The Watergate banknotes

Cash isn't quite anonymous, it's anonymous-ish.

To illustrate this, a few years ago I wrote about the 1932 Lindbergh kidnapping case. The ransom was paid in gold certificates, not Federal Reserve notes. By coincidence, the U.S. went off the gold standard the next year, and all gold certificates were called in. So when the kidnapper spent some of his gold certificates in 1934 to buy gas, his purchase was odd enough to out him to the authorities.

I recently stumbled on a more recent example of cash de-anonymization. Most people know the gist of the Watergate scandal, but to recap five burglars were caught breaking into Democratic headquarters at the Watergate building on June 17, 1972.

Who were they and what were they doing there? At first, no one had a clue. But the police did find around $3,600 in cash on them, much of it in sequentially-numbered $100 banknotes. See the serial numbers below:

Testimony of Paul Leeper, May 1973, Hearings Before the United States Congress, House Committee on the Judiciary [source]

A series of sequential banknotes meant that the cash had come fresh from the U.S. Bureau of Engraving and Printing, the agency that produces banknotes on behalf of the Federal Reserve. The new notes would have been sent to a bank which in turn distributed the notes in their original sequential order to customers.

The serial numbers of the Watergate notes also gave a geographical sense of where they had been issued. There are 12 regional Federal Reserve Banks. Notes beginning with F are issued into circulation by the Federal Reserve Bank of Atlanta, those beginning with C by the Federal Reserve Bank of Philadelphia.

Two days after the break-in, FBI agents contacted these two district banks for more information. It turns out, Federal Reserve Banks do keep track of banknote serial numbers. The Philadelphia Fed informed agents that the notes in question had been shipped to a private bank, the Girard Bank & Trust in Philadelphia, while the Atlanta Fed had shipped theirs to the Republic National Bank in Miami. 

Unfortunately, the two commercial banks did not record the serial numbers of the bills that they had distributed to the public. However, one of the burglars--Bernard Barker--happened to have an account at the Republic National Bank in Miami. (The trail to the Girard Bank & Trust turned cold).

Scanning through Barker's bank information, investigators discovered that several months before five large deposits had been made into his account. This included four checks totaling $80,000 drawn on a Mexico City bank and one for $25,000 from a Miami bank. These funds were eventually traced back to the the Committee to Re-Elect the President, an organization created to help raise funds for Nixon's upcoming election campaign.

And there was a smoking gun. A money trail from the pockets of the Watergate burglars to the President's administration. The burglars, it was further discovered, had been hired by Committee to Re-Elect the President to wire-tap Democrat party phones and photograph documents. So the President was spying on his political enemies.

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There is an interesting sidebar to this story. Two days after the break-in, Senator William Proxmire, chairman of the Financial Affairs Subcommittee, contacted the Fed for information about the banknotes. In a book published in 2008, economist Robert D. Auerbach accused Arthur Burns, Nixon's appointee to lead the Fed, of refusing to cooperate with Proxmire's requests. Presumably Burns wanted to protect his boss.

In his book, Auerbach cited the following internal document, a timeline of the Federal Reserve Board's actions after the Watergate break-in. It is available in the Arthur Burns papers in the Gerald R. Ford Presidential Library:

Congressman Ron Paul aired Auerbach's allegations in front of Congress in 2010. An investigation was soon initiated by the Office of the Inspector General, an independent body that conducts oversight and audits of the Federal Reserve. In 2012, the OIG exonerated Arthur Burns and the Fed. The report noted that Burns was complying with FBI requests to avoid sharing the information lest this interfere with the investigation.

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So banknote users are never entirely anonymous--the serial numbers can be used to unveil who they are. In Watergate's case it was a fairly blunt tool. The notes could only be traced to the burglar's Miami bank, not to his account.  But if tellers at the Republic National Bank had been dutifully recording the serial numbers of notes they gave to their customers, the tool would have been much more accurate, pinpointing Barker as the direct source of the Watergate banknotes.

No bank teller want to tediously record numbers by hand. But in today's world, it is technically possibly for ATMs to record banknotes using built-in serial number readers. Is this actually happening? I am pretty sure that serial numbers are not being collected by North American banks. People would be furious about potential invasions of privacy.

But not so in China. Since 2013, Chinese ATMs and tellers are required by law to record the serial numbers of all banknotes. (I am not sure if the same law applies to Hong Kong):

Even cash can be tracked. The Chinese government has required bank tellers and ATMs to record & log banknote serial numbers since 2013: https://t.co/dxZHRGAOHi pic.twitter.com/kCILa5ndOR

— John Paul Koning (@jp_koning) December 26, 2019

I snipped the above screenshot from a marketing brochure from Glory Ltd, a Japanese company that specializes in cash handling technology. Chinese laws surrounding banknote serial number collection have ostensibly been put into place to prevent counterfeit yuan from entering into circulation. But one could imagine this technology being used by the authorities to track licit money flows.

Say that a Chinese human rights activist deposits ten ¥100 banknotes into their bank account. The police might be curious about who is financing this activist. In theory, they could ask the People's Bank of China, the nation's central bank, to search the various serial number databases for the name of the owner of the bank account from which the ten ¥100 notes originally came. In this way an anonymous cash donation could be de-anonymized.

Chinese citizens who use cash in potentially risky transactions have probably already devised a solution. They can evade serial number sniffing by going through an extra step of "mixing" their cash prior to spending it. This might involve breaking up the notes in a few shops prior to passing them on to the intended recipient. Of course, this trick will only work as long as retailers are not required to install their own note-reading hardware.

I often write about the contradictions of anonymous payments. It would have been great to catch Nixon's thugs with technology that completely de-anonymizes banknote movements. But it is abhorrent to know that human rights activists might be prosecuted using this same technology. Striking a balance is difficult.

"Controllable anonymity"

Reuters and Coindesk report that that the People's Bank of China's imminent central bank digital currency (CBDC) is going to have a feature called controllable anonymity. Perhaps some wires have been crossed in the translation, but it'd be hard to come up with a more Orwellian piece of double speak than this. Plenty of people on Twitter are sneering.

But in this post I'm going to take China's side, if only tepidly.

None of the news articles have made much of an effort to explain controllable anonymity. But we've actually known about this feature for quite some time. Back in 2018, the project's head, Yao Qian, provided a short description of it. It's not as Orwellian as it seems.

China's new CBDC, otherwise known as the Digital Currency Electronic Payment (DCEP) platform, requires users to provide their real identities when they sign up. In the link above Yao calls this real-name at back-end. So the People's Bank of China will be privy to the identity of each user. This is to guard against money laundering and tax evasion. So not much anonymity here.

The element of anonymity crops up in a different part of the transactions cycle. It seems that a payee will be able to control what sort of information they throw off to the counterparties that they are dealing with. Yao calls this voluntary anonymity, presumably meaning that payors/payees can volunteer how much of their personal information they wish to leak out to stores, suppliers, customers, or whatnot. This sort of fine-grained control over one's data isn't something that you can do with, say, a credit card. If I buy groceries at Loblaw, who knows what sort of personal information they are collecting about me.

Source: Technical Aspects of CBDC in a Two-Tiered System, by Yao Qian [link]

So the upshot is that China's CBDC will be providing a certain sort of privacy to users. Which reminds me about what Rodney Garratt and Morten Bech, two economists that specialize in payments systems, have written about payments anonymity. According to Garratt and Bech, there are two grades of payments anonymity. With third-party anonymity, a person's true identity is hidden from everyone who participates in a transaction, including the system operator. Banknotes are the best example of third-party anonymity, since the issuer—the central bank—has no idea who is using them.

Counterparty anonymity is less strong. This sort of anonymity prevails when personal information about the two counterparties to an exchange remain hidden from each other but the system operator is still privy to each user's identity. Yao's controlled anonymity presumably means that DCEP will provide Garratt and Bech's second sort of anonymity, counterparty anonymity.

Federal Reserve researchers like Charles Kahn, William Robers, and Jamie McAndrews have delved into the benefits of counterparty anonymity. The ability to cloak your information from sellers or payees reduces the risk of identity theft, the possibility that a counterparty might stalk you and rob you, or the odds of becoming a victim of direct advertising and other solicitations.

Here is Kahn:

"Suppose, for example, that I wish to make a perfectly legal transaction with a stranger but wish to ensure that there are no unpleasant ramifications down the road. It is not hard to think of examples where the information about the purchase of a good makes the individual vulnerable: a purchase indicating that the individual has high wealth, or a purchase that may be embarrassing, even if perfectly legal (certain medications, for example). More prosaically, making a purchase on the internet involves the revelation of identity in ways that make you subject to spam or harassment. In short, sometimes we want the ability to ensure that others cannot use the information in the history of our transactions against us."

Where does all this leave Chinese consumers with respect to payments privacy? It could be that they are worse off. If the People's Bank of China's new CBDC is being designed to replace cash, then on net Chinese citizens will lose the ability to transact in a way that is anonymous to all parties. Cash provides third-party anonymity, DCEP doesn't.

But it's also possible that Chinese consumers will be better off. If the new CBDC is designed as a complement to cash, then Chinese citizens may actually have more privacy options than before. Not only do they still have access to cash's third-party anonymity, but they also will gain strong digital counterparty anonymity. Surprisingly, this would mean that they will end up with more information-cloaking tools than us Westerners.

Once again I'm reminded of something Charles Kahn wrote. Privacy needs are different, so we should "expect a variety of platforms to emerge for specific purposes." In this context e-cash probably won't "play all the privacy roles that physical cash currently plays," says Kahn. It is possible that this multi-faceted approach to privacy is what is playing out in China.

Data visualization: The People's Bank of China balance sheet

David Glasner and Scott Sumner have posts on Chinese monetary policy. They both inquire about the People's Bank of China (PBoC) balance sheet. I've affixed a chart of it below.

Here's a quick rundown of how the PBoC balance sheet changes. The PBoC sets the yuan-to-dollar exchange rate at some rate below what it would in a free market. Chinese exporters thereby enjoy a subsidy. The law requires that the foreign currency that exporters earn overseas be repatriated and exchanged for yuan. The PBoC prints yuan (bottom green area) or provides deposits (bottom purple area), receiving this foreign exchange in return (top green area).

(scribd pdf)

By creating such large quantities of liquid currency and reserves, the PBoC will force the domestic price level  to rise. In order to prevent this inflation, the Bank must "sterilize", or mop up the liquidity it has created. It does this by issuing bonds (dark blue area at bottom) to domestic banks in exchange for currency and reserves (bottom purple and green). Thus liquid instruments are replaced by an illiquid instrument, bonds. The PBoC also forces banks to hold large quantities of required reserves (bottom purple area), which immobilizes what would otherwise be a fairly liquid instrument. In this way the rise in the domestic price level can be temporarily prevented. The PBoC could also sterilize by selling domestic assets (top pink, blue, or yellow areas) and retiring the currency and reserves it receives. But given that domestic assets held on the PBoC balance sheet haven't changed much over the years, it's likely that different means are being found to sterilize.