Digital Currencies May Well Be The Way Forward. But Not All Of Them Are Going To Make It. How can we enjoy the potential benefits of stablecoins, while maximizing trust in the issuers behind them? This is where central bank digital currencies come in.
By Ghady Rayess
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The popularity of cryptocurrencies has skyrocketed in recent years as a result of enhanced accessibility and news of record-breaking price surges.
This inexorable rise has made millionaires of some, but its notorious volatility has also left many investors nursing substantial losses. These extreme fluctuations in value, as well as the lack of scalability, has ultimately impeded the widespread adoption of cryptocurrency as a payment method. Its shortcomings have, however, given rise to new types of digital currencies, attempting to succeed where their predecessors fell short.
One promising innovation is stablecoins. Over the past two years, the number of stablecoins in circulation has increased exponentially, currently valued at more than US$100 billion. This upwards trajectory stems from the defining characteristic of stablecoins; they are backed by a reserve asset in a 1:1 ratio, most commonly American dollars or precious metals. As a result, its inherent value should not be affected by external movements, as is the case with conventional cryptocurrencies. In fact, stablecoins are quickly becoming the primary competitor to fiat currencies by offering the speed and cost benefits of cryptocurrencies such as Bitcoin- but without the price volatility.
Like cryptocurrencies, stablecoins are exchanged via distributed ledgers known as blockchains. These blockchains use computer algorithms to verify exchanges, eliminating the traditional role of banks or credit card companies. In doing so, they also eliminate the fees associated with intermediaries, lowering overall transaction costs. Stablecoin blockchains are also typically faster than their crypto cousins. In fact, Diem, Meta's stablecoin, is expected to process at least 1000 payment transactions per second. If successful, Diem will process transactions 2.5 times faster than SWIFT, the world's largest facilitator of international payments.
But what does this mean for the general public? Well, for one, the speed and low cost of stablecoin transactions will significantly improve cross-border payments, and ultimately enhance financial inclusion on a worldwide level.
Global stablecoins can make international transactions more accessible by allowing consumers to send money directly through any mobile device or digital wallet, without needing a deposit account. This can greatly benefit people in countries with underdeveloped financial infrastructure, who may not have access to efficient or affordable payment options. Stablecoins also eliminate foreign exchange fees to make cross-border payments more affordable- a particular advantage, for instance, to the blue-collar workers in the Middle East that regularly send money back home to their families.
The principal goal of stablecoins is to offer an alternative to cash by streamlining payments among consumers on a day-to-day basis. But they also hold promising potential for investors. By merging the favorable qualities of both digital and fiat money, stablecoins act as an effective on-and-off ramp between the two worlds. They can be easily converted into national currencies at a fixed exchange rate, so that users can effortlessly move funds from their bank accounts to stablecoin wallets, and vice versa. This provides financial institutions and investors with greater confidence to enter the cryptocurrency trading arena, as they can easily convert their holdings back into their national currency if needed.
Despite their potential to bring about many benefits, stablecoins can present some risks if not regulated. Their increasing popularity and adoption in the mainstream financial landscape has raised concerns among regulators. The rise of stablecoins resembles the "Free Banking Era" of the 19th century, when private American banks were able to issue their own currencies. When consumers lost confidence in a particular bank, they would attempt to withdraw their funds all at once. This often triggered a "bank run," where many customers rushed to withdraw their money at the same time, causing the bank to run out of cash, and ultimately leading to its failure. The same concern exists with stablecoins. While some issuers transparently disclose the assets they hold to back their coins, they are not subject to the same stringent reserve requirements as traditional financial institutions, particularly if the issuer is a private organization. This therefore leads to skepticism about whether stablecoin issuers have enough reserves to maintain the fiat ratio of 1:1 during times of crisis.
The Tether scandal intensified these apprehensions, as the market-leading stablecoin issuer faced multiple allegations of not being transparent about the extent of its reserves. In 2021, Tether settled with the New York Attorney General's office over charges that it falsely claimed that its stablecoin was backed 1:1 by US dollars at all times. The settlement required Tether to pay $18.5 million in penalties, provide regular reports on its reserves, and cease trading with New York residents. Despite the settlement, the concerns surrounding the lack of oversight and transparency in stablecoin issuance and backing continue to persist.
However, when issued by reliable organizations, private or government regulated, stablecoins can be advantageous. For instance, in the case of initial coin offerings (ICO) or stable token offerings (STO), investors can be paid out in stablecoins. This means investors' funds will be subject to less volatility, and more suitable as stored value than less stable cryptocurrencies.
The question therefore is: how can we enjoy the potential benefits of stablecoins while maximizing trust in the issuers behind them? This is where central bank digital currencies (CBDCs) come in. These fully digital currencies are similar to stablecoins in that they offer all the same benefits, namely, greater convenience and accessibility. Like stablecoins, CBDCs can be transferred quickly and efficiently, enabling faster and cheaper transactions than the fiat alternative. Moreover, CBDCs are just as borderless as their privatized counterparts, using blockchain technology to eliminate the need for intermediaries such as banks or foreign exchange services.
Stablecoins and CBDCs can coexist, and both can be regulated by financial institutions. However, there are some key differences between the two. Rather than being pegged to an underlying asset, CBDCs are designed to function as a digital version of a country's fiat currency, directly issued by governing authorities. Stablecoins do not have exchange value with another currency, not even with the fiat currency by which it is backed. Backed by a central bank, CBDCs can be converted to fiat currency, providing a more standardized and regulated framework to ensure safety and stability, as well as greater trust and confidence in its use.
CBDCs are also designed to offer even greater interoperability with other digital currencies and payment systems, due to their centralized and standardized nature. Stablecoins, on the other hand, can be fragmented across multiple platforms, and they may face challenges in achieving the same level of interoperability.
Undoubtedly, both stablecoins and CBDCs have the potential to play an important role in the future of finance. But while stablecoins unlock exciting possibilities as an investment currency and store of value, their role in the future of finance is likely to end there. CBDCs, on the other hand, are primed to take over as the backbone of everyday payments and financial services due to the increased security, trust, and agility they offer through a regulated compliance framework.
