Why Facebook and China are developing their own cryptocurrencies

Photo by Clifford Photography on Unsplash

From seashells and animal skins to gold coins and paper notes, currency has functioned both as a store of value and a common unit for measuring the value of products and services across history. While currency has traditionally been tied to physical objects, most money in use today exists only as bits in data centres. These bits are not a new currency though: they measure wealth in dollars, euros, or yuan, and are convertible to their paper forms through banks and ATMs. Modern technology has also enabled a new type of money: cryptocurrencies like Bitcoin and Ethereum. Unlike the money in your bank account, you cannot check out Bitcoins as physical cash — they can only be exchanged in their own network. While this new form of currency is seldom used in buying and selling items today, they hold great potential for the future. In fact, the Chinese government has announced plans to issue their own sovereign cryptocurrency, as has Facebook with their Libra initiative. How are these cryptocurrencies different from Bitcoin or the way money is stored in banks today, and why should we care about them?

Most, if not all, cryptocurrencies are based on blockchain technology. Blockchain is essentially a distributed database of transactions that allows the addition of new transactions but disallows modifying old ones. This guarantees a crucial property for any currency: immutability of transactions. After a transaction in Bitcoin has been confirmed, it cannot be rolled back. This property means blockchain-based currencies are trustless — when making a transaction, a user does not have to trust any third party to accept the transaction. Blockchain-based currencies are therefore de-centralised and rely on the mathematical algorithms and properties emerging from a distributed network of users to function, rather than a trusted central party ¹. This makes them fundamentally different from centralised payment networks such as Visa, bank transfers or PayPal: users of these networks must trust the network owner to allow their transaction to go through.

Blockchain has sometimes been called the future of currency because of its supposed benefits in scalability, fast transactions, and cheaper fees. In reality, blockchain is worse than existing centralised networks in all of these properties. Blockchain systems tend to be based on the notion of “proof of work” ², where including new transactions in the blockchain has to be coupled with solving a difficult mathematical equation. This disincentivises nodes from modifying already confirmed transactions but results in a network that can handle far fewer transactions than centralised systems, further leading to higher fees and longer transaction times. Mining Bitcoin, (i.e. confirming transactions and receiving additional coins as rewards) also consumes ridiculous amounts of electricity — at the level of individual countries, according to some estimates.

As mentioned earlier, Facebook and the Chinese government are planning to launch their own cryptocurrencies. These currencies would differ from all existing coins by being centralised rather than distributed. The currencies could therefore abandon proof of work and its downsides. The currencies might still be based on blockchain, but they would be mined by trusted central nodes only (in China’s case government servers, in Libra’s case nodes owned by Libra partners ³). The current state of the transaction ledger might also remain private for security reason. On surface level such a currency does not look all that different from a traditional payment network like the one operated by Visa. It is not the digital currency itself that will revolutionise the world, but the applications it enables.

Under the current model, each bank or payment platform keeps track of their users’ money independently. These systems are purpose-built, and do not integrate well with each other. As such, it’s very difficult for governments to keep track of details about a particular person’s finances — it requires finding out what banks they use, where they own assets and tracking their transactions with other people and businesses. And this is without considering cash transactions! In many cases these financial links cross international borders, making information discovery even harder. This obfuscation of financial transactions makes it hard to detect money laundering and financing terrorism. While cryptocurrencies are generally considered more private than bank transfers, this is the case only if there is no way to link a crypto wallet to a person’s true identity. When this is possible, a wallet’s entire transaction history can be traced easily. This method has been used to charge careless Bitcoin users in court over the purchase of contraband in black market websites such as Silk Road [1]. China’s cryptocurrency would almost certainly tie a wallet ID with the citizen’s national ID, therefore enabling the government to keep track of a person’s entire financial history with ease. This is especially important for China because the country’s strong control over outgoing capital has created a lucrative black market for moving money offshore. Facebook’s “official” Libra wallet Novi will also require a verification with a government ID, but it is unclear how much data would be shared with regulators.

While countering white-collar crimes is a noble ambition few would oppose, increased government control has a flip side as well. China’s social credit system has already been used to forbid “undesirable” people from buying transport tickets, and the crypto-yuan would enable them to expand the scheme across all purchases. Tracking the network of money transactions also allows the government to study relations between citizens, and more accurately penalise those who associate with people of low social credit, which is already considered an offence in certain cases. Therefore, I believe China’s digital currency is not mainly about the economic benefits of such a system, but rather a tool to expand the government’s techno-totalitarian system.

While China wants to use their digital currency to increase social control, what is the motivation behind Facebook’s Libra? I believe Facebook is trying to disrupt the power of central banks in developing economies. The focus on developing markets is clear in Libra’s website, which specifically mentions that 31% of the world’s population are unbanked. This group of people is increasingly owning a smartphone yet must conduct all their transactions in cash. At the same time, the local currencies of many developing nations are unstable and prone to inflation. With Libra, Facebook is trying to become the de-facto currency of these countries, providing ease of access to financial services, low or non-existent fees and a currency that maintains its purchasing power. While becoming the de-facto bank and credit card of billions of people could be immensely profitable for Facebook and its partners, it could have significant negative consequences for developing nations as they would no longer be able to fully control their own monetary policy.

Digital currency has great potential in transforming every facet of our lives, both in good and bad. I do not believe distributed currencies such as Bitcoin will ever achieve adoption as society’s main currency, although they can carve out a niche as a store of value outside typical financial institutions. If a centralised digital currency is seeking adoption in our society, we must hold its controllers accountable to make sure our data and the power coming from controlling all cash transactions in a society are used ethically.

Citations:

[1]: Jawaheri, A., & Basil, H. (2017). Deanonymizing tor hidden service users through bitcoin transactions analysis (Master’s thesis).

Endnotes:

¹ Cryptocurrency users have to trust the algorithms implementing the currency, which is why the systems tend to be open source and have comprehensive white papers explaining their design and attack vectors

² Some cryptocurrencies are based on “proof of stake” which replaces mining with a voting process where coin owners decide whether blocks should be accepted or not.

³ It’s not clear how distributed Libra will end up being. I believe Facebook and it’s partners want as much control as they can get away with, and that the network will become more, not less, centralised as time goes on.

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Ville Kuosmanen

Ville Kuosmanen

I care about digital products that improve our lives. Software Engineer at a crypto startup.