, China has launched the Blockchain Service Network (BSN). Although in its early stages, the BSN remains a unique attempt to build a global interoperability network that connects digital assets both across borders and networks.

Many central banks are exploring central bank digital currency (CBDC), but China is at the cutting edge of exploring interoperating their e-CNY with other digital currencies and payment systems. The Blockchain Service Network (BSN) is a government-backed infrastructure network that bridges various distributed ledger technology-based networks. It was founded in April 2020 by Red Date Technology, a Beijing-based software company, and six other private and public sector agencies, including China UnionPay, China Mobile and the State Information Center. For regulatory compliance purposes, the governance of the BSN was split up into BSN China (for private permissioned blockchains) and BSN International (for public permissionless networks) while preserving a certain level of interoperability.

BSN International is expected to launch a Universal Digital Payment Network (UDPN) and integrate CBDCs and stablecoins from various countries in collaboration with international banks and technology companies in 2021. The payment network is supposed to introduce a standardized digital currency transfer method and payment procedure for various information systems. Ultimately, banking and insurance mobile applications will be able to initiate digital currency transaction payment processes using UDPN.

BSN China is expected to serve as a domestic public infrastructure network that will facilitate the development, deployment, operations, maintenance, and regulation of low-cost consortium blockchain applications. (Consortium blockchains grant assess only to selected participants, whereas private blockchains keep write permissions to one entity, although read permissions may be more open, whereas with public blockchains, access and interaction with the network is unrestricted and the identity of its participants is semi-anonymous.)

Rather than starting from scratch, developers can leverage the BSN to build their applications efficiently by choosing desired components from a broad menu of integrated systems. Developers would be able to deploy their distributed applications (dapps) with a single private key across different networks, while servers running on the BSN are designed to be compatible with the blockchains of any participating member.

A network of public city nodes that are linked via the internet form a nationwide (and in the future, worldwide) physical city node blockchain service network. In effect, public city nodes serve as BSN data servers that developers can deploy their applications to using a dedicated channel for transaction processing, data communication, and storage. These disparate channels are supposed to ensure “absolute privacy” of each application while allowing data allocations across multiple channels. Participants and end-users can access those applications at no cost. Currently, the BSN spans various cloud environments and portals, including 108 public city nodes, connecting over 80 cities across mainland China and eight public city nodes in other countries around the world.

The BSN has been integrating public blockchains into the network based on unique capabilities they offer with a focus on building ecosystems with strong use cases. Several public blockchains such as Ethereum, EOSIO, Tezos, Neo, Nervos, IrisNet, and most recently Consensys Quorum have already been onboarded there. The BSN aims to integrate with 30 to 40 public blockchain networks by June 2021. Collaboration with interchain protocols COSMOS and Polkadot are focused on developing an Interchain Communications Hub.

Through the hub users can tap into data generated by outside applications while getting cross-chain services between blockchains adapted in the network. For example, an Ethereum-based dapp would be authorized to access real-time logistics data generated by a dapp built on Hyperledger and processed through the Interchain Hub. The BSN envisions this becoming a standard protocol for dapps from different blockchains, allowing them to call each other with just a few lines of code.

This aim of this collaboration was to provide developers outside China with a standardized development environment to build and run dapps on public blockchains. The public blockchains are supposed to be adapted to the Chinese market with public blockchain nodes that are installed on top of the BSN, so that Chinese developers can access all nodes from all public blockchains via one gateway and one simple monthly plan.

In the localized version for the Chinese market, the network will convert the decentralized public blockchains into permissioned ones, while replacing their native tokens with direct payment by the Chinese currency renminbi to cover transaction fees on these blockchains. This is considered to be the most direct and effective way to ensure regulatory and supervisory compliance and encourage adoption among users within China. Unlike the localized version, the global version of the BSN will allow public decentralized blockchains.

According to industry experts, the BSN is supposed to serve as the backbone of China’s Digital Silk Road ambitions. Others argue that the BSN will encourage the development of digital currencies, stimulate internationalization of digital assets, and expand Chinese developers’ access to the global crypto industry. Regardless of the underlying motivation, thus far, the BSN is the only large-scale network that aims for seamless interoperability between international digital assets and applications across public and private blockchain networks.