Stablecoins, CBDCs or Both?
August 2023 Commentary
Digital assets continue to give back their gains from earlier in the year, retracing about 10% over August. It’s anyone’s guess as to whether this pullback is triggered by macro headwinds, the warning from the US Federal Reserve Chair Jerome Powell that the Fed remains “prepared to raise [interest] rates further if appropriate”, or the SEC’s delay on deciding on the spot Bitcoin ETF applications from several asset managers. And as we often like to highlight during weak markets, evidence of development and institutional adoption continue apace. In August, PayPal’s announcement that it has launched its US Dollar stablecoin, PayPal USD (PYUSD) is one such example.
Stablecoins
The PYUSD stablecoin is fully backed by “U.S. dollar deposits, short-term US Treasuries and similar cash equivalents.” It is issued as an ERC-20 on the Ethereum blockchain by Paxos Trust Company, “a fully licensed limited purpose trust company subject to regulatory oversight by the New York State Department of Financial Services [NYSDFS].”
PYUSD belongs to a class of stablecoins backed by collateral, and such collateral typically falls into one of the three categories of 1) short-term, high-quality cash-like instruments, 2) digital assets, or 3) commodities. The price volatility of the collateral dictates the value of the collateral needed to support the fiat peg of the stablecoin. For example, PYUSD and its cohorts, Tether (USDT) and USD Coin (USDC), have approximately $1 of collateral in cash or equivalents to support each dollar of their respective stablecoin. In contrast, collateralized digital assets back each dollar of DAI, and typically, a minimum of $1.50 of collateral is needed for each dollar. Together, collateral backed stablecoins are distinct from algorithmic stablecoins, the most infamous being TerraUSD, UST. We don’t intend to cover the fundamentals of stablecoins in this article and encourage the curious reader to review https://chain.link/education-hub/stablecoins.
Overall, the market cap of the USD pegged stablecoins across different chains totaled just under $124 B as of the beginning of September, compared to over $180 B towards the end of April 2022 just before the collapse of TerraUSD. Stablecoins have many uses in Web 3 such as a DeFi primitive that allows investors to keep assets on-chain in a stable value and near-instantaneous peer-to-peer payments. Tether and USD Coin, backed by real-world cash equivalents, seem to be the favorites as they constitute close to 88% of the stablecoin market cap. DAI comes in at a distant third, constituting just over $5 B in market cap.
Source: CoinMarketCap, as of 05-Sept-2023
Unlike USDT which is unregulated, PYUSD is regulated by the NYSDFS. As articulated in its stablecoin guidance, the NYSDFS provide detailed requirements of stablecoin issuers regarding,
the redeemability of such stablecoins;
the asset reserves that back such stablecoins (the “Reserves”); and
attestations concerning the backing by these Reserves.
This ought to give stablecoin investors the confidence to transact in and hold PYUSD. Along with the PayPal brand recognition, existing PayPal user base, and integration into the TradFi banking rails, PYUSD should prove to be a competitive product to USDT and USDC.
What About CBDCs?
Central Banks, in the meantime, have been actively working on the issuance of their version of their respective stablecoins, the Central Bank Digital Currencies (CBDCs). The aspiration in exploring distributed ledger technology is to innovate the existing domestic and international payments infrastructure to make it less costly and less risky by allowing for close to real-time and atomic settlements across disparate counterparties. According to the CBDC Tracker, numerous central banks are researching while more than a dozen are actively piloting CBDCs. The most prominent pilot is China’s digital RMB (aka, e-CNY) issued by the People’s Bank of China (PBoC). While the pilot began in April 2020, the uptake of the e-CNY has reportedly been disappointing. After two years and multiple lotteries and promotions being provided, only 261 M people had set up an e-CNY wallet, compared to over 900 M people who use mobile payments in China. Lack of a clear advantage over mobile payments and privacy concerns have hampered adoption.
The e-CNY is an example of one of two major choices in designing CBDCs. It is a wholesale CBDC, the other being a retail CBDC. The wholesale CBDC (wCBDC) design relies on the central bank issuing CBDCs to intermediary banks who in turn provide the platform and distribution for retail usage. In contrast, a retail CBDC is one in which the central bank skips the intermediary banks and issues the CBDC directly to the retail customer.
In contrast to the PBoC, the US Federal Reserve Bank is still very much in its research phase of CBDC design. Project Hamilton, a collaboration between the Federal Reserve Bank of Boston and MIT, completed Phase 1 of its study in February 2022. The project’s “primary goal was to design a core transaction processor that meets the robust speed, throughput, and fault tolerance requirements of a large retail payment system. Our secondary goal was to create a flexible platform for collaboration, data gathering, comparison with multiple architectures, and other future research … The processor's baseline requirements include time to finality of less than five seconds, throughput of greater than 100,000 transactions per second, and wide-scale geographic fault tolerance.” Separately, Project Cedar is a partnership among the Federal Reserve Bank of New York, the Bureau of International Settlements (BIS), and the Monetary Authority of Singapore (MAS) to study the “cross-border multi-currency use case … It explored the ability of distributed ledger technology (DLT) to establish connectivity across heterogeneous simulated currency ledgers, reduce settlement risk, and decrease settlement time.”
Stablecoins, CBDCs or Both?
It is too early to tell whether our economies will come to adopt stablecoins, CBDCs or both, but the results have profound implications for peer-to-peer interactions and the role of intermediaries. Perhaps this is best summarized by listing out the set of key characteristics that seem to concern policy makers, designers, and users.
Source: Firinne Capital
At the heart of these characteristics seem to percolate two main questions. The first is whether we need centralization, at the government or at the regulated corporate level, to ensure the responsible issuance of a stablecoin so that it remains useful for retail and wholesale commerce. Post 2022, there is the potential for a knee-jerk reaction to favor centralization and regulation. Doing so allows for the stablecoins to either be backed by audited reserves or by the full faith of the central bank’s ability to issue money. It allows intermediaries to conduct proper due diligence (conduct know-your-client [KYC] checks) to prevent money laundering and trace criminal activities. On the other hand, it poses significant risks to decentralization and privacy and stifles competition, all of which are core to the ethos of why Bitcoin was created in the first place.
However, it’s a false choice to think of this as having only one of two approaches and ignores the availability of technology coupled with the evolution of regulations to tackle this issue. Data privacy laws need to be enhanced to protect individual rights while limiting centralized access by large organizations including the government. Digital identification is still nascent but can be augmented with zero knowledge proofs and smart contracts to deliver the minimum required information to a protocol that a user is interacting with while keeping the details of that user’s identity private.
The second substantial question is whether the central bank may lose some of its ability to control monetary policy and what are the ripple effects of banks becoming disintermediated, if stablecoins and CBDCs were to proliferate. Banks, through fractional reserve banking, play a key role in credit creation at the national and the local levels. Stablecoins, fully backed by high quality cash or equivalents, represent a narrow banking model that avoids fractional reserves. Will adopters use stablecoins to replace their checking accounts, money market funds (especially if a stablecoin design allows for interest payments), or all their banking needs?
It's far too early to answer either one of these questions. The evolution of the solutions that are attempted to address these questions will be both fascinating and possibly quite disruptive.