Working Paper Series The digital economy, privacy, and CBDC Toni Ahnert, Peter Hoffmann, Cyril Monnet Disclaimer: This paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB. No 2662 / May 2022 AbstractWe study a model of financial intermediation, payment choice, and pri-vacy in the digital economy. Cash preserves anonymity but cannot beused for more efficient online transactions. By contrast, bank depositscan be used online but do not preserve anonymity. Banks use the in-formation contained in deposit flows to extract rents from merchantsin need of financing. Payment tokens issued by digital platforms allowmerchants to hide from banks but enable platforms to stifle compe-tition. An independent digital payment instrument (a CBDC) thatallows agents to share their payment data with selected parties canovercome all frictions and achieves the efficient allocation.Keywords: Central Bank Digital Currency, Privacy, Payments, DigitalPlatforms, Financial Intermediation.JEL Codes: D82, E42, E58, G21.ECB Working Paper Series No 2662 / May 20221 Non‐technical summary The ongoing digitalization of the economy has profound implications for the way payments are settled. Since more and more transactions are conducted online, physical currency (“cash”) is becoming impractical as means of payment for a growing share of economic activity. At the same time technological innovation has led to a proliferation of electronic payments, spearheaded by large technology firms aiming to enrich their ecosystems with financial services. These developments have led to a debate among policy makers about the potential creation of central bank digital currency. Electronic payments create vast amounts of data, so data privacy is one motivation for such a change to our monetary system. While more data can in principle enable better products and services, economists have become increasingly concerned about the anti‐competitive effects of large data monopolies in the form of dominant digital platforms. Broadly speaking, digital public money in the form of a CBDC may have a comparative advantage at providing privacy because, unlike private sector alternatives, it is not subject to profit‐maximization incentives. This paper speaks to this debate by developing a model of financial intermediation, payment choice, and privacy in the digital economy. We study a setting where merchants can distribute their goods online or offline. Online sales are more efficient, but they require electronic payments, whereas inefficient offline sales can be settled in cash. A tension emerges because merchants need financing, and the use of electronic payments (bank deposits) provides detailed information to their financiers (banks), which are thus able to charge higher loan rates to successful businesses. The use of cash guarantees anonymity and forces banks to elicit information through contract terms. This is to merchants’ benefit, who will therefore sometimes decide to distribute their goods offline (which is socially inefficient). The introduction of a CBDC with anonymity enables merchants to prevent banks from extracting information from payment flows. Instead, the bank must elicit such information through contract terms. As a result, merchants distribute more goods online, which raises social welfare. We then enrich the model to incorporate digital platforms that issue payment tokens and provide loans. We show that merchants in fact prefer such tokens to CBDC. Intuitively, the information obtained by platforms through their tokens enables them to compete with banks in the lending market, albeit not perfectly. This improves the credit terms for merchants relative to a CBDC with anonymity, and further raises online sales. However, we show that tokens can also help platforms to fend off potential entrants by keeping merchants locked into a “walled garden”. ECB Working Paper Series No 2662 / May 20222 Finally, we consider a CBDC with data‐sharing features. Since merchants are now able to share information with the platform and the bank, they are able to enforce perfect competition. As a result, merchants completely move to online distribution, which is the socially efficient outcome. Moreover, a CBDC with data‐sharing also prevents anti‐competitive practices by platforms, further raising efficiency. Our results have important policy implications. While a CBDC with anonymity is preferrable to traditional electronic payments such as bank deposits, it may become supplanted by payment tokens issued by large technology firms. This risk would be particularly tangible if those platforms compete with banks in the market for financial services. However, an optionality for data‐sharing features may result in a widespread CBDC adoption. ECB Working Paper Series No 2662 / May 20223 1 IntroductionThe growing dominance of e-commerce has profound