Crypto Dollars and CBDCs: The Battle for the Future

By the end of 2013, it was clear that crypto assets would be the future of finance. It was the first time Bitcoin exceeded $ 1,000. To the chagrin of the Cypherpunks, central banks around the world issued warnings to contain the "decentralized spirit" that threatens the stability of the familiar system. First they ignore you, then they fight.

Bitcoin's rally was interrupted due to a lack of confidence and high volatility, rather than government intervention. At that point, people realized that crypto assets needed a bridge to the financial world based on our own terms. This was the impetus to create “stable cryptocurrencies” or stable coins.

This post is part of CoinDesk's 2020 Year in Review – a collection of posts, essays, and interviews about the year in Crypto and beyond. Sasha Ivanov is the founder of Waves, a blockchain platform.

From that moment on, two different approaches to stabilizing the price of crypto assets developed simultaneously: fiat-backed stable assets and algorithmic stablecoins. While central banks viewed cryptocurrencies as a potential threat to the stability of the financial system and their monopoly on spending money, it was only recently that they began to research, develop and experiment with their own digital currency alternatives (CBDC).

While the tension between stablecoin and CBDCs has not escalated, it is still there for the perceiver. For example, take a look at how China, the European Union and the US have reacted to the stablecoin project libra (now diem). These asset groups, fiat-pegged and algorithmic stablecoins, will eventually compete directly with CBDCs in an attempt to oust each other from the market.

Stable coins with fiat support

The first and most common type of stablecoin are fiat-backed tokens on public blockchains, usually denominated in US dollars. The most popular secured stablecoins are issued by cryptocurrency exchanges – USDF from Bitfinex, USDC from Coinbase and Circle, BUSD from Binance, and GUSD from Gemini. Tether first appeared in 2014 and is now the most popular "crypto dollar" with a market capitalization of more than $ 18 billion.

Fiat pegged stablecoins issuers typically claim that these crypto assets are backed by real dollars, other cryptocurrencies, and government bonds, and that reserves are held in a bank account. This is what preserves a token's "dollar parity". The price of Tether, for example, rarely deviates by more than a tenth of a percent.

See also: Stanford Prof. Darrell Duffie on our great stablecoin future

However, it is not easy to verify the actual support of such stablecoins. One has to trust the reports of the issuer, i.e. a crypto company often registered in an offshore jurisdiction, or the occasional third party certification. (The New York Attorney General is investigating Company Tether's claims regarding its reserves.)

Fiat-powered stablecoin users hardly think about their actual assistance, as the ease of use exceeds all doubts and risks. The stability of their price is maintained through trust without using the market or technical methods.

The essence of “secured” stablecoins resides with a centralized issuer, an organization that has economic and legal responsibility and maintains fiat currency reserves in a bank account. In fact, these are not cryptocurrencies, but token fiat – digital money in the blockchain.

The regulators have already managed to noticeably slow down the release of the Libra.

Conceptually, they are similar to payment systems such as PayPal. On the technical side, their main difference is the transparency of transactions as they go through public blockchains.

USDT has occupied a large niche in the real economy as it facilitates international transfers and allows market traders to easily send money from Moscow to China and many other countries. Instant transfers, low fees, and the lack of knowledge of your customer / anti-money laundering (KYC / AML) requirements on some exchanges made classic stablecoins a very handy tool.

Algorithmic stablecoins

Algorithmic stablecoins appeared even before their cousins ​​with Fiat support. The first instances were started in 2013 in the Bitshares blockchain. They were only supported by the blockchain's base token, BTS, but they turned out to be not stable enough.

The most popular decentralized stablecoin, DAI, was introduced on the Ethereum blockchain in 2017. The US dollar parity is supported by market and technical mechanisms based on smart contracts that implement a price stabilization algorithm. Hence the term "algorithmic".

An algorithmic stablecoin works on a public blockchain and is supported by a base cryptocurrency such as Ether (ETH). This crypto-collateral is tied to a smart contract, and on this basis a new crypto-asset is launched. Price stability is achieved through a CDP (collateral debt position) mechanism with an average surplus of collateral of up to 50%. When redeeming their tokens, users get the ETH back in their wallet.

With the help of price regulation algorithms, a stable crypto asset is thus created without fiat currencies being involved and a connection to the traditional financial system being necessary. Algorithmic stablecoins work like cryptocurrencies. Unlike USDT and its analogues, they are decentralized and not subject to a single issuer or regulator.

The crypto industry is now dominated by secured stablecoins. And while they are able to maintain a dollar peg, algorithmic stable coins can be quite volatile during crises.

Algorithmic stablecoins are widely used in the DeFi industry, but cannot go beyond that yet. They still have to be used in real economic operations.

State and bank stable coins

In late 2013 and early 2014, most central banks issued initial statements and warnings about crypto assets. But it wasn't until Facebook tipped the scales that they started their own research and development for digital currencies.

As of this year, the Central Bank has nearly 50 ongoing pilot or research projects for central currencies (CBDC). A CBDC could be a natural evolution of money as central banks are already familiar with cashless transactions in order to increase financial transparency.

The main advantage of stablecoins for private banks is the wide distribution, user base and reputation of traditional financial institutions.

Earlier this year, the European Union, the UK, Canada, Japan, Sweden and Switzerland, along with the Bank for International Settlements (BIS) and the Financial Stability Board (FSB), started work on a joint study and coordination of the issue of CBDCs . Experiments with CBDCs are scheduled to start in the European Union in 2021.

In October, the Bank of Russia put forward plans to create a digital ruble. A pilot project to test the digital yuan in the real economy is already running in China. The US Federal Reserve has been researching for several years, but the dates for issuing a digital dollar have not yet been set.

See also: 6 central banks form use case group for digital currencies

With the release of CBDCs, central banks are seeking a controlled, safe and stable monetary system that will reduce the incentives for creating cryptocurrencies and other private funds. CBDCs are supported by central banks in the same way as national currencies and have legal tender status.

So far, two state cryptocurrencies have been issued. Venezuela was the first country to issue a state digital currency called Petro in 2018. However, the turnover is not transparent and the collateralisation and use in the real economy are seriously questionable. At the end of October, the Central Bank of the Bahamas published its CBDC "Sand Dollar". It is regulated similarly to the Bahamian dollar and is accepted throughout the island nation.

Trends in the development of stablecoin

From an end-user perspective, CBDCs and bank tokens are very similar to Fiat-backed stablecoins. Therefore, these three asset groups will compete directly with each other and try to force each other out of the market.

The main advantage of stablecoins for private banks is the wide distribution, user base and reputation of traditional financial institutions. People will be using them in the same applications as other banking products. Because of this, stablecoins issued by private companies like jpmcoin and libra are of serious concern to regulators.

Given this, traditional crypto stablecoins may not be needed. They are likely to survive but will be under severe regulatory pressure and their volume will decrease significantly. Their functions are taken over by banks and CBDCs.

CBDCs have the strongest positions thanks to the administrative resources behind them. Regulators have already managed to noticeably slow the release of the Libra and it is possible that this token will not appear in the market until all legal issues are resolved. The state will try to completely overtake the “Blockchain Digital Money” niche, as it does not need any external actors in this area. This process is already underway in China at the pilot level – millions of Chinese in multiple regions are using the digital yuan and their numbers are only going to increase.

The widespread adoption of CBDCs and the elimination of cash are very interesting prospects for governments. This is the very foundation of a modern state financial infrastructure in the 21st century, in which it has full control over all transactions, cash flows of individuals and companies.

No physical audits are required as all transactions are made visible through the technology behind them and it is impossible to hide anything. Sooner or later, more central banks will adopt this concept with different levels of control and possible privacy for citizens.

Strengthen control

The crypto community will respond to strengthening government control with new and improved decentralized stable crypto assets. In unsafe situations, algorithmic stablecoins that are not dependent on banks and regulators can prove their worth.

There is a need for stability mechanisms for cryptocurrencies that are built into blockchain architectures, and for cryptocurrencies with an inherently stable price, rather than a superstructure built over already volatile instruments.

In the crypto industry, they will take over the functions that are now performed by USDT and other secured stablecoins. They become real stable cryptocurrencies and not just digital money.

Mechanisms similar to traditional bond markets are possible to create them, just as the dollar is supported by government bonds. To do this, a token must be issued in a blockchain with already integrated stability. Such mechanisms have not yet been developed.

See also: Marcelo Prates – Central banks had to improve their money game this year – and they did

On the other hand, fiat currencies are depreciating faster and faster amid the pandemic and accelerated money issuance by governments around the world. Hence, the idea of ​​pegging cryptocurrencies to declining fiat currencies becomes a dangerous game. In this case, cryptocurrencies that can withstand the volatility of fiat and will be developed over the next five years will reach the global scale and become the foundation of a truly decentralized financial system.

Year in Review is a collection of posts, essays and interviews about the year in Crypto and beyond.

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