28 October 2021

Vox: Central bank digital currencies, cryptocurrencies, and privacy: What experiments tell us

With the development of new forms of money such as cryptocurrencies and central bank digital currencies, the attention paid to their role as a store of privacy is increasing. This column asks whether privacy is relevant in shaping the demand for these currencies.

The results of laboratory experiments show that anonymity does indeed matters and increases the overall appeal of a medium of payment. This effect is stronger for risk-prone individuals.

Protection of privacy is an important issue in the information age (Acquisti et al. 2015). The particular relevance of this issue in the monetary field becomes evident if we observe three stylised facts. First, public paper currencies, most of which are in the form of large-denomination banknotes, are still appreciated for their resilience and their anonymity. We have seen a rise in the circulation of paper currencies in both advanced and emerging economies (Berentsen and Schar 2018, Shirai and Sugandi 2019), with only Sweden and Norway being notable exceptions (Armelius et al. 2020).

Second, the recent wave of innovation in private payment systems has been characterised by the issuance of private digital currencies; in these payment architectures, cryptographic procedures are used to protect privacy (Schilling and Uhlig 2018, Halaburda et al. 2020, Auer and Tercero-Lucas 2021). A notable share of private digital currency users have expressed their appreciation for the anonymity associated with these systems (Bohme et al. 2015). Moreover, individuals interested in using cash for illegal reasons seem to view private digital currencies as close substitutes (Hendrickson et al. 2019). 

Third, the issuance of a (public) central bank digital currency (CBDC) is an option that central bankers are carefully considering. Given that a hypothetical CBDC can be designed in different ways, and that money digitalisation may lead to a process of unbundling and re-bundling the different properties of money (Brunnermeier et al. 2021, Bordo 2021), the level of privacy is a key issue in this debate, especially with respect to retail payments (De Lis and Urbiola 2020, Agur et al. 2021).

In a monetary transaction, full privacy protection coincides with anonymity. As such, a crucial question arises: does privacy matter in shaping the demand for money? This question can be answer using laboratory experiments based on a novel methodology that combines standard techniques for eliciting individual preferences with some innovative aspects (Borgonovo et al. 2021). 

Money demand, privacy and experiments  

From a theoretical point of view, the experiments were based on a specification of the demand for money, in which a medium of exchange, as a unit of account, has three simultaneous economic functions. The first two are the specific medium’s standard functions as a medium of exchange and as a store of value – that is, the original Keynesian transaction and speculative motives (Baumol 1952, Santomero and Seater 1996). The third is the novel function of store of information and privacy protection (Kocherlakota 1998, Kahn et al. 2005).  

The experiments used the definition of a safe medium of exchange, which focuses on a medium’s liquidity properties (Greenwood et al. 2015). In parallel, the experiments evaluated the ability of the medium of exchange to preserve its expected value (Caballero et al. 2017), which is the second property of a currency. Holding a medium of exchange implies an expected opportunity cost that can be calculated by comparing the total return associated with alternative mediums (or currencies). 

Finally, a currency can offer privacy protection. There is evidence of a preference for anonymity in the financial field (Charness and Neugebauer 2019, Weber et al. 2018), yet individual preferences for the anonymity dimension in the demand for money have not been investigated in previous research, although Athey et al. (2018) analysed the more general preference for privacy. The experiments have been focused on full privacy (i.e. anonymity) and answer the question of whether anonymity in monetary transactions has any value in absolute and relative terms when compared with the other properties of money.

The experiments started with a descriptive analysis of the data and then continue with an inferential analysis. When presented with two mediums of exchange differing only on the anonymity dimension, experiment subjects assigned to the anonymous medium assigned a value 1.44% higher on average than the values assigned to the non-anonymous medium of exchange. Thus, anonymity per se matters....

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