What do banks do that make it so attractive for people to entrust their money to them?
While a big part is processes and technology to foil robbery, a lot of this is achieved by making money more like accounting entries in a digital ledger rather than tangible stuff that has to be created and moved - and trusting the banks to maintain the ledger correctly. On the flip side, doing this makes it easier to "create" money, whether legally sanctioned (as done by a central bank) or not (failing reserve requirements). As the contretemps with Bitcoin has showed, digital systems can be compromised and money stolen - in the case of Mt. Gox the problem was an accounting failure where the system was persuaded that Bitcoin had not been transferred even when real money was paid out, causing Mt Gox to make duplicate real money payments on the same Bitcoin.
We should first remember that it is not only illegal activity that can rob you of your wealth. Making it easier to "create" money also makes it easier for "legal" entities to rob you of your wealth via inflation. Making it easier to trace money also makes it easier for "legal" entities to rob you of your wealth via taxation. The ability to place targetted sanctions on your use of the money devalues your money - by placing restrictions on how you can use your money. It also discourages the animal spirits that are necessary for a vibrant economy - fear of reprisal for politically incorrect behaviour or speech becomes very real. Collecting the money of the people in a small number of large institutions makes it easier to use that money for purposes the people may not approve of - i.e. it facilitates the unauthorized use of your money.
The great thing about tangible money, especially where it is based on a rare commodity like gold, and is held by the people, is that it makes abuse by "legal" (large?) entities difficult. Force must be exerted against the will of millions of people to make an unpopular use of the money. It is far simpler in such a situation to convince a large segment of the population that a cause is worthwhile, and get them to voluntarily contribute to the cause, even if a majority of the population does not agree. "Legal" entities will, in this situation, tend to do things with the cooperation of the people. In fact, one can correlate the liberty and well being of a society directly with the anonmity, stability and dispersion of its money, regardless of its system of government.
The downside of a totally anonymous tangible system is that it makes abuse by "small" "illegal" entities easier. Once you have been robbed, in the limit there is no recourse. In addition, while defending your small pot of wealth in well known home territory is a natural part of living and relatively feasible, modern life often requires that you have access to, or can transfer, a significant part of it far from home turf. If you are lucky enough to have a large amount of wealth, then keeping it (and yourself) safe becomes a real issue. It then really becomes worthwhile to entrust the money to an entity with the expertise and the resources to keep it safe.
We have experience with both systems - cash, and banks with KYC(know your customer) rules. We have them both. But our intangible money system is now so much bigger than our tangible money system. Also, anti-money laundering law (AML) goes overboard, and discourages the cash system to such an extent that we are practically living in a totalitarian society. Would it not be desirable to combine them in such a manner that we could have the benefits of both?
The first step would be to expand the tangible base, and ensure it is widely dispersed. Legal money should be based on tangible objects. It does not have to be a gold standard, but the people must decide exactly how much money there is to go around via an explicit act of creation. There must be a large cost associated with creating, holding or transferring a large amount of money. One could even consider taxing bank deposits or large accumulations of cash to further encourage dispersion to the public.
The second step would be to rework AML so no financial, government, or large commercial institution can refuse to accept payments in cash of any amount. Payors can be directed to specific cash payment locations for security purposes. Persons who make large enough payments can be detained until their identity can be determined, but the payment must still be accepted. The cost to travel to a cash payment location should not exceed a small fraction of the payment, and the cost to use one should be zero. A significant penalty upto three times the proposed payment or €1000 (whichever is greater) should exist to enforce this rule. Cash payment and transport reporting requirements can continue to exist, although it would be desirable to raise the limits so that normal transactions such as that needed to pay rent, or buy a basic automobile, do not need to be reported. Denominations large enough (€1000, €10000) to make significant personal transactions convenient should exist.
A third step makes cash traceable on demand, without giving up anonymity. The serial number present on modern day notes can be used in conjunction with modern technology to do this. A person wanting to make cash traceable takes their notes to a bank which verifies the validity and transferability of the notes, and records a block on the transferability of the notes. A mark placed by the bank on the notes (or substitute notes) alerts people to the fact that the notes may not be transferable. A password is issued to the person to enable them to unblock the transferability, who then walks out with "unstealable" notes. He or she can hold, or mail them safely to an intended recipient, and unblock the notes when the recipient acknowledges receiving them, or prior to making payment, by logging in to the central or issuing bank website (anonymously, from anywhere) with a portion of the serial numbers and the password. Once the block on a note is removed it cannot be reinstated without physically going to a bank with the note. Nor can the mark be removed without going to a bank. Of course, any person who accepts marked notes must check with the issuing bank (anonymously, on a website, possibly using their phone, using the full serial number) to make sure that the notes are transferable. In their own interest, they will establish the identity of the payor if they accept untransferable notes with a promise to make them transferable. The mark is removed (or an unmarked substitute is issued) if a transferable note is physically presented to the banking system. The legal system gets involved and identity gets demanded only if the transaction is disputed. Very importantly, the decision to make cash traceable or not is in the hands of the person who possesses the cash, and even more importantly, the system does not have the information necessary to target a specific person. The central bank has information on how much money is tied up and not actually available for transactions, and approximately where traceable cash is, without knowing who owns it.
Today, central banks have an issue with deflationary pressures. It may be a good idea to restore the balance between tangible and intangible money by injecting a trillion € or so using tangible printed cash in the form of "blockable" €1000 and €10000 notes, but sterilize it by announcing it as the availability of an experimental new form of cash, which will be issued in tranches, and promising to manage the total money supply by sucking out intangible forms with a rate hike. The seignorage should be available where the central bank chooses to execute the issue, based on what best helps the economy.
With two forms of money, tangible and intangible, the central bank has additional levers to selectively push money into the economy. Banks and large commercial organizations will prefer the intangible variety, because it is so much easier to move around in large quantities. They will react to the presence of large amounts of tangible cash by pushing it onto the public. To do so they will have to make more small loans. Credit cards will become wildly popular, but will be used more for payment convenience than real borrowing. Overnight deposits at the central banks will be discouraged even with significant positive interest rates, because physically moving it there and back will be costly, and if not enough the central bank could institute handling charges for physical cash, i.e. effectively negative rates. Another selective rule could be that banks could lend out exactly as much cash as they have on hand - i.e. fractional reserve banking does not apply to cash deposits, but they could lend out 10 times the amount of intangible cash they have. Another selective rule could be that only cash deposits are guaranteed against loss.
The crisis in Ukraine is a golden opportunity to establish this kind of system on a worldwide scale. Attempts to sanction Russia have a good chance of failing, and Russia could escalate by declaring any sanctions an act of war. They are probably the only country that can make a threat of escalation credible. The upshot and comedown of such an escalation would be an international treaty strictly limiting the use of economic sanctions, forcing country legislatures to act economically strictly within their state boundaries. In particular such a treaty should forbid laws regulating extraterritorial activity by non-citizens, and not discriminate when honoring the currency they issue.
The West had better be really careful and nice with China. Money is all about promises and agreements. Another thing that is mostly promises and agreements is the patent and IP system - China could oppose sanctions by refusing to recognize patents and IP agreements, and they have the manufacturing resources (with the West now far behind) to make it stick.
It is hard to see what is now stopping Russia from indulging in a full blown invasion of Ukraine, except for the military involvement of the US. The sanctions could not possibly get worse without seriously affecting the US and EU.