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CBDCs & Decentralized Stablecoins: A Glimpse Into the Future of Monetary Systems

In this guide, we will analyze two similar applications of blockchain technology in the field of instant payments and volatility mitigation. CBDCs and stablecoins offer the same utility enabling users to make payments without worrying too much about the volatility of the asset. However, the way these two are developed and monitored is poles apart. Let’s begin with the basics.

The Case for Digital Currencies

The idea of digital currencies is not something new at all. One of the earliest forms of digital money was known as Bit Gold which was designed by acclaimed cryptographer and computer scientist Nick Szabo in 1998. While it was never officially implemented, Bit Gold is often referred to as a precursor of the Bitcoin architecture.

Several factors strengthen the case for digital currencies. First and foremost, digital money implies digital payments that take a fraction of a second to complete compared to cash transactions that not only require the payer to carry physical cash but might sometimes also take several days to reflect in the seller’s bank account depending on the bank’s processing time. Simply put, digital currencies ensure seamless, fast and secure monetary transactions. On the contrary, international remittances or wire transfers typically charge a significant percentage of the total amount as transaction fees.

Digital currencies also facilitate easy payment tracking to help the users keep track of their financial records. It also provides the users with better accessibility as all that is required is a mobile phone and an internet connection. These factors, among others, make digital currencies a strong alternative to physical cash that suffers from several disadvantages. 

Now that we have established the case for digital currencies and their benefits, let us pivot to CBDCs. 

What Are CBDCs?

As mentioned earlier, CBDCs are short for central bank digital currencies which are essentially digital currencies issued by a country’s central bank. For instance, a stablecoin issued by the US Federal Reserve would be its CBDC. Similarly, a stablecoin issued by the Reserve Bank of India would be India’s CBDC, etc. 

Although digital currencies were already being explored by nations around the world, the arrival of the coronavirus pandemic boosted the adoption of CBDCs. The infectious nature of the pandemic discouraged the use of physical cash and several fintech banks and crypto projects took the spotlight as people transitioned into digital currencies. 

While at surface CBDCs might sound like a relatively easy concept to understand, there are some nuances to this novel innovation. For instance, there are different kinds of CBDCs, the two most important of them being retail CBDCs and wholesale CBDCs.

Difference Between Retail CBDCs and Wholesale CBDCs

As its name indicates, retail CBDCs are supposed to be used by the general public for day-to-day monetary transactions such as purchasing goods and services, paying rent, etc. In essence, a retail CBDC must be accepted as legal tender and considered a safe store of value by the government, businesses and the citizens of a country.

Some of the features associated with retail CBDCs are availability and traceability. Retail CBDCs are becoming increasingly popular not only because of the way they leverage blockchain technology to offer their users a better form of money but also because they help bank the unbanked and foster financial inclusion. Retail CBDCs also help the country in reducing the costs associated with printing and managing cash. Another important aspect is that CBDCs do not require users to have a bank account and it is estimated that the rise of retail CBDCs will also help bring down banking costs for end-users.

On the other hand, wholesale CBDCs are most suitable for financial institutions and banks that hold reserve deposits with the central bank. The Bank of International Settlements stated that wholesale CBDCs could significantly improve security settlement and efficiency of payments. In addition, wholesale CBDCs successfully tackle the concerns around liquidity and counterparty credit. 

A report by the Bank of Canada also posits that wholesale CBDCs hold the potential to enhance cross-border payments. The report notes that one of the primary objectives and use cases of wholesale CBDCs is related to its potential to interlink high-value payments systems or having interoperable CBDCs that share a common underlying blockchain shared by two or more nations that would help with speeding up the clearing and settlement of cross-border payments. As a result, several pain points facing the existing cross-border payments system such as the slow settlement of transactions, low visibility and high costs can be efficiently addressed. In wholesale CBDCs, the central bank functions as a central counterparty in a cross-border environment. 

Now that we have established the differences between retail and wholesale CBDCs, let’s shift our focus to the benefits and concerns surrounding CBDCs.

Benefits of CBDCs

One of the primary benefits of a state-issued CBDC, is that it gives strong competition to payments mechanisms developed by tech conglomerates. It’s no secret that large tech companies benefit from their network effects to push any product into the market among their existing user-base that ranges in millions of people. However, these companies are often found to not be behaving in the user’s best interest and we have witnessed several examples in the past. A state-issued sovereign CBDC would benefit from enhanced citizens’ trust in blockchain technology. In essence, the advantages of CBDCs could help governments tackle the monopoly of big tech in some cases.

Furthermore, CBDCs are completely digital, meaning they can operate as legal tender in scenarios where access to physical cash is not viable. For instance, the coronavirus pandemic showed us the importance of digital money and how CBDCs could come in handy during such situations. Moreover, CBDCs also eliminate certain risks and disadvantages associated with physical cash such as money laundering, etc.

Concerns Surrounding CBDCs

Although CBDCs can indeed benefit nations in many different ways, there are some concerns surrounding a national digital currency that could pose a risk to users. To begin with, a major point of contention surrounding CBDCs is the infringement of user privacy. As CBDCs are issued by a central bank, this very same bank would have access to all personal financial information.

The next cause of concern is to enable single points of failure. Currently, the monetary structure and stability of any nation is the shared responsibility of the central bank, treasury, government and other national regulators. However, depending on the emerging operational infrastructure associated with CBDCs, could increase risk concentration and make the financial system even more fragile.

In addition, a CBDC can also become a concern for national security. A CBDC essentially gives an exposed attack vector to both state and non-state actors to harm the national economy. 

Countries Leading the CBDC Race

A significant number of countries are experimenting with the idea of a CBDC. However, some countries are far ahead of others when it comes to experimenting. China is probably the leader when it comes to CBDC adoption. The Chinese CBDC or the digital yuan has been in the works for more than three years and has witnessed several pilot projects in mainland China that indicate the level at which the People’s Bank of China aims to use CBDCs. 

For instance, during the Winter Olympics earlier this year, over USD 315,000 worth of digital yuan was used every day. During the trial, the People’s Bank of China kept a close eye on the number of people attending the games who used the CBDC. 

Similarly, the Bahamas is conducting pilot tests to ascertain the viability of its own CBDC. Dubbed as the ‘Sand Dollar’, the Bahamian CBDC can be used to purchase goods and services in the country. It is estimated that more than 55,000 people hold the Sand Dollar in their wallets while over 1,000 merchants already accept it. 

The Central Bank of Nigeria also launched the eNaira CBDC in October 2021. However, the pilot has not seen much success to date as only about 80 merchants are currently active in the pilot due to a lack of demand from the general public. A total of 18,460 people have eNaira-funded wallets, a figure well below the central bank’s expectations. 

Summarizing, CBDCs offer an interesting alternative to physical cash that is still backed by the government and its credibility. However, they also present concerns surrounding user’s privacy and excessive government interference which is not acceptable for decentralization advocates.

As an alternative, the crypto industry offers decentralized stablecoins which enable users to rely on DLT technology while at the same time profiting from their crypto holdings through DeFi.

What are Decentralized Stablecoins?

Decentralized stablecoins are stablecoins that are not controlled by a single centralized authority or company. Instead, these stablecoins are typically controlled by a DAO and over-collateralized with other cryptocurrencies. Some of the most popular decentralized stablecoins are DAI, Dollar on Chain and Magic Internet Money among others.

Which are the Top Decentralized Stablecoins by Market Cap?

The largest decentralized stablecoin by reported market cap today is DAI which commands a market cap of more than $6.4 billion. DAI is followed by FRAX which boasts a market cap of almost $1.5 billion. It’s worth noting that except for DAI, the other stablecoins have a very small market cap compared to centralized stablecoins. One of the major reasons for the dissonance between the market caps of centralized vs decentralized stablecoins is the onboarding difficulty associated with the latter. While centralized stablecoins enjoy strong on-ramp support across crypto exchanges, the same is not the case for decentralized stablecoins that are typically used on DeFi protocols for yield farming or liquidity mining.

Why Decentralized Stablecoins Over CBDCs?

Now that we have a fair idea about the differences between CBDCs and decentralized stablecoins, it’s easy to realize which’s the better option in terms of user privacy and freedom. It’s also important to notice that decentralized stablecoins cannot just be censored and do not require users to share any personal details. On the contrary, CBDCs typically involve strong KYC mechanisms.

Risks Associated with Decentralized Stablecoins?

Decentralized stablecoins come with their own set of risks that can be financially worrisome for their holders. The most recent example of risks associated with a decentralized algorithmic stablecoins is UST, the stablecoin of the Terra (LUNA) ecosystem that crashed to under $0.001 after the LUNA cryptocurrency collapsed. Decentralized stablecoins must always be fully collateralized and maintain the peg. Otherwise, they have no real purpose. There are also smart contract risks associated with decentralized stablecoins.

How Is RSK Fostering Decentralized Stablecoins Adoption?

According to the latest data from DeFi Llama, the RSK ecosystem has a TVL of more than USD 108 million. The majority of this value can be attributed to Money on Chain, the leading RSK-based DeFi protocol.

Money on Chain has a native decentralized stablecoin called Dollar on Chain (DoC) that is 100 percent collateralized with bitcoin with a 1:1 USD peg. Users can buy DoC on a secondary market or even mint their own DoC to avoid extra costs associated with the difference in spread. DoC is instantaneous and does not involve any protocol fees. The stable nature of DoC makes it an ideal decentralized stablecoin for daily transactions.

With an increasing number of decentralized applications and protocols building on RSK, we could expect the number of stablecoins to increase in the coming months on the back of strong demand for bitcoin-collateralized stablecoins that do not suffer from the drawbacks of a CBDC while also being easily accessible and usable for daily transactions.