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Eggs in One Basket: Security and Convenience of Digital Currencies

Summary:
As I wrote this article, came across this paper by Charles Kahn, Francisco Rivadeneyra and Tsz-Nga Wong in this piece. They look at this problem of storing digital currencies via passwords in different locations. What if this information is hacked and money stolen? Whose liability? They suggest how finance firms and tech firms offering financial services can provide the solutions against such a problem: We have studied the trade-off between safety and convenience of storing balances in anonymous addresses. This type of aggregation is the foundation of all private digital currencies like Bitcoin. Security risks arise from hackers, focusing on banks and exchanges, and from thieves, attempting to steal private keys and account passwords from customers. The extent of loss depends the

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As I wrote this article, came across this paper by Charles Kahn, Francisco Rivadeneyra and Tsz-Nga Wong in this piece.

They look at this problem of storing digital currencies via passwords in different locations. What if this information is hacked and money stolen? Whose liability? They suggest how finance firms and tech firms offering financial services can provide the solutions against such a problem:

We have studied the trade-off between safety and convenience of storing balances in anonymous addresses. This type of aggregation is the foundation of all private digital currencies like Bitcoin. Security risks arise from hackers, focusing on banks and exchanges, and from thieves, attempting to steal private keys and account passwords from customers. The extent of loss depends the technological choices of banks and the effort of customers, giving rise of a moral hazard problem. With shared liability we find that in general customers will take too little care. Even when managing their balances individually and facing the entire risk of loss, customers will find some level of aggregation desirable, and so will prefer to use wallets, reuse addresses, and rely on password  aggregation program.

Our findings have implications for the design of central bank digital currencies and their ecosystem. If the central bank can establish similar liability rules for loss as with bank notes, customers will have the incentives to exert the appropriate level of care. Enforcing these rules, however, might not be as straightforward. Moreover, determining the liability in case of loss would be even more complicated if the design of the CBDC allows any individual or firm to hold the digital tokens.

If this is possible, we would expect customers to aggregate balances in accounts held at intermediaries like exchanges. This would give rise to deposits in unregulated entities which might be out of reach of domestic authorities. Designing a CBDC that is universally accessible but cannot be
held by certain firms is a technological challenge.

Our framework applies to any digital asset that functions as a bearer instrument. As institutional investors consider holding digital currencies, it would be relevant to analyse other protocols like multisignature and key sharding. Another avenue is to analyse the incentives of large technology companies considering issuing digital currencies, which could provide custody services and earn revenue from the online activity of their customers.

Amol Agrawal
I am currently pursuing my PhD in economics. I have work-ex of nearly 10 years with most of those years spent figuring economic research in Mumbai’s financial sector.

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