Roadblocks and Emerging Practices

September 19, 2000 • Testimony

Mr. Chairman and Members of the Committee, thank you for giving me this opportunity to testify today on the monetary impact of the emerging electronic and digital payment systems on monetary policy and financial privacy. I am an Adjunct Scholar at the Cato Institute, a Senior Fellow at the Discovery Institute, and Chairman of Novecon Financial Ltd. Also, I am the author of the recent book, The End of Money and the Struggle for Financial Privacy.

I will focus my comments today on the emerging digital money‐​like products which, I believe, will supplant most conventional government issued money and existing payments systems over the next couple of decades.


The age of digital money is upon us. The new technologies of the Internet, digital electronics, public key encryption, and the rapid price declines of computing power and telecommunications bandwidth are having a dramatic effect on the financial world. These new technologies are enabling the development of financial markets, procedures, and instruments that economists in the past could only theorize about. Financial transactions can be settled in real time even though the contracting parties may be thousands of miles apart. Money and other assets can be moved at almost the speed of light to any point on the globe for a minuscule cost. Easy to use encryption programs enable almost anyone to move data or money around the globe with complete security.

It is now possible for private digital currency issuers to compete without the high information and transaction costs that burdened the multiple‐​issuer systems in the past. Moreover, new, private monies are emerging, including “digital gold.” The technical barriers have been overcome, as well as many of the economic challenges.

Digital money is the monetary value of government‐ or privately‐​issued currency units stored in electronic form in an electronic device. Digital money is one type of a digital financial instrument that fulfills most or all of the functions of money. The monetary value stored in the electronic device can be transferred to other such devices, allowing the users to engage in payment transactions. This is different from traditional electronic payment systems, such as credit and debit cards and wire transfers, which usually require online authorization and may involve debiting and crediting bank accounts for each transaction.

A prepaid monetary value may be stored in a computer chip on a card — “smart card” — or stored on a computer chip in a wireless device, or on a computer disk drive. Money transfers with cards are most often made through card reader/​writers, while transfers using computers or wireless devices are made over wired or wireless communication networks, such as the Internet. Cards, wireless devices, and computers can also be used to merely authorize monetary transfers from one account to another. These accounts may be bank accounts or reserve assets held in non‐​bank institutions. Stock, bond, mutual fund, and gold deposit accounts may allow ownership transfer of assets, even in micro amounts, to be made by computer or wireless devices. To prevent fraud, all such transfers need to be protected by cryptographic codes. The technology now exists to make such transfers anonymous, like paper currency transactions, if the user so chooses.

Financial cryptographers have developed methods whereby people will be able to securely hold bearer digital cash, bonds, stock, and even financial derivatives, and make very low cost and anonymous transactions with them. A US dollar in paper form is a bearer instrument. That is, the person who holds it is normally considered to be its lawful owner. There is no list of owners of paper currency (a registration record); ownership is conveyed by physical possession. Gold coins are bearer instruments.

The advantage of bearer instrument transactions is that settlement is in real time, and therefore there is no risk of non‐​payment, as there is in book entry transactions such as checks and credit cards. There are no charge backs to the merchant, and the risk of fraud (in the absence of counterfeiting) is greatly reduced. Bearer instruments are also anonymous, which can protect the owner from corrupt governments or criminal types. However, because of this anonymity, many governments do not like or have prohibited certain types of bearer instruments because they make it hard for tax officials to collect revenue.

Digital monetary and financial products are “disruptive” technologies, in that their creation upsets the existing legal and public policy order as to how money and financial products and institutions are regulated and organized. National borders are ceasing to have the relevancy they once did. Both businesses and governments need to build the appropriate legal order for the digital age and understand how it should be managed. This will require changes in laws and regulations, leaving businesses in a thicket of uncertainty during the transition period. Central bankers, treasury officials, law enforcement authorities, and intellectual property administrators (patent officials, etc.) will by necessity have to adjust to a different world. Their challenge will be to create a new set of rules and procedures that bring the necessary order without impinging on the rights of privacy of individuals and institutions, or destroying the economic efficiencies that the new technology is bringing.

Policy Implications of Digital Payments Systems

Many legal issues will arise as digital money becomes more prevalent. Given that most digital money will be global in the sense that the Internet will facilitate its movement or use outside its issuing jurisdiction, the lack of legal uniformity between countries raises many policy issues. For instance, who has the liability if a failure does occur in a particular digital money system because of fraud or for some other reason? When digital money payments are made across national borders, who has jurisdiction? Does digital money violate the monopoly rights of central banks to issue money? May a central bank issue digital money? Do non‐​bank issuers of digital money need to be regulated, and if so, who should the regulator be? Who is going to determine if the clearing organizations have sufficiently robust and fraud proof systems? Given that various digital money systems are now being developed and offered, the answers to the above questions will probably slowly evolve over the next few years as real problems emerge. Already, multilateral financial institutions like the Bank for International Settlements and the International Monetary Fund have established working groups to try to develop recommendations for their members in dealing with the above‐​mentioned issues. These BIS and IMF recommendations will be of particular interest to the world’s central bankers who are facing the front line of change.

To the extent people use privately‐​issued digital money for transactions, the demand for government money is reduced. If people are willing to hold liquid balances in the form of digital money, the quantity of demand deposits (checking accounts) that people need or desire is smaller, hence reducing the central bank’s supply of money. The same principle holds true for other money substitutes, from very limited money substitutes (i.e., balances held on telephone cards, or frequent flyer miles) to broad money‐​like products (i.e., digital gold). As these broad and narrow‐​use money substitutes grow in popularity because of their ease of use in the digital age, the amount of money supplied by central banks will decline. Until some non‐​government money reaches a critical mass whereby most users and businesses find they can do a substantial portion of their business in the “new money,” virtually all digital money and money substitute products will be reconverted to central‐​bank‐​issued money at some point. However, even during this period of partial and temporary substitution of digital money for central bank money, the demand for central bank money will gradually decline.

Justifiable concerns have been raised about the innovations in payments technology and the development of digital money and their impact on inflation. For monetary systems with a quantity anchor (such as the US dollar and other fiat currencies), technology changes resulting in an increase in the money multiplier or a decrease in money demand will increase the price level unless base money is reduced by an appropriate amount. If digital money is issued by an institution other than a bank, which has no reserve requirement, the growth in digital money will increase the money supply unless the central bank takes corrective action. The increases in the money supply resulting from the new technologies will be both gradual and easily recognized, and hence would be neutralized by the central bank by appropriate reductions in the monetary base. As with all innovations with payments technology, the introduction of digital cash has a one‐​time effect on the price level. The money multiplier would be larger but stable at its new level.

If digital money is issued by a bank at the expense of deposits, and is subject to the same reserve requirements as deposits, the monetary effect would be approximately neutralized. If digital cash issued by banks is subject to a 100% reserve, or if digital cash is issued by a non‐​bank, with a 100% reserve, no new money is created. With any price rule digital money system (i.e. commodity backed systems), inflation by definition is not a problem.

In general, electronic payments and digital money systems increase the efficiency by which the existing money supply can make payments, thus reducing the demand for money. These improvements tend to take place gradually over time, and are observed as an increase in the velocity of money, which requires a compensating adjustment in base money by the Federal Reserve. In sum, I see no reason for great concern in terms of monetary policy management by central banks as a result of these new technological innovations. The changes will be gradual and obvious, giving plenty of time to make policy adjustments to prevent inflation.

One effect of the decrease in demand for central bank money will be the disappearance of central bank seigniorage revenue. At present, the world’s central banks make a considerable income from issuing paper banknotes, which are non‐​interest bearing central bank liabilities. Among the G-10 countries, seigniorage as a percent of GDP ranged from a low of .28% in the UK to a high of .65% in Italy in 1996. This seigniorage not only provides for all of the central bank operations, but also provides their treasuries with significant revenue. However, it is also apparent that the efficiency gains for the economy from digital money swamp any negative effect on government revenue of the loss of seigniorage revenue, which has been in effect a tax on the banking system.

It can be expected that the growth of digital money will have a direct and significant impact on the common measures of the money supply, particularly currency and demand deposits (M1 and M2). Given that many central bankers target these monetary aggregates in the conduct of their monetary policy, the focus of monetary policy may need to change. The growth of digital money could ultimately cause a substantial drop in banks’ demand for settlement balances. In the major economies, cash is the largest component of central bank liabilities. Extensive use of digital money is likely to shrink the balance sheets of the central banks significantly. At some point the shrinkage might restrict the central banks’ ability to conduct open market operations or foreign exchange sterilization operations. However, to the extent that the new digital monies are fully backed by assets such as gold or high‐​quality financial instruments, the need to conduct open market operations will diminish, because the supply of money for transactions should automatically adjust to demand.

As more and more transactions are settled on a real time basis, the risk of non‐​payment and fraud declines, and hence the need for regulation and monitoring also declines. The role of the central bank may ultimately shrink to doing little more than defining the numeraire for the national money. The definition is likely to be a modern version of the gold standard. Specifically, a national currency in the future may well be defined as a monetary unit that is equal to a basket of specified commodities with a one world price, such as gold and crude oil, and even some services. Any good or service having a one world price that is set in organized auction markets could be a candidate for a currency basket that would be used to define the value of the monetary unit. Some central banks might also continue to serve as a lender of last resort to large financial institutions, by using off balance sheet transactions. The need for such a lender of last resort would seem to diminish in a world of instant information on almost all activities and institutions, and real time settlements. In the new century, the kind of financial shocks and surprises experienced in the past ought to be increasingly rare, unless financial regulators interfere too much with the market adjustments that will naturally occur in a world of increasingly perfect information.

The rapidity of adoption of digital money systems by consumers depends on how their cost, convenience, and anonymity is perceived in relation to paper currency and coin. Eventually, electronic transfer and digital money systems will totally replace paper and coin, because they can greatly reduce transaction costs and will ultimately become more convenient. At the current level of technological advance, it appears that within relatively few years, whether they involve a few cents or millions of dollars, almost all monetary transactions will move over the Internet, or by wireless device, or by chip card for small transactions. The question of anonymity will remain an impediment until policy makers understand that the fundamental desire and right to personal privacy must be accommodated with the new technologies, to an extent no less than people now have with cash.

The role of central banks will change, and will likely shrink, as a result of the new technologies. One danger to the world economy is that central banks will try to hold on to their traditional roles by restricting the new technologies or regulating them in such a way as to make them non‐​economic. Regulators should keep a hands‐​off approach until a problem has been clearly demonstrated and, at that time, devise corrective actions to do the least damage to innovation and financial freedom.

Law enforcement officials around the world have been concerned about the potential abuse of digital money systems for the purpose of money laundering, and hence are trying to restrict or ban them. Officials in various government and regulatory agencies, such as the Financial Crimes Enforcement Network, assert that they should have more power and ability to monitor all transactions. It is true that digital money systems, particularly anonymous ones, may indeed make the job of money laundering easier. On the other hand, many government law enforcement agencies throughout the world have abused basic rights to financial privacy. The benefits of digital money greatly outweigh the potential criminal abuses, and hence measures to restrict the use of digital money should be resisted. Without the availability of anonymous systems there will be strong resistance on the part of many individuals to fully move to e‐​payments systems and digital money.

The existing efforts against money laundering, primarily by the US and major European governments, have not proven to be the least bit cost effective. For instance, in the US in 1998, only 932 people were convicted of money laundering, yet the cost to the private and public sectors of the anti‐​money laundering efforts exceeded 10 billion dollars, which comes out to more than 10 million dollars per conviction. The distinguished British law professor, Barry Rider, has calculated that “the British state has been able to take out 0.004 per cent of the criminal money that has flowed through London.” There is no evidence that authorities in the US are having much more success. Money launderers do not have a statistically significant chance of being caught and losing the profits from their misdeeds, and hence the deterrent effect of such laws is negligible.

Privacy advocates have also documented that the money laundering laws are very arbitrarily enforced in many countries, including the United States. Money laundering is a crime of motive, rather than one of specific activity, hence its enforcement, by the very nature of the crime, is highly subjective. This subjectivity leads to selective and politically biased enforcement. Because of the constant threat of the vagueness of the money laundering laws and regulations, constructive financial innovation has been retarded, particularly in the development of digital monies.

The money laundering laws have propelled the US to adopt attitudes insensitive to foreign countries’ rights to self‐​determination, and to violate the sovereignty of foreign states. The US tries to impose policies on foreign states and businesses that the US would never accept if the situation were reversed. The US and the European Union have no business telling smaller developing nations that they are involved in “harmful tax competition,” or that they should abolish bank and corporate secrecy laws. Small nations have a need and a right to attract foreign capital, and it is perfectly legitimate for them to compete against harmful tax, regulatory, and privacy policies that bigger nations impose on their own citizens.

Anti‐​money laundering legislation has not only proven to be ineffective and counterproductive, but greatly undermines the financial privacy rights of individuals. Such laws require widespread reporting on the financial activities of bank customers by bank employees to their governments, thus undermining the separation of business from law enforcement, and ultimately the financial privacy necessary for civil society. The fact is, the new technologies of various forms of encrypted e‐​payments will make the task of enforcing the money laundering laws even greater, unless governments are permitted a level of financial privacy intrusion that most civilized people will find unacceptable. However, widespread adoption of digital money will actually reduce the number of crimes most people care about, such as murders, thefts, and robberies. In 1998, there were approximately 18,000 murders in the US, and a substantial number involved people trying to take someone else’s physical money. A move to digital money would reduce the murder, theft, and robbery rates. Stealing digital money is a much more complex undertaking than stealing paper currency, and will be beyond the capabilities of most common criminals. If there is no physical money to steal, the incentive for criminals to steal and kill people for money will be greatly reduced. Abolishing the anti‐​money laundering laws is likely to speed up the use of digital money, resulting in less total crime, and less wasted money by governments, even though it will make life slightly easier for money launderers.

Eventually, knowledgeable people are likely to conclude that the “war on money laundering” is going to be no more successful than was liquor prohibition in the United States during the 1920s. It will become increasingly obvious that the resources utilized in the “war on money laundering” could be better spent attacking the underlying crimes. The knowledge of how to utilize high levels of encryption is now widespread. This knowledge, coupled with the Internet, smart cards, and related technology, ultimately means that it is almost futile to try to prohibit the hard‐​to‐​define crime of money laundering.

Conclusion and Recommendations

Digital payments and monetary systems are coming of age, and will replace most existing money and payments systems over the next couple of decades. These changes will bring enormous economic benefits in greatly increasing the efficiency and reducing the costs of our payments systems. In addition, the absence of paper currency and coin, which is readily subject to theft or loss, should greatly reduce crime. The US government has a choice of either embracing the new technologies and helping them along (mainly by getting out of the way), or taking a “Luddite” approach and attempting to restrict and deny the inevitable. A civil society depends on a government that does not unduly restrict liberty and economic opportunity.

The following recommendations, I expect, will seem radical and frightening to those who do not understand the new technologies and where we are headed. However, I expect that those who do understand the new technologies, and desire a civil society that provides both privacy and economic opportunity, will see these recommendations as desirable and necessary.


  1. Remove all restrictions on issuing digital bearer financial instruments, including stocks and bonds. Financial cryptographers have already figured out how to issue such instruments in cyberspace, and many feel that they do not need government’s permission. Rather than create a new class of cybercriminals, governments should recognize the reality, and do something that is both good for the economy and that supports civil liberties.
  2. Remove the capital gains tax from trading in commodities, in order to allow the full development of commodity backed digital currencies (like gold). The capital gains tax on commodities does not bring any revenue over the long run to government, given that losses and gains offset each other. In the real world it is probably a net loss for government since people will be more prone to report their losses rather than their gains, and it reduces the efficiency of the commodities markets.
  3. Remove all restrictions on anonymous digital money and payments systems. Restrictions are almost impossible to enforce, and privacy is a basic human right.
  4. Repeal the Bank Secrecy Act and the subsequent related anti‐​money laundering legislation. The existing legislation and implementation is not cost effective, is subject to abuse, interferes with basic civil liberties to an unacceptable degree, and actually results in higher levels of crime.

Thank you Mr. Chairman. I would be pleased to answer any of your questions.

About the Author