CBDCs vs. Stablecoins: Key Differences and What You Need to Know
Digital currencies are gaining attention across various sectors and countries, suggesting the era of physical cash may be drawing to a close. Also known as electronic currencies, these are digital assets that store value and facilitate payments for goods and services.
Unlike physical banknotes, digital currencies can only be accessed and transacted using a computer or mobile phone. Two prominent types have emerged: Central Bank Digital Currencies (CBDCs) and cryptocurrencies like stablecoins. Although both are digital, they serve different purposes. Understanding these distinctions is crucial for consumers, business owners, and investors to make informed decisions.
What are Central Bank Digital Currencies (CBDCs)?
A Central Bank Digital Currency (CBDC) is a digital currency issued by a country's central bank. Its value is fixed by the central bank and is equivalent to the nation's physical currency. It functions similarly to cash and can be used for payments, as a store of value, or for settling transactions between businesses and financial institutions.
A primary goal of CBDCs is to promote financial inclusion. Traditional banking often involves complex procedures that can discourage participation. By offering easier and more convenient access to financial services, CBDCs can encourage more people to join the formal financial system.
Additionally, CBDCs can improve the efficiency of cross-border transfers and payments by reducing costs. Built on technologies like blockchain, they enable the transfer of money without territorial limitations.
Several countries have already launched or are piloting CBDCs, including the Bahamas (Sand Dollar), China (e-CNY), India (e-Rupee), Jamaica (JAM-DEX), and Nigeria (eNaira).
Types of CBDCs
Central Bank Digital Currencies are generally classified into two types: retail and wholesale.
Retail CBDCs are designed for public use, facilitating transactions between consumers and businesses. They can be token-based, allowing for anonymous transactions using public and private keys, or account-based, requiring users to have a verified digital identity to transact.
Wholesale CBDCs are restricted for use by banks and other financial institutions. They are intended for settling large-value, infrequent transactions between these entities, improving the efficiency and security of the interbank payment system.
What are Stablecoins?
Stablecoins are a class of cryptocurrency designed to have a stable value by pegging it to another asset, such as the U.S. dollar, gold, or another commodity. The high volatility of many cryptocurrencies makes them impractical for everyday transactions.
To solve this instability, stablecoins tie their value to a more reliable asset. This stability has made them an attractive choice for retailers, institutions, and individuals seeking to facilitate trades and payments both domestically and across borders.
Types of Stablecoins Based on Backing Mechanisms
Stablecoins maintain their value through different backing mechanisms that ensure stability.
Fiat-backed stablecoins are collateralized by fiat currencies like the U.S. dollar (USD) or the Euro (EUR), typically at a 1:1 ratio. The reserves of the fiat currency secure the stablecoin's value. Examples include Tether (USDT) and USD Coin (USDC).
Crypto-backed stablecoins are backed by reserves of other cryptocurrencies. To counteract the volatility of the underlying crypto assets, these stablecoins are typically over-collateralized, meaning the value of the reserves is significantly higher than the value of the stablecoins issued. DAI, which is backed by assets like Ethereum (ETH), is a well-known example.
Algorithmic stablecoins use smart contracts and algorithms to manage the coin's supply and maintain its price peg. The system automatically reduces the token supply if the price falls below the target and increases it if the price rises above the target. The collapse of TerraUSD (UST) highlighted the inherent risks and potential unsustainability of some algorithmic models.
Commodity-backed stablecoins are collateralized by physical assets like gold, oil, or real estate. Gold is the most common commodity used for backing. Examples include Tether Gold (XAUT) and Paxos Gold (PAXG). While these offer exposure to the underlying commodities, their value can still fluctuate with the commodity's market price.
Key Differences Between CBDCs and Stablecoins
While both are stable digital currencies, CBDCs and stablecoins differ in several fundamental ways.
The most significant difference is the issuer. CBDCs are issued and backed by a country's central bank, giving them the status of legal tender. In contrast, stablecoins are created by private companies or decentralized entities and are not considered official national currency.
Their backing mechanisms also vary. A CBDC is backed by the full faith and credit of the government, just like physical cash. Stablecoins are backed by specific reserves, which can be fiat currency, commodities, other cryptocurrencies, or algorithmic formulas.
Regulation is another key distinction. CBDCs are fully regulated by government agencies. Stablecoins exist in a varied regulatory landscape, ranging from partially regulated to completely unregulated, depending on the issuer and jurisdiction.
Finally, they offer different levels of privacy and control. CBDC transactions are centralized and can be monitored by the government. Stablecoins, particularly those from decentralized issuers, can offer greater transaction privacy since they are not controlled by a central government authority.
Adoption and Future Outlook
CBDCs serve as a digital alternative to physical currency, aiming to promote financial inclusion, enable seamless cross-border transfers, and improve the delivery of financial services. They also allow governments to monitor the money supply more effectively and enforce regulatory compliance, enhancing the country's monetary policy.
Stablecoins have already seen wide adoption for payments, remittances, and as a less volatile asset for cryptocurrency traders. Their popularity has highlighted the vast potential of a stable digital currency and has influenced the development of CBDCs worldwide.
The coexistence of both is likely, as they serve different functions. However, challenges remain. CBDCs raise privacy concerns due to government monitoring, while stablecoins face issues of regulatory uncertainty and accountability, especially when a de-pegging event occurs. Both are also vulnerable to cybersecurity threats like hacking and phishing. Continued collaboration between blockchain developers and policymakers will be essential to address these risks and shape a secure and efficient digital financial system.
Potential Future of CBDCs and Stablecoins
The widespread adoption of stablecoins for payments and remittances has revealed the potential of a stable digital currency, influencing the development of CBDCs by various nations. This has raised questions about whether the two can coexist or if they will compete for dominance.
Coexistence is possible because they serve different purposes. CBDCs function as a nation's legal tender, while stablecoins are privately issued digital assets used primarily for transactions. However, challenges persist. CBDCs may face resistance due to privacy concerns from government monitoring. Meanwhile, many stablecoins remain largely unregulated, creating a lack of accountability, as seen in the collapse of TerraUSD (UST).
Both currencies are also susceptible to cyberattacks, which could destabilize the financial economy. Recent advancements in blockchain security and new regulations like the Markets in Crypto-Assets (MiCA) in Europe are positive steps. Continued collaboration between developers and policymakers is crucial to shaping the future of these currencies in a global financial system.
Conclusion
Central Bank Digital Currencies and stablecoins are distinct yet interconnected forms of digital currency. They differ in their issuance, backing, control, and primary use cases, making it important to understand their unique characteristics. Together, both are poised to play a vital role in shaping a future global financial system where geographical borders are less of a barrier.
Please be advised that this article does not constitute investment advice. You should act at your own risk and, if necessary, seek professional advice before making any investment decisions.
Roman Klochko