This is the first installment in a series exploring stablecoins and central bank digital currencies (CBDCs).
The uptick of cryptocurrency adoption since fall 2020, along with the expansion of decentralized finance (DeFi) protocols, have made stablecoins a major player in the digital assets space. Around the world, regulators grapple with how to manage stablecoins, while many central banks consider what’s next for digital currency in and outside of their countries.
The basics
- A stablecoin is a cryptocurrency that is tied to the value of an underlying asset, often a fiat currency such as the U.S. dollar. Stablecoins can be tied to short-term securities (such as government debt) or backed by other cryptocurrencies (such as Etherum) or other assets (such as gold or oil).
- A central bank digital currency (CBDC) is digital money 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 CBDC is how they are used – most stablecoins are currently used to facilitate investments, whereas most CBDCs are envisioned to facilitate payments. These different use cases also inform which regulators have jurisdiction, and what rules will (or can) apply.
Stablecoins
When most think about stablecoins, they think about coins like USDC (Circle’s USD Coin), Tether (USDT), and QCAD. These stablecoins (and many others) track the price of fiat currency (such as U.S. or Canadian dollars). This makes them attractive cryptocurrencies, especially for cryptocurrency traders who want to lock-in profits without ‘off-ramping’ to fiat currency. However, just because a stablecoin mirrors a price of a particular currency does not mean 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 US$78 billion in its bank account.
Stablecoins hold appeal for cryptocurrency traders. Similar to any form of investing, trading fees can eat away at profits, so some investors use stablecoins to temporarily store value (after the sale of a particular cryptocurrency), without leaving the cryptocurrency market (e.g. exchanging cryptocurrency for a fiat currency). This does not address other fees, such as ‘gas fees’, that are charged to compensate users who use computing energy to process and validate transactions, but it does keep the user outside of the traditional banking system. This is particularly helpful for DeFi transactions, where traders can borrow or lend cryptocurrencies, and generate yield or interest. Stablecoins can be used in the DeFi market to generate yield while mitigating market volatility.
As with other cryptocurrencies, stablecoins are also a low fee alternative for global transfers (in part because there are no foreign exchange fees) and are vulnerable to hacking or cybersecurity threats. The adoption of stablecoins is correlated to cryptocurrency, but it also faces the same technological barriers to entry that cryptocurrency is trying to overcome.
CBDC
As cryptocurrency adoption increases, and in turn, stablecoin usage increases, the role central banks will play in the digital money space, including deploying CBDC, becomes increasingly time-sensitive. As of September 2021, 86 per cent of central banks were actively researching virtual currencies. CBDCs are being investigated by central banks for a wide range of reasons, which will be outlined in further detail in part 3 of this series. Here are a few examples:
- Competitive: As noted in the Bank of International Settlements’ “Annual Report”, CBDCs are more cost efficient than physical cash, as they have lower transaction costs, they can promote financial inclusion, and they can help monetary policy flow more quickly and seamlessly.
- Conceptually reduces third party risk and delays: A well-designed CBDC would simplify the implementation of monetary policy, such as effecting near real-time delivery of government programs in times of crisis (e.g., pandemic related funding support).
- Privacy and Fraud: Cryptography and a public ledger may make it easy for a central bank to 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 payments rails technology. This is particularly helpful in regions where brick and mortar banking infrastructure is either non-existent or is still developing.
To date, most countries have not transitioned to any form of digital currency for payments. The Bahamas became the first country in the world to go beyond pilot stages and achieve an official launch of its CBDC, the “sand dollar”. China has also made strides in its digital currency launch, as the first major world economy to pilot a digital currency that was ready for use for retail transactions in time for the 2022 Winter Olympics. Notably, over $9.7 billion of transactions have already been made with China’s CBDC.
How CBDC and stablecoins compare
CBDC and stablecoins are both forms of digital assets designed to be universally accessible as an electronic record or digital token. What sets CBDC apart from stablecoins is the issuer (a central bank in the case of CBDCs), and the market purpose that is being addressed (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 because the “backing” of a currency is tied to the central bank (CBDC would be a direct liability of the central bank), central banks are accountable to ensure the security of any digital currency they issue. In addition, CBDCs may be minted on private ledgers 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.
Reach out to any of the authors or key contacts below if you have questions about stablecoin regulations and central bank digital currencies.
