…and why the future of money may not be entirely cryptocurrencies.
What distinguishes the value of a banknote from any other piece of paper? Trust. Trust that the banknote has value in the present and will be worth something in the future. Trust that it has originated from a trusted source. Trust that the consensus we have built to agree to trust this source will exist in the future.
This trust is what makes a piece of paper money or a banknote worthless. It was about 5000 years ago that Mesopotamian people created the shekel, which is considered the first known form of currency. Gold and silver coins date back to around 650 to 600 BC while it was not until 700-800 AD when the first paper money was invented in China. And since then, mankind has come a long way with a range of digital assets with the recent one being cryptocurrencies. Whatever be the format, humans have long been using currency as a means of exchange, a method of payment, a standard of value, and a store of wealth.
Cryptocurrencies, Central Bank Digital Currencies (CBDC), and Stablecoins are the latest buzzwords in this list. This blog is a quick overview of these digital assets, the differences between them, and the impact they could have on the world as we now see it.
Cryptocurrencies reinvented the idea of trust by making the generation and circulation of money public. Cryptocurrencies reinvented the idea of trust by making the generation and circulation of money publicly visible and verifiable. Essentially, instead of monetary authority, cryptocurrencies get their value from the trust of their users in the underlying protocol and the ecosystem. They are a wide range of privately issued digital assets such as Bitcoin, Ethereum, DogeCoin, etc. Not denominated in the currency of any sovereign authority, cryptocurrencies don’t have a sovereign issuer or a central party managing the demand and supply. From a technology standpoint, they utilize cryptography and game theory to store the record of transactions and ownership of the associated “digital coins” in a ledger that is distributed and synchronized across a number of computers rather than relying on a single central party to operate and maintain the system. The protocol prevents the coins from being duplicated and thus, eliminates the need for a central authority (e.g. banks) to verify these transactions. In turn, they don’t have any intrinsic value, as they come with no right to convert them into anything else, and – unlike regular currencies – they come with no legal right to sue them to settle debts or pay tax bills. Thus, they entirely rely on the trust of the people in its technology. Their prices vary based on the global demand and supply for the respective asset.
Means of exchange / a method of payment: Regulations about the use of cryptocurrencies vary significantly across the globe. While there are a few governments that have recognized cryptocurrencies and embraced them as a mode of payment, many have introduced bans to limit their use. In the regions that have allowed its use, it may be used to buy everything from coffee to real estate to illegal drugs.
Store of value (wealth): Cryptocurrencies are susceptible to many market forces. Or rather, they are highly vulnerable to tweets or reactions from investors, players, stakeholders, and even the decisions by governments across the world. Their prices are highly volatile, one unit of cryptocurrency may not be of the same worth from now till the time you finish reading this blog 😃 . This limits their use for day-to-day transactions. Many would not accept payments in something whose value can change dramatically within a day. Additionally, the belief or desire by many holders that their value will always go up makes them more unattractive as payment mechanisms, since why would you willingly spend something that you believe will be worth a lot more in the future, undermining its value proposition.
Regulation: Cryptocurrencies are not regulated by a single authority/ government/central bank. As a result, they could be leveraged by bad actors resulting in concerns about fraud, tax evasion, money laundering, etc, and thus, pose economic risks.
The question arises why are they still popular?
One probable explanation is – it is for the hope to make easy money from speculating on cryptocurrencies. Additionally, they can be transferred relatively quickly and anonymously across borders with a very low fee compared to traditional modes of payments.
Because of the mentioned drawbacks of cryptocurrencies, many crypto projects and companies are now exploring ways to reduce this price volatility and risk to boost the adoption and participation of the public in the crypto ecosystem. Additionally, merchants and traders wanted a way to switch in and out of highly volatile cryptocurrencies without having to interact with the legacy banking systems in order to do so. This has led to a new subset of cryptocurrencies called “Stablecoins”. As the name implies, these currencies are supposed to be stable, with the stability directly imbibed within the asset/currency. The idea is that these stablecoins will be pegged to another asset/currency(eg, Gold, USD) that would exist outside the system. So, the stablecoins on the digital system get their trust, resultantly the value, from these underlying assets, whose values don’t strongly fluctuate. In some cases, stablecoin issuers claim they hold balances of the underlying asset on a 1:1 ratio with the stablecoins they have issued. In other cases, algorithmic techniques are used to attempt to maintain a peg. This reduces the overall price volatility of stablecoins in comparison to the above-mentioned class of cryptocurrencies.
As in the below diagram: The whole set of cryptocurrencies can be viewed as a sum of two groups of assets: one group with cryptocurrencies such as Bitcoin, Ethereum, Dogecoin, etc and another group with Stablecoins such as Tether, USD Coin, Binance USD, and Dai, with the distinction that the latter is pegged to an external asset while the former is not.
Means of exchange/method of payment: They are well equipped to be a strong medium of exchange. As they use distributed ledger technology, cross-border transactions are faster and also cost-free compared to traditional modes of payment. They can provide low-cost, easily accessible digital payments within national borders or across the world. Stablecoins have the potential to bridge the gap between cryptocurrencies and fiat currencies and could play an important role in the future of transactions, banking, and finance.
Store of value: Being pegged to traditional assets such as gold, USD, etc they serve to be a trusted store of value.
Regulation: This is a reason of concern for many regulators/experts for the long-term use of stablecoins. These are 2 major concerns:
- For now, all the stablecoins in the market are issued by private organizations and companies. For a continued value for these stablecoins, these organizations must have enough dollar reserves to back their currency, which may not be the case. For example, Tether, the world’s 3rd largest cryptocurrency by market value has $60B worth of tokens in circulation on the platform (more deposits than many US Banks) and it remains the largest stablecoin. It is called to be pegged to US Dollar with 1 Tether ~ 1USD. And that’s not the total market value of stablecoins. The market is now worth $155 billion, growing 445% this year. Regulators and critics are concerned whether the companies have enough reserves to back the stablecoins under circulation on the system. Another concern is the reserve must be in the form of the pegged sovereign (in Tether’s case: USD) and not other financial assets. (varying labels of credibility).
- Stablecoins are not issued by any government or central bank. Thus no regulations are governing the system for frauds, money laundering, and regulatory checks. Investors are not protected in case of any unprecedented events.
Central Bank Digital Currency
Central Bank Digital Currencies (CBDCs) could be viewed as central bank-issued stablecoins, a digital form of fiat currency. It is a digital token or record of a country’s official currency. It is issued and regulated by the nation’s monetary authority or central bank. In turn, they inherit the trust in the fiat currency. The number of central banks engaged with exploring and experimentation around CBDCs is growing. More than 85% of the central banks are considering digital currency. Unlike cryptocurrencies, CBDC won’t be decentralized and would be managed by a single entity: the central bank. CBDCs could provide the same speed and benefits as cryptocurrencies (such as easy transfers and payments) without the associated risks.
Means of exchange/method of payment: This is the same as using your fiat currency for digital payments. Easy mode of payment, with faster digital payments and settlement.
Store of value: Same benefits as buying the equivalent fiat currency as a store of value.
Regulation: CBDC’s would be regulated by the monetary authority/ central bank. While on one hand, it could mean stronger checks on thefts, money laundering, etc. on the other there are concerns about the privacy of users in such a system that could give the government/central bank access to all our spending habits.
Another benefit CBDC could offer is enabling financial inclusion. CBDCs can be an effective way for governments and central banks to bring the masses under the financial umbrella – to provide basic banking services and easy access to digital payments, loans, etc. Some governments also view CBDCs as programmable money—vehicles for monetary and social policy that could restrict their use to necessities, specific locations, or defined periods.
The majority of these digital assets employ DLT(Distributed Ledger Technology) and blockchain as their underlying protocol (with the exception of CBDCs which may be based on Blockchain or not). R3’s Corda is a scalable, permissioned peer-to-peer (P2P) distributed ledger technology (DLT) platform that enables the building of applications that foster and deliver digital trust between parties in regulated markets. To learn more about DLT, blockchain, and Corda head over to our homepage. If you are a developer looking to learn more about the technology, our newly launched Developer Portal is your one-stop solution. And lastly, if you are looking to build your own CBDC, our CBDC Sandbox could indeed help you understand the range of capabilities and possibilities of CBDCs.
Lastly, there is no point denying the fact that digital currencies are here to stay, whether, in the form of cryptocurrencies or CBDCs or a mix of both, only time will tell. For any of them to become the future they must earn the trust of the users, the governments, and the world at large.