Stablecoins & Central Bank Digital Currencies
Problems of Currencies Today
The global economy today runs on fiat money. Fiat money is a government-issued currency that is not collateralized by an underlying asset (e.g. US dollar). Fiat money is widely used as a medium of exchange because the value of the currency remains stable. A stabilized currency helps an economy combat inflation (or deflation) and reduces uncertainty surrounding general prices of goods and services. If a chocolate bar costs $2 today, it is unlikely that it will be $4 tomorrow. Review our article on the History of Money for more background on the functions of different currencies.
Most cryptocurrencies’ prices are unpredictably volatile and have the tendency to fluctuate, making them difficult for everyday use. An upside of cryptocurrencies is that they operate on blockchains and therefore benefit off the perks of being decentralized. Being decentralized, blockchains provide cryptocurrencies with a number of advantages over fiat money – to learn more about blockchain and its benefits, refer to our article: Overview of Blockchain Technology.
Stablecoins are similar to fiat money in that they both offer price stability, and similar to cryptocurrencies in that they are both decentralized. A stablecoin is a digital currency that pegs its market value to a reserve asset. They are collateralized by an asset whose value remains stable which allows for price stability. There are different types of stablecoins depending on the asset used as collateral: fiat-collateralized stablecoins, commodity-collateralized stablecoins, crypto-collateralized stablecoins, and algorithmic stablecoins.
Fiat-collateralized stablecoins & commodity-collateralized stablecoins:
Stablecoins using fiat money as collateral are the most common. Fiat-collateralized stablecoins are backed at a 1:1 ratio where 1 stablecoin is equal to 1 unit of currency. Every stablecoin that exists is linked to fiat money being held in the stablecoin issuer’s reserves. To mint new stablecoins, a buyer has to deposit fiat money into the issuer’s reserve. The amount of stablecoins received in return will be equal in value to the deposit. The buyer can also convert their stablecoins back to fiat money. Similarly, the buyer will receive an amount of fiat money that is equal in value to the amount of stablecoins being redeemed. The issuer will then burn the redeemed stablecoins. Tether (USDT) and USD Coin (USDC) are notable examples of fiat-collateralized stablecoins; they are currently the two largest stablecoins in terms of market capitalization and volume.
Other than fiat money, stablecoins can be backed by other tangible assets such as gold and real estate. Commodity-collateralized stablecoins work in the exact same manner as fiat-collateralized stablecoins. The asset used as collateral can potentially appreciate over time which increases the incentive for holding these stablecoins.
Stablecoins can also be backed by cryptocurrencies. Crypto-collateralized stablecoins are similar to fiat-collateralized stablecoins and commodity-collateralized stablecoins in the way they operate. Although, the buying process is slightly different. Stablecoins backed by cryptocurrencies are over-collateralized because the price of a cryptocurrency can be volatile.
A hypothetical stablecoin using a cryptocurrency as collateral might ask for $150 worth of Ether (ETH) for $100 worth of stablecoins. If the value of ETH dropped by 30%, the stablecoins would then be collateralized by $120 worth of ETH. The excess amount of ETH deposited relative to the amount of stablecoins received would absorb the cryptocurrency’s price drop and the value of these stablecoins would remain at $100. This is contrary to the 1:1 ratio that fiat-collateralized stablecoins and commodity-collateralized stablecoins follow. MakerDAO’s DAI runs on Ethereum and is arguably the most popular crypto-collateralized stablecoin in existence.
Unlike the other types of stablecoins, algorithmic stablecoins are not collateralized. These stablecoins use an algorithm to achieve price stability instead. The logic behind algorithmic stablecoins is based on the basic principles of supply and demand. The algorithm issues more coins when the price of the coin is above normal levels and buys coins off the market when the price of the coin drops below normal levels; supply is either increased to decrease price or decreased to increase price. Ampleforth (AMPL) and Empty Set Dollar (ESD) are some of the most popular algorithmic stablecoins on the market.
Central Bank Digital Currency:
The rapidly growing cryptocurrency market—combined with the rise of stablecoins—is contributing to a transition away from physical currencies. The shift to a digitized economy has led to a reduction in the need for traditional financial intermediaries. As a result, many of these institutions are trying to figure out how to best adapt to this growing digital economy. One option being explored by governments around the world is the use of Central Bank Digital Currencies (CBDCs).
CBDCs are digital tokens that represent the virtual form of a nation’s fiat money. Just like fiat money, they are designed to fulfill the essential functions of money: a store of value, a means of exchange, and a unit of account. CBDCs are not cryptocurrencies despite being a digital currency. They are controlled by central authorities where cryptocurrencies are maintained by peer-to-peer networks. Central authorities do not include private corporations; only central banks – which are government institutions – can issue CBDCs.
Organizations issuing CBDCs prefer permissioned networks due to issues surrounding privacy and transparency. A majority of people do not want their financial information on a public database; an individual would feel uncomfortable knowing their saving’s account balance is open for anyone to see. Private blockchains provide a solution where access to the system is controlled and limited. A central bank can also control what types of information can be seen according to the user. An employee at the bank may need greater access to confidential data in order to facilitate transactions or verify if a candidate is qualified for a loan. The Bank of Canada is currently working with top Canadian universities – namely University of Toronto, York University, McGill University, and University of Calgary – to design a CBDC. McGill University proposed a CBDC where authorities are only able to identify the receiver of cash, maintaining the privacy of an individual making a payment.
The Need for a Digital Economy
Digital currencies (e.g. stablecoins and CBDCs) hold a number of advantages over traditional fiat money:
- Programmable money and smart contracts for execution
- Lower transaction fees
- Efficiency – quicker receipt of funds in comparison to current economic institutions
- Indisputable audit trail – helping to detect financial crimes (e.g. money laundering)
- Widens the range of options for monetary policy
Digital currencies are revolutionizing the world as a number of countries are beginning to incorporate them into their economies. The People’s Bank of China (PBOC) began developing their digital yuan in 2014 and plans to have it ready for international use by 2024 or 2025. The growing trend towards a digital economy has sparked the notion that digital currencies will lead to the eventual extinction of paper money. It is difficult to predict what the economy will look like in years to come – but with the total market value of all cryptocurrencies already growing to $2.48 trillion – it is reasonable to believe that digital currencies will eventually serve as the world’s primary medium of exchange.