CBDC: Challenging Stablecoins’ First-mover Advantage

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As the trend to create central bank digital currencies (CBDCs) grows around the world, it’s worth taking a step back and asking why.

The two most common responses pit CBDCs against stablecoins: first, as a way to improve efficiency and reduce costs and bottlenecks endemic to the payments industry.

Or second, or that they are a reaction to the challenge that the explosive growth of stablecoins like Tether’s USDT and Circle’s USDC presents to governments’ ability to control their financial systems – i.e. the threat governments saw in the potential of Facebook’s now-discontinued Libra/Diem stablecoin to completely bypass fiat currencies, preventing them from influencing their own economies.

But there is a third area where stablecoins present a challenge for fiat currency that CBDCs would eliminate, or at least diminish. It’s the growing sector of the crypto economy with the potential to change everything from financial markets and payments to contracts and supply chains: the smart contracts that are fueling the blockchain revolution.

Price stability required

While public debate about cryptocurrencies has generally focused on protecting investors in speculative crypto trading markets – which cannot function without stablecoins – it is increasingly clear that smart contracts at the heart of the blockchain revolution will need a stable form of cryptocurrency prices.

The example of the most basic smart contract – the sale of a used car by its owner – shows this. The buyer locks the crypto – usually ether – into a smart contract that spells out the price and actions required for the self-executing contract to be paid – handing over the car, in this case.

Which is nice if the process if the whole transaction happens in one go, it’s like taking a product off the shelf and bringing it to the register. This is how Ripple’s international payment system uses XRP cryptocurrency – the sender buys it in fiat when he needs to send funds, and the receiver sells it immediately, leaving no more than a few seconds, which eliminates the problem of price volatility.

But if there are a few days in the process – say, the buyer wants it inspected by a mechanic – the price volatility of all cryptocurrencies means that the value of the crypto the seller has agreed to d to accept as payment for the car could be much less. A 10% price change, which is quite common over a few days, means the seller could get $4,500 for their car instead of the agreed-upon $5,000.

And since smart contracts cannot be changed once created, the seller would have no recourse.

Now translate that to farmers selling produce to Walmart, for example, or merchants buying widgets from a manufacturer.

The movement towards stability

Preventing this is how stablecoins are currently used on public blockchains – and why their use is exploding. Look at Circle’s USD Coin, which took just 18 months to grow from a market cap of $1 billion to over $52 billion.

For an example of this trend, look no further than decentralized finance, or DeFi, markets.

In protocol lending, for example, borrowers lock volatile price cryptocurrencies into contracts that provide collateral — but they borrow stablecoins. The collateral must reach 150%, and even then, price fluctuations that cause smart contracts to liquidate the collateral are common.

This volatility shows why so-called utility tokens like Ethereum’s ether are ultimately too unstable price-wise for their intended use – as means of moving value and information across blockchains. (And why the SEC calls almost all securities cryptocurrencies.)

So where did CBDCs come from as a digital dollar or digital yuan?

The only way smart contract-based commerce works on blockchain will eventually require the use of a price-stable currency.

Right now, stablecoins are the only game in town. And since every major economy except China is at least a year or two away from building a CBDC capable of doing this job – and that’s only if they’ve made the decision to launch a CBDC, which neither the US nor the EU has – stablecoins will have plenty of time to establish their role in the next generation of commerce.

Which would leave fiat little use other than as a peg to make stablecoins stable – at retail or wholesale.

And that’s why central banks are increasingly interested in CBDCs – they offer a way to avoid the challenge of stablecoins.

That’s why central banks saw such a threat in the Libra/Diem stablecoin: it wasn’t just that stablecoins could bypass fiat, it was that with 2.3 billion users, Meta’s stablecoin wouldn’t have given them time to build a competitor.

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