What we know as the financial system and money changes daily thanks to advances in digital technologies. Years ago, it was just fiat currencies – paper money and coins. Today, we have a more sophisticated monetary system with cryptocurrencies, stablecoins, and now the newly introduced central bank digital currencies (CBDCs), all vying for a place.
When the first stablecoin (Tether USD) was introduced in 2014, it brought the stability of the US Dollar and other government-backed currencies to the cryptocurrency and DeFi ecosystem. More like finding a near-perfect spot between centralized and decentralized monetary systems. CBDCs are out to change all that.
In this article, we compare the value CBDC provides with that of stablecoins, draw out the pros and cons of investing in either of them and explore what the future holds for both.
Central Bank Digital Currencies and Stablecoins: The difference
CBDC (termed central bank stablecoins by some) refers to an electronic record or digital token of a country’s fiat currency. For example, the digital yuan or e-CNY is the electronic form of the Chinese yuan. CBDCs are created by the central bank of the issuing country to serve as a legal tender and enjoy the full backing of the issuing country and government. As of October 2021, 83 countries around the world are pursuing CBDC development, with 13 already in advanced stages.
Stablecoins are digital financial instruments formed to reduce fluctuations in the cryptocurrency market. They achieve this by pegging their value on external references like fiat currencies (usually the US Dollar) or gold or being backed by other cryptocurrencies or smart contracts.
The two couldn’t be any more different, and these pointers show why:
Nature of currencies
CBDCs are digital representations of fiat currencies and so are not cryptocurrencies. The central bank of the issuing government serves as a central authority and controls the creation, circulation, and use of the currency. Due to this, some experts have argued that CBDCs would erode private citizens of their privacy.
On the other hand, stablecoins are cryptocurrencies. Their creation, circulation, and use are decentralized with no central regulatory authority. However, fiat-based stable coins are directly influenced by the value of a centrally controlled fiat currency.
Exchange value refers to the exchangeability of a currency to another currency. For example, the foreign exchange value of the 1 US Dollar to British Pound is 0.75 Pound Sterling (according to Google) as at the time of writing.
Stablecoins do not have any exchange value with any currency, not even fiat currencies. They can only be paired against the currency or commodity they are pegged to and nothing more. CBCDs being valued as much as a country’s fiat currencies maintain the exchange value of the issuing country’s currency. Therefore 1 digital Dollar would still be worth 0.74 digital Pound Sterling. CBDCs can also be converted to any fiat currency in the world.
Mode of Business
Since Satoshi created bitcoin in 2009, other cryptocurrencies have followed suit, introducing solutions that solved one or more problems facing traditional banking, such as collateral-based loans, high cross-border payment fees, and more.
Stablecoins operate a more democratized business model, acting as a stabilizer between the price of crypto-assets and the value of fiat currencies or commodities. In essence, they serve as a safe haven for investors who want to leave their funds in neither pure cryptocurrencies nor pure fiat.
This model largely differentiates stablecoins from the oligopoly business model of CBDCs. Experts have argued that governments are designing CBDCs to limit the relevance of cryptocurrencies and perverse the traditional banking system.
In contrast, stablecoins aim to change the world’s financial system, while CBDC attempts to curb unregulated digital currencies in the world.
Since stablecoins are decentralized, there are no taxation aspects connected to them. Although governments worldwide, especially the United States’ Security and Exchange Commission, are rallying to introduce cryptocurrency taxes, there is no certainty stablecoins would be taxed.
Central bank digital currency is directly connected to the taxation policies of issuing countries since they are the digital equivalent of fiat. Therefore, earning in central bank money does not exempt a user from all kinds of currency taxes.
Use of Currency
CBDCs greatly cater to unbanked citizens. The availability of a digital wallet means people can carry their money around in digital format on a smart device without having to bank with an existing bank.
CBDC can be used for retail payments through users’ wallets. However, universal access attributes of CBDCs make offline payments possible.
CBDCs could be used to facilitate faster cross-border remittance. International collaboration among the major economies of the world could help create the necessary infrastructure and arrangements for remittance payments and reception using CBDCs. They can also be pre-programmed to serve specific purposes in one area and general-fit purposes everywhere else.
While stable coins share similarities with CBDCs in retail payments and cross-border remittance (when adopted), they serve far more uses. Investors can use them as a safe haven asset to escape cryptocurrency market fluctuation. A good portion of these stablecoins is invested in crypto lending, which currently offers the most high-yield opportunities for investors.
Stablecoins are perfect for trading at cryptocurrency exchanges without bearing the costs of using fiat currencies or risking crypto price volatility. In 2019, over 40% of trading on Binance was done with Tether.
Stablecoins make the process of escrow completely automated through smart contracts without the need of an intermediary like a bank. Furthermore, they stabilize escrow smart contracts, significantly saving them from losses due to price volatility.
To further contrast these two currencies, we examine their pros and cons and what to expect when investing in either.
Pros and Cons of Investing in CBDC
Here are some pros of investing in CBDC:
Pros of CBDC
- The most apparent impact CBDC would have is lowering transaction costs while increasing the speed of retail payments. One way it would achieve this is by reducing the cost of producing, storing, distributing, and disposing of paper money.
- More importantly, CBDCs would foster financial inclusion by improving access to digital payments for unbanked households. Users can access current digital payment tools at considerably lower costs without opening a bank account.
- CBDCs offer a trustworthy alternative to digital currencies like cryptos. Since they are controlled and issued by central banks, users have more confidence in their stability. As more people adopt it, banks and fintech businesses would be driven to innovate better payment systems, fostering economic growth.
- The liquidity benefits of CBDCs cannot be denied. The use of digital cash means liquidity is always available 24/7, even on holidays. Cash automated teller machines (ATMs) would no longer be necessary, and institutions providing cash through these liquidity channels avert the risk associated with cash.
- The lack of involvement of intermediaries in CBDC’s payment processing would increase the speed of settlements between banks or other financial players.
- Central banks could turn into direct competitors of payment service providers with commercial banks, forcing banks to lose income.
- Privacy is not guaranteed with CBDCs, given that a single authority controls them. Users’ financial data are fully open to issuing bodies and whoever they intend to share such data with.
- Governments control them.
Pros and Cons of investing in Stablecoins
Unlike cryptos, the price volatilities of stablecoins remain constant, which will not affect your invested amount at any cost. Here are the pros of investing in stablecoins:
- A stablecoin would maintain its value several years after purchase, saving you huge losses due to a significant drop in crypto market prices. However, if the market entirely collapses, your stablecoins can be affected.
- Processing fees in stablecoins are relatively cheaper compared to credit card payments.
- Using stablecoins is more convenient for people to use compared to other high-risk digital currencies. Transparency is offered by stablecoins that are backed by regular audits.
- With stablecoins, you can invest in crypto lending, yield farming, and others. Most platforms offer a high annual percentage yield (APY) to investors. This is better than most traditional investment options provided by banks.
- Stablecoins are decentralized. If yours get stolen, there are no ways to get them back. As with all other cryptos, if you forget your keys to your stablecoins, in most cases, it’s gone forever.
- There is also the risk of the creators behind the stablecoin project. The project might go bankrupt, lose traction, or the creators might bail on it, causing lots of losses to investors.
- Unlike Cryptocurrencies, there are no significant gains expected after investing in Stablecoins. This is because the coin values are not affected by market rises and falls. Therefore, if you keep a 10,000 USDT over 4 years without lending out to crypto loans, farming it, or buying a cryptocurrency, chances are, it would still be worth 10,000 USDT.
How CBDCs would change Stablecoins and DeFi
The public embraced stablecoins and DeFi because they liberated money from the many clogs found in the traditional financial system. However, they are challenging to navigate for newbies to the crypto world, thus deterring many people from using these innovative financial tools.
Central banks are aware of the disruptive potentials of decentralized finance and the entry-barrier for the public and so introduced CBDCs to accomplish two tasks; compete with DeFi with digital currencies that are simpler to work with. In the coming years, more countries would adopt and issue CBDCs, and more stablecoins serving distinct purposes would appear. However, it is too early to predict the greater impact of CBDCs on stablecoins or DeFi, given that e-currency projects are still in their infancy.
However, the significant forces of regulation and adoption would decide the ultimate fate of CBDCs and stable coins. CBDCs are subject to regulatory oversight from the government, so they may be termed safer by some. Still, the public’s willingness to adopt it as a medium of exchange remains in question.