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November 23, 2020

Monetizing Privacy with Central Bank Digital Currencies

Monetizing Privacy with Central Bank Digital Currencies

In prior research, we documented evidence suggesting that digital payment adoptions have accelerated as a result of the COVID-19 pandemic. While digitalization of payment activity improves data utilization by firms, it can also infringe upon consumers’ right to privacy. Drawing from a recent paper, this blog post explains how payment data acquired by firms impacts market structure and consumer welfare. Then, we discuss the implications of introducing a central bank digital currency (CBDC) that offers consumers a low-cost, privacy-preserving electronic means of payment—essentially, digital cash.

Payment-Driven Data Monopolies

We consider a market in which (1) firms use historical data to develop more attractive goods and services for future consumers and (2) consumers choose between various payment options based on prices. Whether data are accumulated or not depends on the payment method. Transactions using digital payments enable firms to capture consumers’ personal data; cash does not. Data are not shared between firms. By gaining exclusive access to data from their own customers, firms may use this information to gain a competitive edge.

In the absence of regulation or other re-distributional policies, prices determine the division of data-generated economic surplus between firms and consumers. Given that data is essential to compete in product markets, firms may want to provide discounts to encourage consumers to use digital payments. The extent to which firms can effectively price discriminate with regard to payment methods depends on the market structure.

Our first result is that payment data catalyzes the formation of a “data monopoly.” A firm that obtains small advantages in information early on sets prices aggressively to expand its share of consumer data, and monopolizes the market over the long run. In such a market, we find that the monopoly firm controls the vast majority of data and is able to offer a product that is far superior to its competitors’ products. This gap in product quality enables the firm to set discriminatory prices between payment types, taking into account the profit-maximizing quantity of data it would like to extract from consumers. As a consequence, consumers obtain only a small share of the surplus generated from their data.

Interestingly, policies aimed at breaking up the data monopoly may not be beneficial for consumers. We show that a data-sharing policy can restore competition in monopolized market by improving other firms’ abilities to produce competitive goods. However, greater competition weakens any single firm’s ability to incentivize consumers to provide their data through discounted prices on digital payments. While consumers receive a bigger share of the surplus in a competitive market, the size of the surplus shrinks relative to a world in which one firm is privy to a greater concentration of data.

The Economic Impact of Digital Cash

A low-cost, privacy-preserving electronic means of payment—digital cash, for example—combines the convenience of existing digital payment methods with the privacy-preserving aspect of cash. Thus, the emergence of digital cash directly reduces the cost to consumers of making purchases whilst preserving privacy. A broader insight from our model is that it can also improve consumer welfare indirectly by increasing the amount of market surplus obtained by consumers.

Introducing digital cash preserves the data monopoly market structure, but changes the data monopolist’s pricing behavior. The data monopolist has to offer better prices to consumers who pay digitally to prevent them from using digital cash. As a result, digital cash increases consumer welfare by lowering prices while preserving the total surplus. The consumers’ share of the surplus generated from data is roughly equal to the intrinsic value of privacy.

Our model shows that digital cash can be an effective policy tool for improving consumer welfare. It provides consumers with a “bargaining tool.” Importantly, consumers benefit from the existence of digital cash, regardless of whether utilization is high or low. Even if consumers ultimately choose not to use the digital cash as their modal form of payment, the option enhances their ability to be compensated for sharing their data, in effect, monetizing privacy.

Thinking about Privacy in the Design of a CBDC

While cash was not specifically created to provide privacy in exchange, privacy is a feature inherent in its use. Some have argued that the privacy feature of cash is just as important as its role as a substitute for perfect credit relationships; see Kahn, McAndrews, and Roberds (2005). As cash use continues to decline, the question naturally arises as to whether central banks should provide a digital alternative to cash that also provides some privacy features.

A comprehensive assessment of the costs and benefits of CBDCs is well beyond the scope of this post. Nevertheless, the possibility that a privacy-preserving digital payment method may improve consumer welfare represents a relevant consideration for central banks to take into account. The provision of a CBDC is arguably within the scope of two of the seven core functions of the Federal Reserve System: to foster a safe and efficient payment system and to promote consumer protection.

Moreover, it fills a vacuum that private firms may not be willing or able to provide. Privacy-preserving digital payment alternatives, such as cryptocurrencies, involve high transaction costs and can be environmentally costly. Private initiatives proposed by “BigTech” firms are likely to lead to even less privacy. Central banks are better positioned, relative to private intermediaries, to commit to safeguarding data from outside vendors, because a central bank has no profit motive to exploit payments data. By helping consumers to monetize privacy, central banks would not be proposing a radical transformation to the payments landscape. Rather, they would be preserving aspects of payments that existed prior to the digital revolution.

There are practical challenges to the provision of digital cash by central banks that we have not addressed. Offering ubiquitous and direct access to central bank money, let alone one that is privacy-preserving, requires a reliable and robust system. With the commitment to privacy, regulators and lawmakers would have to rethink how to adapt current anti-money laundering practices. Finally, the impact of CBDC on the existing banking system and financial stability must be considered.

Rod Garratt holds the Maxwell C. and Mary Pellish Chair in Economics at the University of California Santa Barbara.

Lee_michaelMichael Lee is an economist in the Federal Reserve Bank of New York’s Research and Statistics Group.

How to cite this post:

Rod Garratt and Michael Lee, “Monetizing Privacy with Central Bank Digital Currencies,” Federal Reserve Bank of New York Liberty Street Economics, November 23, 2020,


The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

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