Part 1 by Ryan Shea, Crypto Economist (3 Feb 2022)
I ended the last article asking whether central bank digital currencies (CBDCs) and private cryptocurrencies can peacefully co-exist, or will even be allowed to co-exist? Simple to ask but not so easy to answer. It’s a big topic that touches on a wide variety of issues, often quite complex in nature.
As the name implies CBDC is simply a digital version of central bank money. It may not seem it from this definition but as the Fed stated in its just published report on CBDCs it represents a “highly significant innovation” in money.
At present, the only central bank money held directly by the population is notes and coins. This represents a small fraction (3% in the UK) of what is generally considered money. Moreover, because of the increasingly digital nature of our lives - a trend accelerated by the Covid pandemic - the importance of notes and coins in every day transactions is declining. Most of what people consider money is privately-created by commercial banks i.e., bank account balances. This is the only form of money that can currently be used in online transactions.
The creation of a CBDC would change this by providing the population with a public alternative that is as safe and risk-free as bank notes. This is important if the shift towards a cashless society continues. Even though cash forms only a small part of what the population considers money the ability to convert deposits held digitally at commercial banks into central bank money (bank notes and coins) on demand ensures they are viewed as near perfect substitutes ie. it provides a crucial valuation anchor. In a world where cash is no longer a widely accepted method of payment, it is unclear in the words of BoE deputy Governor Cunliffe, “whether the Bank of England could continue to provide that anchor, particularly in times of stress”. In short, failure to respond to the digitization of money risks undermining one of the central bank’s main objectives, maintaining financial stability.
This is not the only reason why CBDCs are high on central banks agenda. Spurred on by the rise in the market cap of crypto-assets and a deepening in the associated private sector ecosystem – both of which are indicative of crypto’s rising acceptability – public authorities, including central banks, have accelerated efforts to understand better this new asset class, assess the ramifications and potential impacts on the global financial system and the broader world economy.
What is apparent from these efforts is that cryptocurrencies have both positives and negatives. Regards the former, utilizing the blockchain technology that underpins cryptocurrencies has the potential to provide greater functionality and lower transaction costs for financial payments relative to commercial bank digital money. On the latter, the emergence of private cryptocurrencies from a niche in the technology space to a $2tr asset class in just over a decade has heightened concern they could be a destabilizing force to the current monetary and financial systems.
The BoE’s formal position is, like the Fed’s, one of neutrality as to whether a CBDC should be implemented. However, in my view, the pros outweigh the cons from a central bank’s perspective – and not just in the UK - hence I fully expect them to be introduced in one form or another. It’s a case of when, not if.
Regards when, most anticipate it will be several years before they are widely adopted because designing a CBDC is not a simple exercise. There are many issues that need to be addressed before implementation. The following is a synopsis of pros and cons detailed in a 2020 BoE discussion paper entitled “Central Bank Digital Currency: Opportunities, challenges and design.
First and foremost, there is the question of the appropriate infrastructure. Blockchains may have sparked interest in CBDCs but it is not certain that central banks, who by nature are pretty centralized (the clue is in the name), will adopt this technology. Running a CBDC on a blockchain or distributed ledger technology (DLT) doesn’t have a single point of failure compared to a centralized system, but the latter may be a better institutional fit and benefit from increased security and performance.
Privacy is another important consideration. DLT requires transactions to be disclosed to all nodes in the network – they are, by nature, transparent. A CBDC could be designed in a way that protects users’ privacy to a greater extent than some existing payment systems. Nevertheless, it is clear that any CBDC payment system would have to be compliant with AML (money laundering) and CFT (terrorist financing) regulations. This means the identity of CBDC users would need to be known to at least one authority or institution in the wider CBDC network who can validate the legitimacy of their transaction. Unlike bank notes where anonymity is the baseline, truly anonymous payments would not possible under any CBDC design. (This is one reason why they are not perfect substitutes).
There is also the issue of remuneration. Bank notes do not attract interest payments, but a CBDC could be made interest bearing. The benefit from such a change would be it allows faster and fuller transmission of monetary policy to deposit rates. Additional benefits would occur when unconventional monetary policies are required. QE could be conducted in a more direct method with payments made straight into household’s wallets rather than the present convoluted wealth-inequality-boosting method. Negative interest rates could also be applied (i.e., token burning) easing the zero-bound constraint.
On the flipside, remuneration would make CBDC’s even closer substitutes for commercial bank deposits. This increases the potential for greater disintermediation of the sector by increasing the incentive for households and businesses to shift larger amounts of money into CBDC (even without remuneration some substitution would be almost certain to occur, at least initially). If this substitution effect was very large, it could reduce commercial bank funding, with potentially significant implications for the amount and cost of credit provided to the rest of the economy.
Whatever CBDC design is adopted, there is one non-negotiable feature: only the central bank will be able to “create” or “destroy” CBDC. Or, in more formal language, a CBDC would ensure monetary sovereignty remains with the central bank/government.
Predicated on the assumption that CBDCs will exist in the not-too-distant future what does it imply for private cryptocurrencies? Will they peacefully co-exist or, in more provocative language I used in the title, are CBDCs crypto-killers?
By virtue of it being issued by the central bank, CBDC would be digital, risk-free and have one-for-one exchangeability with bank notes guaranteeing price stability vis-à-vis the fiat benchmark. As mentioned in the previous article, cryptocurrencies come in a wide variety of flavours but for anyone familiar with the crypto-asset landscape that sounds a lot like one specific type of token – stablecoins.
For those not so familiar, stablecoins are cryptocurrencies that use various mechanisms to ensure they do not deviate much from their respective benchmark, most commonly the US dollar. The first stablecoin (originally called realcoin but now known as Tether) was launched in 2014.
The regulators have been paying very close attention to this specific token type and not just for the often given reasons relating to cryptocurrencies such as to protect consumers from fraud, concern about their use in money laundering, tax evasion and darknet markets like Silk Road.
In the aforementioned discussion paper, the BoE warned that
“[Un]certainty about, or large fluctuations in, the value of stablecoins could give rise to similar risks to financial stability associated with the operational or financial failure of the payment system itself. These could include risks to the users’ ability to manage their liquidity or to meet payment obligations, or the risk of such fluctuations causing a collapse in confidence with potential contagion risks for the system. Stablecoins may also not be interoperable with each other and with other payment systems, creating closed loops and inefficiencies.”
Ensuring financial stability is, naturally, of paramount concern for any responsible government and provides sufficient justification for introducing crypto-asset legislation. Reviewing the various proposals under consideration though it is clear it doesn’t end there.
Stablecoins have much smaller market caps than more traditional cryptocurrencies ($172bn out of a roughly $1.7tr total). Ceteris paribus this should make them less of a financial stability risk. However, they have been growing rapidly and as the EU acknowledges in their legislative proposal (MiCA) published in 2019 it is
“likely that a subset of crypto-assets which aim to stabilise their price by linking their value to a specific asset or a basket of assets could be widely adopted by consumers [my emphasis]”.
Their price stability vis-à-vis a fiat benchmark not only makes them potentially more attractive than traditional cryptocurrencies to a larger section of the population but it does so by enhancing their ability to serve as a medium-of-exchange. This makes them a closer substitute to fiat money than Bitcoin and Ether, their more volatile crypto predecessors, and hence more troubling to regulators and, especially, central banks.
In recognition of these concerns, Article 19 section 2c of its MiCA proposal, which deals with stablecoins (it uses the phrase “asset-referenced” tokens), the EU states
“Competent authorities shall refuse authorisation where there are objective and demonstrable grounds for believing that:
c) the applicant issuer’s business model may pose a serious threat to financial stability, monetary policy transmission or monetary sovereignty.”
Can’t ask for more explicit than that. Threaten the ability of the ECB to implement monetary policy, or challenge the power of the state to exercise exclusive authority to designate what is legal tender and control the issuance and retirement of said legal tender (wikipedia definition of monetary sovereignty) and your token will be banned within the EU.
Be successful, but not too successful, is the EU’s not-so-implicit message to token issuers.
Those with sharp eyes may have noticed the above definition of monetary sovereignty refers to legal tender not money, the two things are – to the confusion of many - not the same thing. Strictly defined legal tender is a means to pay off a debt such that a person cannot be sued for failing to repay, i.e. it is recognized by the court of law as satisfactory payment. The result is some funny quirks. For example, in the UK the smallest denomination coins, 1p and 2p coins, only count as legal tender up to 20p. Debit and credit cards are not legal tender even though they are the most popular payment form. Most contentiously of all – especially with London black cab drivers it would seem in my experience - Scottish bank notes are also not legal tender, not even in Scotland, because they are (unusually) issued by private banks.
That said, as evidenced by the now dominant position of credit and debt cards in financial transactions, legal tender status is much less important in determining whether something is widely used as a form of money than its inherent characteristics. Not having legal tender status is not a sufficient condition to remove any threats from stablecoins to the current monetary status quo. More is required and regulators are coming for stablecoins. This will have a bearing on the answer to the question asked at the outset. To understand why it’s time to dig a little deeper into the stablecoin ecosystem.
Like the wider crypto-asset market there are many flavours of privately-issued stablecoins. They can be classified based on their underlying collateral.
· Fiat-backed: Collateralized by redeemable holdings of a financial asset in the reference fiat currency, which serves as the valuation anchor. Examples include Tether and USDC.
· Crypto-backed: Collateralized by holdings of other cryptocurrencies, which serves as the valuation anchor. Examples include DAI.
· Algo-backed: Uncollateralized. Software and rules serve as the valuation anchor. Examples include Terra.
The most popular class of stablecoin measured by market cap is fiat-backed. Their simple structure is similar to many existing financial institutions – they are not much different from regular money market funds - making them easier to understand, implement and pitch to investors and users than other privately-issued stablecoins. Hence, their success. Also, price stability is assured by design. Finally, they do not disintermediate the commercial banking system. Any funds used to purchase fiat-backed stablecoins are recycled back into the banking system when the issuer posts the monies as collateral.
The most obvious downside for users, arising from their necessarily centralized structure, is credit risk in relation to the issuer. That said, this drawback, which does not apply to CBDCs, could be mitigated by regular independent audits to ensure there is adequate collateral. Those found to be in breach of the rules – despite being the first and largest fiat-backed stablecoin Tether has been under close scrutiny on this front culminating in the CFTC issuing a $41mn fine for allegedly misstating its reserves - could be banned by the government. This would be a relatively straightforward process given their high degree of centralization and reliance on traditional financial assets makes them very “accessible” to regulators as the USDC – another popular USD pegged stablecoin - website makes clear.
“A global blacklist is maintained by the USDC smart contract, and this was implemented to comply with legal requirements such as a court order or global sanctions restriction. Reserves associated with USDC balances held on blacklisted addresses may be wholly and permanently unrecoverable.”
Such accessibility serves to discourage their use for dubious transactions – bad for criminals, good for regular users, especially those with high compliance standards such as financial institutions and institutional investors. However, one has to question in a world where all fiat-backed stablecoins are subject to extensive regulatory oversight – the larger or more significant they are the more oversight will be applied - what additional benefits they provide over CBDCs: in elevator pitch terminology, what’s their USP?
Ignoring any use of unregulated stablecoins for nefarious reasons, their main purpose is to provide efficient on-off ramping between crypto and fiat thereby avoiding time delays and costs associated with moving between the two, the potential benefits of which are considerable given the price volatility of cryptocurrencies. In the event that CBDCs are structured such that they provide direct access to the public and also allow transactions with a wide range of cryptocurrencies such as Bitcoin, it is far from clear that fiat-backed stablecoins have a purpose. The widespread arrival of CBDC in this form would, almost certainly, sound their death knell.
That said, it is far from certain that central banks would adopt such a strongly centralized structure. The BoE in the aforementioned discussion paper set out an “illustrative” CBDC where
“a core ledger, provided by the BoE, would record CBDC and process payments, and private sector ‘Payment Interface Providers’ would handle the interaction with end‑users of CBDC and provide additional payments functionality through overlay services.”
The BoE concluded that this model would be superior to one where the central bank provided all CBDC-related services because serving retail customers is not their comparative advantage. Moreover, due to a lack of competition (one central bank versus the alternative with multiple private companies as partners), innovation could be stifled. There was also an argument in favour of private sector involvement due to privacy concerns as the alternative would require all personal data to be stored at the central bank. All these arguments apply to central banks more generally.
Stablecoin issuers seem well-positioned to fulfil the role of private Payment Interface Providers plus they could be incentivized to make this shift. Prudence would dictate that being partnered to the central bank as described would require them to be granted access to the central bank’s balance sheet, in much the same way as commercial banks are currently. This would give them additional protection from during times of financial stress, a positive from their users’ perspective. It would be in return for more regulatory oversight, but that is coming down the pipe regardless of what happens with CBDCs.
We should make clear at this point, the above relates to a stablecoins backed by only one type of fiat currency. This is not the only possibility. Meta’s Diem (originally Facebook’s Libra) was conceived as a multi-currency stablecoin. For standard diversification reasons, this would – arguably - offer better stability, but it has come in for quite strong pushback from numerous authorities and understandably so.
As I noted before, money benefits from strong network effects, so strong it should be considered a necessary condition for anything to be considered money. Being able to leverage off Facebook’s huge consumer footprint would give Diem a massive advantage in this regard, making it a strong candidate to be widely adopted in numerous countries around the globe. If Diem was adopted on such a widescale, its multi-currency makeup would interfere with monetary sovereignty and monetary policy. It could lead to the emergence of a digital currency area (DCA). There is no guarantee this would be an optimal currency area – an area where a single monetary policy is superior – and certainly would be beyond the nation state level at which central banks operate and voters vote. This no small point. As former BoE governor Carney correctly observed in a speech to the BIS in 2021
“When it comes to money, the consent and trust of the public must be nurtured and continually maintained.”
When money crosses borders that defines the limit of voter reach, maintaining trust may be difficult. This may be especially challenging for Diem after the earlier Cambridge Analytica scandal.
Given such pushback the Diem project announced it would be “augmenting the Libra network by including single-currency stablecoins”. It hasn’t yet given up hope of becoming a multi-currency fiat backed stablecoin but I for one suspect it will not be given the green light by the regulators (it almost certainly breaches the EU’s proposal guidelines). Also because Diem’s reserves, which back the token, are held in regulated institutions a ban would be easily applied and effective.
CBDCs are coming. Fiat-backed stablecoins are not especially challenging for the authorities to deal with. In fact, they could quite readily co-exist within the same ecosystem.
Next week, in the second part of the article, I’ll look at the other two types of stablecoins - crypto-backed and algorithmic. Spoiler alert: they are much more challenging.
Until next time.
Ryan Shea, crypto economist at Trakx
 See: https://www.federalreserve.gov/publications/files/money-and-payments-20220120.pdf
 The temptation to quote Michael Caine at this point is almost unbearable, but I will refrain.
 In 2018 cash accounted for only 28% of transactions in the UK by volume down from 60% ten years earlier – see: https://www.bankofengland.co.uk/paper/2020/central-bank-digital-currency-opportunities-challenges-and-design-discussion-paper
 Throughout this article we will be focused on a specific form of CBDC namely the retail or general purpose version not a wholesale version because it has more far-reaching implications.
 Digital central bank money and bank notes and coins are unlikely to be perfect substitutes for reasons we will go on to discuss.
 A key difference is bank notes are not interest-bearing unlike commercial bank deposits. When such behaviour occurs in the extreme we call them bank-runs.
 See: https://www.bankofengland.co.uk/speech/2021/may/jon-cunliffe-omfif-digital-monetary-institute-meeting
 Over 80 central banks are exploring CBDCs see: https://www.atlanticcouncil.org/cbdctracker/
 One of the pros is a CBDC could facilitate ‘programmable money’ by enabling transactions to occur according to certain conditions, rules or events. One example given by the BoE, is automatic routing of tax payments to tax authorities at point of sale, a very tempting aspect for any fiscal authority.
 See: https://www.bankofengland.co.uk/-/media/boe/files/paper/2020/central-bank-digital-currency-opportunities-challenges-and-design.pdf
 It is possible that new business models could emerge with dedicated firms that verify users’ identity, for example, using zero knowledge proof technology to validate personal details. However, a trusted entity would still be required probably (self sovereign identity is an active field of research).
 The arbitrage between zero yielding bank notes would imply some lower threshold exists, it just might be lower than can be achieved currently, particularly if we become a largely cashless society and bank notes are sparingly used in financial transactions. In contrast, a non-interest-bearing CBDC would serve to reinforce the zero bound because of the lower storage costs and higher security of holding them compared to bank notes.
 Substitution effects could be mitigated by introducing a gap between the interest rate paid on CBDCs versus the remuneration of reserves held by for commercial banks. They could also be tiered to discourage large individual holdings of CBDC and/or hard limits on holdings or caps on transfers or flow of transfers.
 In recent decades we have become accustomed to central banks that are operationally independent. However, history shows that this demarcation is not impervious to the macroeconomic backdrop. In 1946, with national debt standing at over 250% of GDP, the BoE was nationalized. It did not regain independence until 1997 – over 50 years later when debt to GDP was a much more manageable 50% of GDP. No central bank whose independence is in the gift of the fiscal authority (the government) can be truly considered independent.
 Stablecoins can also, of course, use other references – see below.
 The first government legislation on cryptocurrencies was enacted by Japan in 2016 when the Payment Services Act was amended making virtual currencies (as they were then known) a legally accepted means of payment and required exchanges involved in these products to register with the authorities. The prompt for the legislation was the Mt. Gox hack two years earlier.
 Overlooking the fact that fiat money, particularly large denomination notes like the EUR 500 note (nicknamed the “bin laden”) has not been particularly successful in this regard either.
 See: https://www.bankofengland.co.uk/-/media/boe/files/paper/2020/central-bank-digital-currency-opportunities-challenges-and-design.pdf
 Not sure traditional is the correct word for an asset class just entering its teenage years!
 Tether is the largest stablecoin by market cap at $78bn - see: https://coinmarketcap.com/view/stablecoin/
 One of the three prerequisite functions of money that we outlined in our previous article.
 The US authorities are also paying close attention - see: https://www.wsj.com/articles/risks-of-crypto-stablecoins-attract-attention-of-yellen-fed-and-sec-11626537601?mod=article_inline
 Refer to the link in footnote 3 above.
 Asset referenced tokens are defined in the proposal as “a type of crypto-asset that purports to maintain a stable value by referring to the value of several fiat currencies that are legal tender, one or several commodities or one or several crypto-assets, or a combination of such assets;”
 See - https://en.wikipedia.org/wiki/Legal_tender
 What makes this piece of EU legislation particularly pernicious is that it occurs at the white paper stage, so even before a project really gets going. The EU can ban a token based solely on their perception that it could become widely accepted as a money substitute and undermine financial stability, interfere with monetary policy or threaten monetary sovereignty. On the plus side, harmonizing legislation across the EU significantly reduces the regulatory burden on token issuers within the region.
 See: https://www.bankofengland.co.uk/knowledgebank/what-is-legal-tender
 Given this, the probability of the UK following El Salvador’s lead and making Bitcoin – a private decentralized cryptocurrency - legal tender is about as close to zero as you are ever likely to see in the real world.
 A clear indication of the direction of regulatory travel for stablecoins - see: https://www.cftc.gov/PressRoom/PressReleases/8450-21
 As a safeguard against such risks Trakx does not utilize Tether in its operations.
 See: https://support.usdc.circle.com/hc/en-us/articles/360016060352-Can-a-customer-send-USDC-tokens-to-any-address-Can-addresses-be-blacklisted-
 In the EU proposal a token’s significance will be based on several metrics including market cap, size of the reserve of assets backing the value of tokens, the number of transactions and interconnectedness with the financial system. Those deemed “significant” will be “subject to more stringent requirements” because of “specific challenges in terms of financial stability, monetary policy transmission or monetary sovereignty”.
 The BIS has described them as “only an appendage to the conventional monetary system and not a game changer.”
 Mark Zuckerberg clearly likes rebrands. Strictly speaking, Diem is backed by a consortium of global businesses including Uber and Coinbase, in addition to Meta.
 See: https://www.bankofcanada.ca/wp-content/uploads/2021/12/sdp2021-17.pdf
 The BIS may be known as the central banks central bank, but it does not operate a global monetary policy, that remains at the level of the nation state.
 The ECB is a transnational central bank. Despite strong political backing for the single currency it has not been without its intra-regional monetary tensions.
 See: https://www.diem.com/en-us/economics-and-the-reserve/#the-libra-reserve-and-protections
 No commercial banks would be hurt or injured ie, disintermediated in the making of Diem.