Cybersecurity and privacy in digital currencies

The transition from cash to digital, tokenised payment methods presents us with new challenges, but also some familiar ones. Payment transactions are the lifeline of the economy, which means they must be particularly protected to withstand attacks. On the other hand, there is a great need for privacy, as new technical possibilities also increase desires to analyse data.

But let’s look at cash first. When two people engage in a cash transaction, e.g. a customer rendering banknotes to a merchant, a number of security requirements are already controlled for:

1. Both the payer’s and the payee’s identities are in physical proximity. Banknotes are handed over directly, with no way to “redirect” the transaction.

2. Authenticity of the banknotes can be established by haptic and visual properties of the physical objects. A merchant may employ additional authenticity checks of the banknotes: an ultraviolet lamp, a counting machine, or other devices.

3. The rightful ownership of the banknotes is proved by physical possession. No identity check or authentication is necessary.

4. The payment is completed and settled by change of ownership of the banknotes: the cash physically changes hands. Clearing and settlement are not necessary.

5. The payer is prevented from double-spending, i.e. using the same banknotes for two concurring payments: as opposed to data, physical objects cannot be cloned.

6. In a series of multiple of cash payments, it is impossible for any third party to track the payment patterns.

To summarise: Cash is a secure and private means of payment, because it is a physical bearer instrument.

Security in the digital world

These characteristics need to be applied to the digital world, where they are based on cryptographic and other technical measures. In technical jargon, these are named as follows:

1. Authenticity of sender and receiver

2. Authenticity of the asset

3. Proof-of-ownership of the asset

4. Non-repudiation of transactions

5. Prevention of double-spending

6. Privacy

There are various dimensions to the design of digital currencies, each of which has an impact on security and privacy. For simplicity, this article will only deal with sovereign currencies, i.e. euros, US dollars, etc., but not cryptocurrencies.

The primary dimension that has emerged in the academic debate is “accounts” vs. “tokens”. The best way to explain this is by analogy with traditional instruments.

An account-based system corresponds to a table that assigns a value to each account number. An entry subtracts a value from one account and adds the same value to another account. This is how deposit accounts already work today. The key feature is that an account is long-lived, i.e. each account accumulates a large number of incoming and outgoing transactions over time.

In contrast, a token-based system is somewhat more difficult to explain. A token is a digital piece of data with individual key and value. This corresponds most closely to a banknote with a serial number and denomination. Unlike in the physical world, however, digital tokens are not tied to a specific denomination. For example, a token can have a value of €15.38. But the value does not change over time. During a transaction, either complete tokens are transferred or, if the value is not quite right, they must be split. (For that, the sum of the new tokens shall equal the old token.) The system creates new keys for each token, which means that there is no direct link between the money and the owner.

Sadly, the term “token” is ambiguous. Confusingly, stablecoins and other crypto assets are often referred to as tokens, although they are usually account-based systems, for example Ethereum. Bitcoin, on the other hand, is a true token-based system.

The Federal Reserve summarises the essence of tokens as follows: “digital units of value that can be transferred anonymously.” It therefore makes sense to characterise such tokens as a digital bearer instrument.

Trust between entities

Regardless of how digital money is actually designed, the ecosystem faces an additional challenge. There are several entities, such as banks, the central bank, merchants, end users, etc., between which a relationship of trust must be established. These entities have different requirements.

For example, banks would offer their customers wallets and related services. Customers therefore trust their bank based on the business relationship alone. But there is no such trust relationship between customers of different banks.

The technical solution is for all parties to agree on a Public Key Infrastructure (PKI). The issuer or operator of the infrastructure, for example the central bank, is at the top and defines the basic rules of the game, according to which all entities receive individual certificates with cryptographic keys. These can then be used for mutual authentication. All parties should also store the keys on secure hardware to protect themselves against attacks.

Together with cryptographically sound payment protocols, a PKI can fulfil the security features listed above.

Privacy

Of course, privacy must be considered. A system that makes every transaction publicly traceable—such as a stablecoin on Ethereum—may be highly secure and transparent, but not privacy-friendly.

There are various technical approaches to solving this problem. These are often described with the umbrella term Privacy-Enhancing Techniques (PET). Some of them are based on cryptographic measures, others on organisational ones.

For example, digital currency can be designed in such a way that the integrity data (authenticity of the money itself) is decoupled from the payment data (identities of the payment parties). In the context of CBDC, this would mean that the central bank knows which tokens are in circulation, but not to whom they belong. This satisfies the principle of data minimisation. All metadata would be stored locally in the wallets.

However, such measures must be carefully weighed against the legitimate interest in prosecuting money laundering and other criminal offences. The design must therefore also be based on the legal situation.

Conclusion

• Physical cash offers a high level of security and privacy.

• Digital currencies should also achieve this level, presenting technical challenges.

• There are various ways in which digital currencies can be designed, for example as account-based or token-based solutions.

• Trust between participants can be established through a PKI.

• Technical and organisational measures can provide privacy, but this must take place within a regulatory framework in order to prevent money laundering.

This post has also been published on LinkedIn.