Central Bank Digital Currencies, part 2: Stablecoins and CBDCs
In our previous article, we introduced CBDCs and discussed why they are being developed. In our next piece, we explain what CBDCs are, and also introduce the concept of stablecoins, explaining the similarities and differences between the two. We also begin to analyze the geopolitical angle, identifying the major powers and what are their motivations for developing CBDCs.
CBDCs and Stablecoins
CBDCs are essentially digital versions of cash, which means they have the same value as the fiat currency upon which they are based. Some of you may be familiar with stablecoins, which are cryptocurrencies that are identical in value to fiat currencies or other assets. While the two concepts are superficially similar, they are in fact very different, and for that reason we need to set definitions for both terms before we delve into a discussion of stablecoins, their implications for geopolitics and how their existence impacts CBDCs.
A cryptocurrency is a type of digital currency that is secured via strong cryptography and has its transactional information recorded on a distributed ledger, typically a blockchain.
A stablecoin is a cryptocurrency that has its value pegged to another asset, which reduces the relative price volatility that Bitcoin and other major cryptocurrencies are known for. Stablecoins are designed to offer the near-instant processing, cryptographic security and privacy of cryptocurrencies while having a more stable price (relative to fiat or other real-world assets), making them practical as a currency for everyday use by the public.
While stablecoins are most commonly pegged to fiat currencies (such as the USD or the EUR), they can also be pegged to commodities, or even other cryptocurrencies. This is done either by:
maintaining the pegged asset as collateral (back stablecoins), or
through an algorithm that controls the stablecoin’s money supply, similar to how central banks ‘prints’ money to maintain a steady rate of inflation (unbacked stablecoins).
A central bank digital currency (CBDC) is a term used to describe various initiatives by governments and their central banks to create a digital version of their national fiat currency. Unlike conventional bank deposits which are backed by commercial banks, CBDC is digital money that is backed by the central bank.
CBDCs allow governments to more easily implement monetary and fiscal policies, and can also expand financial services (such as providing accounts and loans) for unbanked or underbanked citizens.
While most planned CBDCs are superficially similar to fiat-pegged stablecoins, there are some critical differences.
CBDCs are exclusively public (governmental) initiatives, while stablecoins are private (corporate).
CBDCs are regulated by central banks while stablecoins are unregulated.
CBDCs are designated to be accepted as legal tender, while stablecoins are not.
The disruptive potential of stablecoins
Stablecoins present a serious challenge to national fiat currencies as they offer users the ‘best of both worlds’;
Like all cryptocurrencies, Stablecoins feature blockchain technology; an immutable ledger of transactions, allowing private, secure and direct payments that are near-instantaneous, without the use of intermediaries.
Unlike most cryptocurrencies, their price is not volatile as they feature mechanisms which are designed to ‘stabilize’ their price, making them useful as a medium of exchange.
As blockchain developers continue to work on making the use of stablecoins more accessible and easier for the general public, we are slowly approaching a world in which people may prefer to use stablecoins over the fiat currencies to which they are pegged.
Stablecoins are also a ‘dollarization’ threat, particularly in weaker economies where they are much more attractive than the domestic fiat currency. On a certain scale, this is already happening in countries such as Venezuela, which have highly volatile fiat currencies and there is limited access to alternative fiat.
Another major advantage of stablecoins is that unlike conventional fiat currencies, they are ‘smart’ money, in the sense that they can be programmable. This is performed via smart contracts, self-executing contracts that are coded to automatically perform certain actions based on predetermined triggers. Since smart contracts are immutable, transparent and automated, they can be used for a range of financial services such as loans, mortgages, cross-country remittance and may even be used to control monetary policy.
The rise of stablecoins is without a doubt the greatest challenge to the system of national fiat currencies yet. Since the start of 2021, they have grown from a total value of $20 billion to $114.8 billion. Governments are scrambling to figure out the correct approaches to regulation. Approaches must be coordinated internationally to address diverse economies, jurisdictions, legal systems, and different levels of economic development.
Regulators must balance between allowing too much disruption of existing financial systems and overregulating cryptocurrencies to the point of discouraging innovation. An ideal regulatory approach will provide privacy for small-scale transactions while subjecting larger ones to mechanisms for anti-money laundering (AML) and combating the financing of terrorism (CFT).
To reduce the use case for stablecoins (as well as for other motives), some governments are developing CBDCs, digital versions of their national currencies that fulfill a similar role to fiat-pegged stablecoins.
Major powers and CBDC development
When it comes to CBDCs, we have identified three major players: China, the US and the EU. Each has a different set of motives behind their development (or lack thereof) of CBDCs.
China - Oversight, Control and a SWIFT alternative
The Chinese CBDC is known as the E-CNY and it is currently the most advanced CBDC, as it is already deployed in pilot programs in several cities across China and having already cleared over $ 5 billion USD worth of transactions. The E-CNY whitepaper states that the motives behind its inception relate to creating a payment infrastructure for an increasingly-more digital economy, eliminating cash, and “addressing the rise of cryptocurrencies”. As of September 2021, China has declared all cryptocurrency transactions as illegal, part of an ongoing crackdown on crypto that started with a 2019 ban that outlawed Chinese cryptocurrency exchanges.
What is not explicitly stated is that blockchain technology will allow the government to exert even more oversight and control over the finances of its populace. China is already enjoying a head-start in this area owing to the popularity of the WeChat Pay and AliPay mobile payment platforms. The E-CNY is understood as the government’s move to co-opt this system of digital payments and replace the current duopoly.
The initiative can be understood to be a part of Beijing’s push for “financial security” (金融安全). In 2019, General Secretary Xi Jinping endorsed enhancing financial security through “controlling people, watching money, tightening the system firewall”. Like all CBDCs, the E-CNY should in theory be a more secure form of money as it is backed by the People’s Bank of China (PBOC) rather than a commercial bank that may fail. However, the E-CNY does not bear interest, which makes it a less attractive form of storing money, relative to interest-bearing commercial bank deposits, which should discourage significant bank runs that could otherwise potentially disrupt the Chinese commercial banking industry.
While primarily a domestic initiative at this point, the E-CNY could, in time, provide the basis for an alternative to the US-dominated SWIFT system of international payments. The PBOC has proposed developing interoperability between the CBDCs of different countries, having shared proposals with other central banks and monetary authorities. However, interoperability will inevitably mean that countries will have some level of access to the ledgers of other countries, and this may be problematic for certain governments.
US - Preserving the Dollar’s lead
Opinions regarding stablecoins and CBDC differ greatly among US leaders, not only between party lines (with Republicans being less supportive), but even internally, within institutions such as the Federal Reserve. Enthusiasm for a proposed US CBDC is somewhat dulled by the fact that the US Dollar is world’s number one international reserve currency, and the Dollar’s dominant position is also reflected in the world of stablecoins; 9 of the top 10 biggest stablecoins (by total market value) are pegged to the USD. The proliferation of stablecoins is only reinforcing the US Dollar’s already dominant position, which is why some US leaders may prefer implementing a regulatory framework for the growing amount of USD-pegged stablecoins over developing their own CBDC.
The Fed may be less inclined to take on the same sort of centralized control that the Chinese government is seeking through the E-CNY. There are clear risks to major disruption of the two-tiered system. A CBDC could become a more attractive form of depositing money compared to commercial banks, which could lead to bank runs that would severely reduce the reserves of commercial banks.
On the flip side, the Fed would also have to take on the responsibilities traditionally assumed by commercial banks - credit risk analysis, know your customer (KYC), AML mechanisms, determining which payments are acceptable and which are not. The Fed would have to massively expand its ranks and would also gain a great deal of power, but this is clearly not something in the interest of the US government. If a US CBDC is developed, it will likely consist of a hybrid, two-tiered system in which the commercial banks would be involved in these responsibilities. CBDC accounts would be held at regular commercial banks, but the central bank will provide the funds for them, providing it with indirect control over supply.
EU - Creating a digital Euro
The motives for the EU’s venture into CBDC include the growing share of cashless payments, preparation for a digital economy, helping bolster the Euro’s challenge to the Dollar’s status as the dominant reserve currency. The EU CBDC is not designed to replace cash in Europe as Beijing plans to do with the E-CNY in China, but rather to complement it.
Fabio Panetta, former Director General of Bank of Italy and current member of the ECB’s executive board, has cited economic security concerns as a major reason for the development of an EU CBDC. International payments are currently largely controlled by entities outside of the EU, and developing a Euro-pegged CBDC could help the EU regain autonomy over this industry. Other motives include the usefulness and utility of a Euro CBDC as well as the ensuing transition from an industrial to an increasingly-more digital European economy.
However, the development of a CBDC has not been without its opponents within the EU. Critics have highlighted the centralized aspect of a CBDC as well as the diminished role of national central banks. In line with its past regulations on GDPR and data collection, the EU recognizes privacy as the chief concern of its population, and the design of the European CBDC will be centered around this issue. That being said, European CBDC must still adhere to AML/CFT regulations, as well as detecting tax evasion.
Another concern is that the creation of an EU CBDC could see many investors move their bank deposits into a digital Euro, which could destabilize and threaten the European commercial banking industry. Similarly to the US, the EU is wary of the risks a CBDC poses for the current two-tiered system. The European CBDC will be designed as the ‘digital equivalent of cash’ and central bank accounts will be intended to only contain money for short-term spending, i.e. a maximum of several thousand euros. One suggested mechanism is to have a negative interest rate above a certain sum (3000 Euros) that would make it prohibitively expensive to store large amounts of money in a CBDC account.
The EU has recently (July 2021) launched the Digital Euro Project, with the upcoming 2 years being devoted to addressing key issues regarding design and distribution.
List of sources
Auer, Raphael A., Giulio Cornelli, and Jon Frost. Rise of the central bank digital currencies: drivers, approaches and technologies. No. 8655. CESifo Working Paper, 2020.
Klein, Manuel, Jonas Gross, and Philipp Sandner. The Digital Euro and the Role of DLT for Central Bank Digital Currencies. FSBC Working Paper, Frankfurt School Blockchain Centre, 2020.
Liu, Chao, Xiaoshuai Zhang, and Francesca Medda. "Euro CBDC: A Regime to Enhance the Next Generation EU Fund." Available at SSRN 3824961 (2021).
Sandner, Philipp G., Jonas Gross, Lena Grale, and Philipp Schulden. "The digital programmable euro, Libra and CBDC: Implications for European banks." Libra and CBDC: Implications for European Banks (July 29, 2020) (2020).