Stablecoins and Central Bank Digital Currencies (CBDCs)
Cryptocurrencies are known for their wild fluctuations: in the last 6 months, the price of Bitcoin (BTC) has fluctuated between $19,438 (July 2022) and $67,582 (November 2021). If someone had paid you BTC for services rendered in November 2021 and you had planned to buy a car in July 2022, you’d be unhappy that you hadn’t immediately cashed out: your BTCs are valued at 70% less than the day you received them. You’d still be happier than a SquidCoin holder: any amount they bought is now worth nothing. Of all the advantages SquidCoin had as a cryptocurrency, a store of value was not one of them.
Suppose there was a cryptocurrency token whose value was pegged 1-to-1 with the US dollar. This would give it all the advantages of cryptocurrency (privacy, ease of use, global transactability) with the same store of value as the cash in your wallet had. It wouldn’t necessarily be a good investment or speculation vehicle, but you could always trust that it would be worth what you paid for it. These cryptocurrencies exist and they’re called stablecoins. There are stablecoins for many fiat currencies around the world, but this article focuses on USD-backed stablecoins.
A stablecoin is defined as any cryptocurrency pegged to a fiat currency. There are many issuers competing to have the most trustworthy USD-backed stablecoin, the most popular in the table below:
As you can see, the value of each USD-backed stablecoin is $1 US dollar. (In actuality, the value of these stable coins is closer to 0.999, but for the purposes of simplicity it’s treated as $1.) If someone offers to sell you a USD-backed stablecoin for more than $1, they’re having a joke your expense: a USD-backed stablecoin should always be priced at $1.
Why would I want a stable coin?
There are any number of reasons:
- You want a store of value, but you don’t want to physically hold the cash. Perhaps you live in a territory where physical cash can be confiscated, stolen, or destroyed.
- You want to send money to people around the world who value the US dollar. The US dollar is considered to be the world’s reserve currency, which makes USD-backed stablecoins a reasonable medium for the exchange of value.
- You want to avoid fees from international remittance services like Western Union. International remittance companies can charge fees of up to 20%.
- The cost of holding, insuring, or transporting the physical cash outweighs the cost of digitally storing it. There is always a cost to hold money; whether it’s the cost of a leather wallet, a safe, or a bank vault, the adage applies: “more money, more problems”.
- You want something a store of value that is convertible to fiat currency. Stablecoins are rarely accepted in retail establishments.
- You are Scrooge McDuck and are running out of space in your money bin. The team at Eikonomics calculated the volume of Scrooge McDuck’s money bin and estimated his net worth to be between 27 to 69 billion USD. Amazingly, a cartoon character whose name is synonymous with wealth in the English language is still worth less than Jeff Bezos.
Today, the US Federal Reserve does not issue stablecoins. Instead, issuers of stablecoins are private organizations that have created the circumstances by which the holder of a stablecoin may redeem it for $1 US dollar. If you have a large enough quantity of these tokens, you can redeem them directly with the issuer: fill out the form, pass the KYC check, and pay up to $25 for a wire transfer. Practically speaking, it’s almost always easier to sell USD-backed stablecoins on the open market. But why would you want to sell a stablecoin for a US dollar? Theoretically they’re the same value, right?
Is each stablecoin backed with $1 USD?
For some issuers, the answer is yes: Gemini (the issuers of GUSD) hold a bank account containing 1 US dollar for every Gemini stablecoin token in existence, with independent audit reports to prove it. This transparency gives confidence that GUSD can always be redeemed: if not by the market, then by the Gemini themselves. Other issuers like Tether rely on the market’s belief that 1 Tether will always equal $1 USD: if it wasn’t, the market would correct itself to the true value.
But perhaps a more useful question would be, how do I know a USD-backed stablecoin has value? As a potential owner of stablecoins, it’s important to understand why people treat currency as valuable. Prior to 1938, the value of the US dollar was linked to the price of gold: holders of US banknotes could redeem them for an equivalent amount of gold with the US Federal Reserve, at the rate of $35 per ounce. When the gold standard was abolished, it was replaced with a promise by the US Federal Reserve that each dollar maintained the same value post-gold standard. Whether by hook or by crook, this belief has held true.
Why trust a Central Bank Digital Currency (CBDC)?
CBDCs are stablecoins issued by a country’s reserve bank. They offer the flexibility of cryptocurrencies, with the store of value enforced by the government of the country. So long as the government mandates that debts can be paid with their CBCD, then it is the equivalent of legal tender. As of writing, only Nigeria and The Bahamas have released stablecoins, though some countries like South Korea have launched pilot programs.
But is a CBDC as useful or as trusted as a privately issued stablecoin? For Ethereum-based stablecoins such as USDT or GUSD, a source of user trust is the security of the underlying Ethereum network: mathematics and cryptography ensure that no single entity, whether private or government can change ownership of a token unless the owner has consented. If stablecoins were hosted on a less secure blockchain with fewer miners (say, “SquidCoinChain”), the security of the network (and therefore the value of the tokens) would be in question.
For this reason CBDCs may not be as trustworthy as stablecoin issuers. Unlike Ethereum-based stablecoins that have network-level prevention of arbitrary ownership changes, government-run blockchains offer no such protection. A government that controls 51% of blockchain nodes has the ability to arbitrarily modify token ownership; in contrast, the cost of performing the same attack on the Ethereum network is in the magnitude of tens of billions of dollars. For users to trust CBDCs, they must trust the underlying network. This raises the interesting question: are governments willing to place CBDCs on a network that they do not control?
What’s the future of stablecoins?
Stablecoins are here to stay. Hundreds of billions of dollars of fiat currency is now represented as stablecoins on the blockchain. The question has since evolved into:
- Can privately issued stablecoins make CBDCs irrelevant?
- Can CBDCs actually be trusted?
- Are governments willing to place CBDCs on a blockchain they do not control?
- How will the market react to news of a stablecoin issuer fractionally reserving?
- If the US Federal Reserve releases a CBDC, will the price of non-backed stablecoins trend toward zero?
As with most cryptocurrency and all economics discussions, theory will be debated but the market will decide.
