This is the first installment in a series exploring stablecoins and central bank digital currencies (CBDCs).
The rise in cryptocurrency adoption since the fall of 2020, along with the expansion of decentralized finance (DeFi) protocols, has made stablecoins a major player in the digital asset space. Around the world, regulators are grappling with how to handle stablecoins, while many central banks are pondering the future of digital currency inside and outside their countries.
- A stablecoin is a cryptocurrency tied to the value of an underlying asset, often a fiat currency such as the US dollar. Stablecoins can be tied to short-term securities (like government debt) or backed by other cryptocurrencies (like Etherum) or other assets (like gold or oil).
- A central bank digital currency (CBDC) is a digital currency backed and issued by a country’s central bank. Therefore, CBDC is the digital format of a fiat currency for a particular nation or region, backed and regulated by a central bank rather than tied to an underlying asset.
- A key difference between stablecoins and CBDCs is how they are used – most stablecoins are currently used to facilitate investments, while most CBDCs are envisioned to facilitate payments. These different use cases also indicate which regulators have jurisdiction and which rules will (or may) apply.
When most think of stablecoins, they think of coins like USDC (Circle’s USD Coin), Tether (USDT), and QCAD. These stablecoins (and many others) track the price of fiat currency (like US or Canadian dollars). This makes them attractive cryptocurrencies, especially for cryptocurrency traders who want to lock in their profits without “downgrading” to fiat currency. However, just because a stablecoin reflects the price of a particular currency does not mean that it is fully backed by an equivalent reserve of that currency in a bank account. In other words, 78 billion USDT does not necessarily mean that the issuer of USDT has 78 billion USD in their bank account.
Stablecoins attract cryptocurrency traders. As with any form of investing, trading fees can eat away at profits, so some investors use stablecoins to temporarily store value (after a particular cryptocurrency is sold), without leaving the trading market. cryptocurrencies (for example, exchanging cryptocurrency for fiat currency). This does not include other fees, such as “gas fees”, which are charged to compensate users for using computing power to process and validate transactions, but it does keep the user out of the traditional banking system. This is particularly useful for DeFi transactions, where traders can borrow or lend cryptocurrencies and earn returns or interest. Stablecoins can be used in the DeFi market to generate returns while mitigating market volatility.
As with other cryptocurrencies, stablecoins are also a low-cost alternative for global transfers (partly because there are no exchange fees) and are vulnerable to hacking or cybersecurity threats. Stablecoin adoption is correlated with cryptocurrency, but it also faces the same technological barriers to entry that cryptocurrency tries to overcome.
As the adoption of cryptocurrency increases, and in turn the use of stablecoins increases, the role that central banks will play in the digital currency space, including the deployment of the CBDC, becomes of more and more urgent. In September 2021, 86% of central banks were actively seeking virtual currencies. CBDCs are studied by central banks for a wide range of reasons, which will be described in more detail in Part 3 of this series. Here are some examples:
- Competitive: As noted in the “Annual Report” of the Bank for International Settlements, CBDCs are more cost effective than physical cash because they have lower transaction costs, they can promote financial inclusion, and they can help monetary policy to unfold faster and seamlessly.
- Conceptually reduces third party risk and delays: A well-designed CBDC would simplify the implementation of monetary policy, such as the near real-time execution of government programs in times of crisis (for example., pandemic-related financial support).
- Confidentiality and Fraud: Cryptography and a public ledger can allow a central bank to easily track money throughout its jurisdiction.
- Financial inclusion: A well-designed CBDC system can revolutionize the remittance industry by simplifying the transfer of money within regions and across borders using payment rail technology. This is particularly useful in regions where the physical banking infrastructure is either non-existent or still under development.
To date, most countries have not switched to any form of digital currency for payments. The Bahamas has become the first country in the world to move past the pilot stages and achieve an official launch of its CBDC, the “sand dollar”. China has also made progress in launching its digital currency, as the first major global economy to pilot a retail-ready digital currency in time for the 2022 Winter Olympics. more than $9.7 billion in transactions have already been made with the Chinese CBDC.
How the CBDC and stablecoins compare
CBDC and stablecoins are two forms of digital assets designed to be universally accessible as an electronic record or digital token. What distinguishes the CBDC from stablecoins is the issuer (a central bank in the case of CBDCs) and the market objective that is targeted (i.e. payments in the case of CBDCs and investments in the case of stablecoins).
Since central banks are subject to their own regulations and the “backing” of a currency is tied to the central bank (the CBDC would be a direct responsibility of the central bank), central banks are responsible for ensuring the security of any digital currency they issue. Additionally, CBDCs can be minted on private registers and operated by financial institutions (the current “two-tier” model adopted by most proposed CBDCs). On the other hand, stablecoins are issued on public blockchains by a company, which allows individuals to operate nodes and execute smart contracts, lending the utility of stablecoins to DeFi, but without the same protections.
In part two of this three-part series, we will discuss stablecoins, their risks, and some proposed regulatory frameworks.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.