The Rise of Digital Dollars: Stablecoins & Central Bank Digital Currencies

(6 min read)

Fast take

  1. What digital dollars are (stablecoins, CBDCs)

  2. Macro implications of digital dollars - from its impacts to the payments industry to central bank monetary policies

  3. The path forward for institutions and central banks


Before we get into today's issue...

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Without further ado...


Why digital dollars?

The existing financial system — while certainly functional in processing $120 trillion in payments annually — has its share of inefficiencies, including its reliance on middle men and legacy systems, which often come in the form of credit card providers that charge up to 3% per transaction, and bank wires costing as much as $50 each.

The emergence of mobile digital payment solutions such as Venmo in the US, or PayNow in Singapore seem like potential solutions. But these domestic solutions are merely layers sitting above very old and outdated banking networks like the Society for Worldwide Interbank Financial Telecommunication (commonly known as SWIFT), which enables worldwide financial transactions between banks.

Here's the tldr; SWIFT to the banking world is kinda like those really old pipes in apartment buildings in Manhattan that creak as you turn the hot water on - ancient and broken at its core, but yet no one wants to foot the bill to solve the problem. There is only so much you can innovate in the payments space when your plumbing systems are literally from the 70s, thirteen years before the internet was even invented.

Enter stablecoins.

Stablecoins

Back in 2013 at a San Jose Bitcoin conference, J.R. Willett (inventor of the ICO) talks about the possibility of issuing new tokens on top of the Bitcoin protocol. Willett then went on to implement this idea via the Mastercoin protocol (now called Omni), which later ended up being the technological foundation of Tether (USDT). Its controversies aside, USDT is the first stablecoin ever created and is currently the largest dollar-based stablecoin by market capitalization (>$19 billion at time of writing).

Today, various dollar-backed stablecoins have come to market including USDC, GUSD, PAX and many more. These are examples of fiat-backed stablecoins, which are essentially cryptocurrencies that are collateralized by a corresponding fiat currency reserve. For example, 1 USDC is backed by 1 US dollar in reserves held in a bank.

In some ways, stablecoins were the perfect solution to fill to the void left by traditional banking systems by providing dollar access to the world's unbanked population of 1.7 billion people, allowing borderless and cost-efficient transactions without the price volatility of cryptocurrencies such as Bitcoin (needless to say, the infamous case of someone paying 10,000 bitcoins for two pizzas would not have happened if stablecoins existed back in 2010). With the inefficiencies in traditional payment systems, stablecoins could even be the next big thing in e-commerce.

Just last week, Visa seemed to have caught on. The world's second largest card payment organization announced that they are connecting its global payments network of 60 million merchants to USDC, a dollar-backed stablecoin. USDC currently has a market cap of $3bn.

And, I won't be surprised if other players like PayPal make similar moves, considering Dan Schulman's tone in a recent interview with CNBC:

"... no question that people are flocking to digital forms of currency... we talk to regulators and central banks around the world and it became to clear to me that it became not a matter of if but when we'll start to see more and more central banks issue more digital currencies, and utilities in cryptocurrencies" – Dan Schulman (CEO, PayPal)

Speaking of central bank digital currencies, aka CBDCs...

CBDCs

Let's start with what it is and what it's not.

  • CBDCs are a digital form of fiat money issued by central banks. Central banks essentially have a direct relationship with users of CBDCs, cutting through middlemen such as commercial banks. No country has officially launched such a money, though real world tests have been conducted (we will touch on this shortly)

  • CBDCs are not cryptocurrencies in any way. Unlike the decentralized nature of cryptocurrencies such as Bitcoin, CBDCs are centralized and regulated by a country's monetary authority

Next, the why.

  • The rise of and potential threats (to central banks) from the emergence of stablecoins and Facebook's Libra (now rebranded to Diem), allowing digital currencies to easily move across borders outside the banking system

  • Countries including the US struggled to distribute COVID stimulus checks directly to consumers and businesses (for instance, those without bank accounts would face 3.5% in bank costs to turn checks in to cash)

  • Countries like China are taking this opportunity to completely shift away from physical cash

What are governments doing?

  • Countries such as the US, Europe and Saudi have been public about their open stance on CBDCs, albeit still in the research stages.

  • China's version of its CBDC, aka its Digital Currency Electronic Payment (DCEP), already ran pilots in four cities (Shenzhen, Suzhou, Chengdu and Xiong'an), where transactions totaling more than 2 billion yuan ($300 million) have already taken place. JD.com, one of China's top two online retailers in China, has become the first virtual platform to accept the DCEP as payment. So far, China's DCEP is proving to be successful and will be ramping up in 2021.

It makes sense. The concept of cash being obsolete has been discussed since 2017.

There are, however, other less apparent benefits of central banks having direct relationships with end users of their digital currencies

  • While China is already nearly cashless and a lot of transactions happen digitally, they do so beyond the purview of the state on privately-owned apps and platforms (i.e. Alipay and Wechat). Its DCEP allows Beijing to bypass the walls of middlemen layers, providing an unprecedented amount of information about how and where people are, and what they're spending their money on - a tool to help strengthen the state's surveillance and control over its economy and society.

  • It even allows the PBoC to manage its monetary policies, by having direct access to levers controlling interest rates and monetary supply of its digital yuan. For the intellectually curious, my favorite Durian dives into the DCEP and its precision monetary policy here.

The future of digital dollars

The race to adopt digital dollars has started for corporates, institutions and central banks. Mainstream stablecoin adoption continue to accelerate, and CBDCs are an inevitable development in the future of money (as per Citi and StanChart). The future of digital dollars will most likely involve a mix of stablecoins and CBDCs, with more innovations emerging from where overlaps exist.

Regardless, it is time to change the plumbing.

What's more, we live in a world where digital dollars are generating more yield than their fiat counterparts, but that's a topic for another issue...


Disclaimer: Nothing written in this post is intended to serve as financial advice. Do your own research.

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