The world faces a challenge, with over $3 trillion illicitly flowing through the global financial system in 2023.
According to a report from Nasdaq-owned fincrime technology firm Verafin, those numbers may not reflect the peak of this “industry vertical”.
This vast sum encompasses proceeds from activities like narcotics trade, human trafficking, financing of terrorism, various fraud cons, and schemes targeting banks, leading to significant worldwide financial losses. In response, central banks across the globe are considering the adoption of Central Bank Digital Currencies (CBDCs) as a measure to counteract these issues.
Since May 2020, the number of countries and currency unions contemplating the adoption of Central Bank Digital Currencies (CBDCs) has increased from 35 to 134, covering 98% of the worldwide GDP. Among these, 68 nations are further exploring, engaging in development, pilot projects, or actual launches. This includes 19 of the G20 countries, with 11 already conducting pilot tests.
Progress on retail CBDCs in the U.S. has slowed, creating a disparity with other G7 countries. Meanwhile, the European Central Bank (ECB) is moving forward with the digital euro, testing transactions in a controlled setting.
Advocates believe CBDCs could provide unmatched transparency, possibly disrupting global illicit financial activities.
Opponents worry that CBDCs’ traceability might push illicit activities further underground, beyond the reach of the formal banking system.
Nonetheless, CBDCs’ potential to reduce illegal financial flows remains an area of contention. But, could CBDCs be the long-sought answer to combating black money and money laundering? Let’s take a critical look.
The Technological Advantages of CBDCs
CBDCs present a viable strategy for addressing the issue of money laundering, thanks to their digital format and the foundational blockchain technology. The transactions made with CBDCs are documented on a blockchain, ensuring a permanent and transparent record of all transactions. This level of transparency enables regulatory bodies to monitor the movement of money and pinpoint potentially dubious activities more efficiently than conventional cash transactions.
CBDC system can leverage AI and machine learning-powered tools for real-time analysis of transaction patterns, identifying any potentially suspicious behavior for further review. By offering more comprehensive data on transactions, CBDCs can improve the due diligence process, aiding financial institutions and regulators in understanding the origin of funds and identifying the involved parties more effectively.
Furthermore, CBDCs can support international efforts to combat money laundering by facilitating easier cross-border transactions, which, in turn, enhances information sharing and the overall effectiveness of global anti-money laundering initiatives. Additionally, by integrating AML regulations directly into their framework, CBDCs can simplify adherence to compliance requirements, ensuring transactions align with AML standards.
Use Cases for CBDCs
CBDCs offer a range of promising applications across various sectors. Here are the use cases of CBDCs in the economic system:
Domestic payments
CBDCs provide a digital alternative to physical cash, allowing for electronic transactions within a country. This improves convenience and efficiency while reducing reliance on traditional banking systems.
Cross-border payments
CBDCs enhance the efficiency of international transactions, offering a quicker, less expensive, and clearer process compared to conventional approaches. This is advantageous to companies, people, and economies. For expatriates, CBDCs provide a more economical and swift solution for remitting money back home, cutting down on the fees and time delays typical of traditional remittance methods.
Financial inclusion
CBDCs connect, enabling those without access to traditional banking or limited banking services to engage with official financial institutions, thus bringing them into the formal economy. Additionally, CBDCs allow for direct government aid and subsidies into citizens’ electronic wallets, improving efficiency and transparency while decreasing overhead expenses.
E-commerce
CBDCs facilitate online transactions, offering retailers and customers a safe, affordable, and effective means of payment. Thus, CBDCs boost the growth of electronic commerce.
Privacy and Security Concerns With CBDCs
While CBDCs offer promising solutions to combat money laundering, there are concerns about privacy and security. In countries with corruption and weak rule of law, extensive data collection could lead to additional challenges for businesses and individuals. CBDCs could enable extensive government surveillance, leading to financial data misuse for political or social control.
Another issue is the potential for government surveillance. Since CBDCs are managed by central banks, all transactions are recorded on a centralized or blockchain ledger, allowing governments to monitor financial activities in real-time. This level of control could lead to increased state surveillance, potentially infringing on individual financial privacy and civil liberties.
Another concern is the risk of data breaches. CBDCs rely on digital infrastructure, making them susceptible to cyberattacks. If hackers gain access to CBDC transaction records, they could expose sensitive financial information. The centralized nature of CBDCs also poses a single point of failure, making the system vulnerable to systemic risks.
Various measures are being explored to mitigate these risks. For example, Sweden’s e-krona pilot uses an open-source distributed ledger to ensure that transaction data is only accessible on a need-to-know basis, thereby enhancing privacy. Additionally, technologies like zero-knowledge proofs can help verify transaction legitimacy without revealing sensitive data, balancing the need for transparency with privacy concerns.
Regulatory frameworks also play a crucial role. Effective data protection regulations, such as the European Union’s General Data Protection Regulation (GDPR), can help ensure that personal financial data is handled securely and transparently. Consumer education and robust cybersecurity measures are essential to protect against digital threats.
Addressing Financial Crime Risks
CBDCs could improve traceability, transparency, and automated transaction monitoring. They could help central banks and governments cooperate internationally to promote collective mechanisms and regulatory frameworks. By being programmable, governments could monitor or even stop transactions. CBDCs may stop money from being received by criminals and sanctioned groups.
Even when it falls into the wrong hands, digital currencies could be programmed to be useless or seized by the authorities. Digital currencies could attract new cybersecurity risks. Key features like programmable wallets and the ability to disguise larger volumes under a penny are concerns. AML regulation would have to catch up globally, nationally, and regionally to prevent unlawful use of CBDC.
Even if digital currencies fall into the wrong hands, they could be rendered useless or seized by authorities because they can be programmed that way. However, digital currencies also pose new cybersecurity risks, such as programmable wallets and the potential to hide large volumes under a penny. To prevent the unlawful use of central bank digital currencies (CBDC), anti-money laundering (AML) regulations need to be updated globally, nationally, and regionally.
For the authorities, the proposed adoption of CBDC presents risks and rewards in the fight against financial crime. By extending central banks’ control powers and placing them back at the heart of the financial system, CBDCs increase their overall relevance and help them dictate monetary policy.
On the flip side, digital currencies could make the financial system more susceptible to new forms of criminal exploitation. The global nature of CBDCs and the need for a cross-border regulatory framework worldwide are of particular concern. For now, in the exploration and pilot phase, governments need to make careful choices when exploring CBDCs.
