The Race to the Starting Line: The Rise of CBDCs

Data analysis and visualizations by Vishal Joseph.

In the past decade, the value of cryptocurrencies and digital assets has grown exponentially, rising from $14 billion in 2015 to $2 trillion this March (Fig. 1).

Figure 1: The market capitalization of cryptocurrencies over the last 7 years. Source: Coininfo.io

Within cryptocurrencies, stablecoins—cryptocurrencies backed by a stable asset—hold a market cap of $180 billion (Fig. 2) and account for approximately 10% of the total valuation of cryptocurrencies. In just one quarter last year, the total number of stablecoin users doubled. The popularity of stablecoins has caused panic amongst regulators, who worry about illicit financial trades, and a sense of opportunism from venture capitalists, who see this as a turning point in global financial markets. Amidst the panic, though, regulators see an opportunity to join this digital revolution: almost 100 countries are looking into creating digital versions of their own currency, referred to as Central Bank Digital Currency (CBDC).

Figure 2: The market capitalization of the top 6 stablecoins from 2015-2022. Source: Coininfo.io

Stablecoins are so named because they are pegged to stable reserve assets—such as the US dollar or treasury or corporate bonds—and therefore promise a minimum value. Their use-case in the US is primarily to facilitate trading, lending, or borrowing of other digital assets through existing platforms like Ether, which houses the coin Ethereum. Their popularity comes from their ability to provide, in a volatile crypto world, a stable floor value for the decentralized operations inherent to cryptocurrencies. The growth in stablecoins’ market capitalization is correlated with the increased use and trade of regular cryptocurrencies, since stablecoins are used as a mechanism to store value from crypto trades for faster access and reuse. As we can see in Fig. 3, the market capitalization of stablecoins truly took off last year as the market for Bitcoin and Ethereum exploded.

Figure 3: Correlation between the market capitalizations of stablecoins and regular cryptocurrencies. Source: Coininfo.io

Having said that, stablecoins are not actually as stable as their names claim. Most notably, Tether, the largest stablecoin, recently ran into problems with their “stability”. In 2019, Tether claimed the value of its stablecoin was backed “1:1 by traditional currency held in our reserves.” However, an investigation that year by New York State Attorney General found that Tether and its holding company Bitfinex were $850 million in the red, and that Tether was only 74% backed by reserves. In 2020, Tether then disclosed that it was 76% backed by “cash and cash equivalents.” However more than half of those reserves were invested in a type of short-term corporate debt called commercial paper, for which the market collapsed in March 2020, forcing an intervention by the Federal Reserve. Despite this and other incidents of instability, the use of stablecoins is comparable to the use of money market funds—a type of mutual fund—in Europe (Fig. 4).

Figure 4: Comparison of Stablecoin and Money Market Fund values in June 2021. Source: EU Central bank: The expanding functions and uses of stablecoins

With such high stakes, the President’s Working Group on Financial Markets released a report last November detailing their concerns with the stablecoin ecosystem, along with their recommendations. Their primary recommendation was for Congress to enact legislation “to ensure that payment stablecoins and payment stablecoin arrangements are subject to a federal prudential framework on a consistent and comprehensive basis.” While Congressional action takes time, on March 9^th, 2022, President Biden signed an executive order (EO) to ensure “Responsible Development of Digital Assets.”

Among the 7 measures in the EO, which include consumer protection, mitigation of illicit financial acts and protection of US and global financial stability, the measure to explore a Central Banking Digital Currency stands out. CBDCs are not the same as stablecoins. Rather, they are digital versions of a country’s currency. Seeing the general interest in stablecoins—as well as their issues—central banks are considering CBCDs as a way to use their own currency to fill in gaps in the crypto market and expand services to those not covered by the traditional financial infrastructure.

However, this innovation is not new. In fact, CBCDs were explored by Finland and Uruguay as far back as 2014. More recently, a 2021 Bank of International Settlements survey of central banks found that 86% were actively researching CBDCs, 60% were experimenting with them, and 14% were deploying pilot projects (Figure 5).

Figure 5: State of Global CBDCs. Source: cbdctracker.org

The primary policy goals of CBDCs are to promote financial inclusion, increase access to payments, improve efficiency of payments, reduce the illicit use of money, and ensure resilience of payment systems. The prevailing objective for most central banks is to increase the reach of banking services to areas that have been historically underserved, a task that stablecoins cannot accomplish. The current and ongoing shift from paper money to digital payments in the private sector has increased the penetration of banking services in some regions, but it has not been able to scale effectively, largely due to low profitability for commercial banks. Central banks hope their non-profit nature will help provide low-cost payments as a public good, backed by an emerging technology that will withstand the test of time. They believe that CBDCs could expand the reach of banking systems to all corners of society, a major step to financial inclusion.

However, achieving these goals for any CBDC depends on the underpinning technology and operating model. The issue is, when it comes to CBCD technologies, central banks are largely failing to tap into the zeitgeist, which seems to favor decentralization of the financial system. Unlike their CBDC counterparts, stablecoins are designed to operate on public ledgers, providing anonymity and security to consumers that have grown to mistrust financial institutions. The added ability of stablecoins to engage with smart contracts, an upcoming use case of blockchain, makes them more appealing to younger users than a CBDC that will inherently be less dynamic.

As developed economies look to deploy CBDCs, there is little improvement to be had over their robust existing infrastructure. Therefore, countries with less stable currencies and less mature financial infrastructure have more to gain and fewer hurdles to clear to create their own CBDCs, a move that could, theoretically at least, increase financial inclusion where most needed. While the long-term state of CBDCs is unknown, the race to the starting line is tilted, for once, toward the developing world.