The White House released its annual Economic Report of the President this month, detailing the economic policy goals of the Biden Administration. This year, 15 percent of the report concerns digital assets, deriding token-based blockchains as having no use case. It proposes a Central Bank Digital Currency (CBDC) built with an account-based blockchain as a potential alternative. Although the report claims an account-based CBDC would provide the benefits of blockchains while using intermediaries to mitigate the risks, it ignores how obfuscating these intermediaries is what makes blockchains efficient.
Understanding how token-based blockchains create a more efficient financial system requires a bit of background. At its core, a blockchain is a ledger of transactions. In a token-based model, users called “miners” compete with one another to validate these transactions, and are rewarded with cryptocurrency (hence they are mining new cryptocurrency). The validated transaction is added to the distributed ledger that all miners possess.
Credit cards, on the other hand, use centralized processors and intermediaries instead of distributed validators. Besides the merchant taking the payment and the cardholder, at least four additional parties (called merchant service providers) are involved: the financial institution that enables payment, the payment gateway, the interchange and the cardholder’s bank. All these parties are necessary to validate the transaction.
Going through these various parties incurs fees on the merchant, which are passed on to the consumer through higher costs. The advancement that token-based blockchain has made is its removal of all intermediaries between the consumer and the merchant. Though miners are needed to validate transactions, this simply means updating the ledger. The transaction is peer-to-peer and involves cryptographic techniques that directly match the sender and receiver.
Without merchant service providers, operational costs decrease significantly. The result is a far more efficient transitory process and money saved by the consumer. To put this in perspective, merchant fees can range between 0.5% and 5 percent, plus a $0.20 to $0.30 flat fee on each transaction. In comparison, a transaction fee using Bitcoin Lightning, a popular cryptocurrency, costs less than a penny.
A review of various studies comparing blockchains and traditional payment processors found that the obsolescence of fee-charging intermediaries lowered transaction costs. Additionally, eliminating discrepancies between the merchant and the consumer made issues like chargebacks impossible. Solving this problem alone saves merchants over $20 billion annually.
The account-based model that the Biden Administration proposes works quite differently. As the name suggests, this model focuses on the accounts and not the assets. In this way, account-based models are able to better identify and track user activity with peer-to-peer transactions being eliminated. If the token-based model could be compared to money, since it changes hands easily and person-to-person, the account-based model is far more like a traditional money processor.
Though still utilizing a blockchain, the account-based model requires institutional intermediaries to work. Users establish an account, then get inspected by an interfacer to validate funds, allowing the user to be debited or credited. These transactions are then updated in the ledger by a central authority.
Many skeptics fail to see how this system would fundamentally differ from traditional finance since the same middlemen are present. Such a model could make marginal advancements in consumer security. Unfortunately, reimplementing intermediaries negates the core efficiency of the blockchain. Coupled with extensive privacy concerns, it’s hard to say if an account-based CBDC implementation would result in tangible improvements. Positives resulting from better fraud protections are potentially outweighed by financial privacy losses.
A CBDC has the potential to save consumers and merchants billions of dollars in increased transaction efficiency and financial transparency. The current proposal’s attempt to preserve financial intermediaries would not. Instead of giving us a cash alternative with all the same privacy guarantees and an added level of transaction efficiency, Biden’s CBDC would model the existing inefficiencies of the status quo.