Stablecoins and CBDC's
Why We Have Stablecoins
In the beginning, there was only bitcoin. A digital commodity with a highly predictable issuance schedule. Shortly after that, developers, cryptographers and cypherpunks swiftly started working. They focused on improving privacy in digital currency and the expressiveness of what that digital currency could do. This movement caused the rise of privacy coins such as Monero and Zerocoin, but more importantly, a programmable digital currency was born in the form of Ethereum. Since then, we have witnessed an explosion of use cases ranging from financial primitives like exchanges, lending and borrowing facilities to digital art.
The most challenging problem in the space, especially when attempting to harness the power of financial primitives, was the sheer volatility of digital currencies like bitcoin and Ethereum. Imagine trying to create lending markets for an asset with 20% plus price swings in a day, not easy. This problem produced a need for "Stablecoins", a stable digital currency interoperable with decentralised services.
A Stablecoin is a digital currency pegged 1:1 with either a fiat currency or a tangible asset such as gold.
The Different Types
The differences between Stablecoins simply come down to how the issuer pegs the value of their Stablecoin to its underlying asset. We have seen three distinct variations between Stablecoin designs.
Fiat Collateralised Stablecoins
These are digital currencies backed by fiat money, such as US dollars, that sit on the issuer's balance sheet. The backing of fiat collateralised Stablecoins, in theory, should be 1:1; for every stablecoin issued, the issuer should hold the same amount of US dollars. At all points in time, the holder of these kinds of Stablecoins should be confident that their coins are redeemable for US dollars; as long as this confidence persists, these Stablecoins should maintain their peg.
Commodity Collateralised Stablecoins
These operate similarly to fiat collateralised Stablecoins but are usually pegged to the value of an underlying commodity, something like gold. The issuer of these Stablecoins acquires tangible assets such as gold and issues digital coins that serve as an IOU to the underlying commodity. These are often referred to as asset-backed tokens.
Crypto Collateralised Stablecoins
These types of Stablecoins utilise cryptoassets such as bitcoin and Ether to collateralise and back the coins they issue. For example, MakerDAO is the decentralised equivalent of a central bank. MakerDAO, however, is a lot more similar to central banking during the gold standard, where deposits led to money creation, versus the central banking system of today, where the issuing of credit leads to money creation. In the MakerDAO system, you can deposit cryptoassets and create DAI, a synthetic stablecoin algorithmically pegged to the US dollar. One DAI is always redeemable at MakerDAO for $1 of the underlying collateral, mainly Ether.
Due to the volatility of underlying digital assets, these crypto collateralised Stablecoins need to be significantly over collateralised to avoid solvency issues. The current collateralisation ratio of the MakerDAO system and its stablecoin DAI is 174,40%. In the event that collateral in the system diminishes to a point where the issued Stablecoins become under collateralised, a liquidation event can occur. This isn't enforced by human decision making but rather the hard-coded rules of the MakerDAO system.
What They Are Used For Today
Today Stablecoins of all designs play a vital role in crypto networks. There's no denying that the primary use case of many crypto networks is speculation. As speculators, it's complicated to understand profitability when your base currency is highly volatile relative to your traditional units of account like the US dollar. Stablecoins primary use case, at least in our view, is to act as a stable currency for speculators to move in and out of different cryptoassets.
Having said this, we observe more real use cases for Stablecoins in crypto networks. The most notable is seen in Ethereum based financial services where Stablecoins are used for lending, borrowing and providing liquidity to automated market makers on various decentralised crypto exchanges. Stablecoins have taken DeFi from a meme to a thriving financial system where individuals can gain access to credit and liquidity.
The Rise of Nation-State Digital Currency
Over the last year, conversations regarding central bank digital currency have gone from exploratory to being cited as a crucial digital age innovation. Money, after all, is a technology, and central bankers are looking to upgrade their money to better suit the needs of their citizens.
What Do We Know About CBDC's?
It is challenging to assess CBDC's because there aren't many projects that have actually led to an actual digital currency rollout. There is, however, a vast amount of research out there for what these new digital currencies might look like and the tradeoffs that central bankers, policymakers and governments face when designing them. We will attempt to outline these tradeoffs and architectures, but we need to be cognizant that this is an area of active research and development; therefore, realities may look very different going forward.
The first distinction we need to make is how Stablecoins differ from CBDC's. Fiat collateralised stablecoins are issued by private institutions, companies like Tether (USDT) and Circle (USDC). The value of these Stablecoins comes down to the solvency of these companies. This is why you may have seen speculation and concerns over Tether. Due to the lack of regulation, there are no real standards of practice for these companies and certainly no required minimum disclosures, at least not yet. The concerns stem from the fact that we don't really know what backs something like USDT. Is it dollars in a bank account, commercial paper or other financial instruments? Regardless of our opinions, this is a real cause for concern as the claim that USDT or USDC provide sits with the intermediary, not with a central bank. It is crucial that regulators create crystal clear standards of practice for these companies to avoid potential blow-ups of the intermediary.
CBDC's are different in that they are issued by central banks. Currently, we have 3 main types of "money", Banknotes (physical notes and coins), reserves (commercial bank deposits at central banks) and bank deposits (household and business deposits at commercial banks). CBDC's introduce another form of money to our current system and can be designed to replace, complement, imitate, or expand the expressiveness of existing forms of money.
A research paper published by the Bank of International Settlements outlined a framework dubbed "the CBDC pyramid", which attempts to illustrate consumer needs versus central bank design choices. You can find this research here in paper 1 and here for paper 2. These are long publications, so we will summarise the findings below:
The CBDC pyramid outlines the four main design categories for CBDC's:
The legal structure of claims that a CBDC provides
The operational role of central banks and commercial banks
Whether to use distributed ledger technology (DLT) or conventional centralised infrastructure
Whether the CBDC should be account-based or token-based
The first two categories being the legal claim and operational aspect has led to three potential models for CBDC's.
This model is the most similar to how banking works today. The CBDC represents a claim at the central bank and aims to replace/upgrade reserves which are commercial bank deposits at central banks. The primary use case for indirect CBDC's is in wholesale payments, mainly being interbank transactions. In this model, the private sector handles the transaction processing of retail payments. The central bank does not maintain a ledger of retail balances at commercial banks; it only holds a ledger of wholesale balances between commercial banks.
Indirect CBDC's could drastically improve the way commercial banks settle with one another, eliminating many of the credit and liquidity risks current central bank settlement systems experience. However, it would require substantial monitoring and regulation of commercial bank operations as commercial banks would distribute an IOU on CBDC's they hold at the central bank to households and businesses. From a retail perspective, this probably won't unlock the true potential of CBDC's.
In this model, CBDC's operate more like banknotes. They are issued by the central bank as an alternative to cash, and all transactions are handled by the central bank itself. In this model, the private sector does not handle transaction processing, but rather the money itself becomes disintermediated.
This architecture would require central banks to upgrade their operational capacity to perform tasks traditionally performed by the private sector. Whilst disintermediation would reduce costs for the end-user, this may come with the caveat of a less reliable payment system. Central banks are simply not equipped to handle such volumes and complexities; these are better handled by the private sector.
The hybrid represents a blend of pure CBDC architectures. There's very little detail about what this would look like in practice. Still, the aim would be to operate legal claims in a similar fashion to direct CBDC's whilst also allowing central banks to maintain and monitor a retail ledger. This approach is more realistic about central bank operational capabilities and enables the private sector to participate in payment processing for retail.
Distributed Ledgers or Centralised Infrastructure?
The next question when designing CBDC's is whether to utilise distributed ledgers (DLT) or conventional centralised systems. Unlike Bitcoin, CBDC's are created to have a centralised point of control. The idea that a group of distrusting nodes needs to agree on the ledger's state is a foreign concept to central banks and, in their minds, a suboptimal way to coordinate money. Perhaps they may even be right, but only time will tell.
The most significant limitation cited by central banks regarding DLT is the design limits due to its distributed nature. Remember, for a transaction to be processed, executed and settled using DLT, it requires the validation of each and every node on the network. This leads to slow transaction throughput (low transactions per second); this limitation is not present with conventional systems.
If central banks decide to utilise DLT, it more than likely will be for the indirect CBDC model as these transactions would be low frequency, high-value wholesale payments between banks. DLT and the direct model for CBDC are difficult, if not impossible, to implement as the system will struggle to handle the necessary number of transactions.
Account or Token-Based?
The last question central banks face in designing CBDC's is whether to apply an account-based system or a token-based system. This is identical to the difference between cash and your deposit at a bank. Cash is a bearer asset; whoever holds the cash owns the cash. Bank deposits are only yours if you can verify your identity.
The question becomes, should CBDC's be bearer assets or account-based assets. This decision comes down to the objectives of the central bank. How accessible do they want their money to be? How much control do they want over their money? Do they want their money to be able to operate offshore or only locally?
CBDC's still leave a lot to the imagination, and central banks have a long way to go before they roll these out. As always, we will try to keep you updated on these developments as they happen. We hope you all have a fantastic weekend.
Notable Articles and News Stories This Week:
Wyoming Becomes First US State to Legally Recognise DAO's
From July 1, individuals and organisations can create legally recognised Decentralised Autonomous Organization (DAO) in Wyoming. This is the first time in America, but also the first time in the world an organisation created on a blockchain can have legal recognition. This can have significant implications for people starting businesses on blockchain-based networks. This also represents a critical step in bridging the gap between traditional corporate or organisational structures and unincorporated groups governed by the code of smart contracts.
Read more about the new law here
Visa Crypto Cards Have Racked Up $1B in Spending in 2021
In an announcement on Wednesday, Visa saw over a billion dollars of spending activity on their crypto-related cards in the first half of 2021. Visa has partnered with over 50 crypto firms to allow people to spend their cryptoassets at points of payment across the globe. Cuy Sheffield, the head of crypto at Visa, stated, "the next part is making it easier for our clients to issue and interact with those cards with things like being able to settle USDC. Then we're starting to spend a lot of time around how Visa can be a bridge between our existing network of financial institutions and the crypto ecosystem". This is an exciting step toward making crypto spendable on a day to day basis for all.
Read more here
'Bitcoin Mayor' Candidate Eric Adams Wins New York's Democratic Primary
Eric Adams has promised to make New York City into a "center of Bitcoins". Eric Adams has won the Democratic mayoral primary in New York City, per election results released yesterday. Adams was a big proponent of crypto on his campaign trail, stating, "We're going to bring business here. We're going to become the center of life science, the center of cybersecurity, the center of self-driving cars, drones, the center of Bitcoins". Adams has long been a believer in disruptive technology and welcomes it. However, he will have some competition in Miami's Mayor Francis Suarez, who has already spent months making Miami America's crypto hub.
Read more about the election here
Whilst we all have the option to look, to seek to understand, it’s often easier not to. Bitcoin, Ethereum and distributed ledger technology are complex systems that require significant due diligence. At Etherbridge, we aim to lower the barriers to understanding this fast-growing digital economy.
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This is not financial advice. All opinions expressed here are our own. We encourage investors to do their own research before making any investments.