A Path of Challenges: Will CBDCs Prevail Over Private Blockchains?

Real innovations and breakthroughs don’t happen in the blink of an eye. Bitcoin (BTC) took many years to get to mainstream users since its inception in 2009. The bull market run in 2017 drastically improved crypto market volumes, but institutions still regarded it as another “dot com” bubble.

Later, when distributed ledger technology, or DLT, was more widely accepted, a new type of digital asset aimed at bringing stability to the crypto market gained full recognition. Stablecoins had been (and still are) issued by private firms, but many failed to operate successfully for various reasons in 2020.

Now, governments are exploring ways to not lose their grip on global finance via technology, developing stablecoins and central bank digital currencies, or CBDCs. What will prevail over time, private initiatives or state?

Trusting the blockchain

The latest research from Big Four audit firm Deloitte indicates that nearly 40% of the firms surveyed have already implemented blockchain in their business ventures. However, the commercially viable immutability of DLT has both pros and cons. An evident benefit with this technology is that no one can retroactively forge crucial data or alter vital information. Blockchain is a perfect demonstration of the trust quantification model gone live.

As to the tech’s downsides, even parties who can’t afford any chance of error still make mistakes from time to time: judges, prosecutors as well as various governmental bodies at large. Moreover, all the official services or banking structures experience certain issues and database errors, which they often try to cover up. The blockchain has no preferences, as no user is able to change data or record there, and making a mistake would bring more negative consequences than ever before. 

Benefits of stablecoins

Stablecoins’ benefits create significant room for these assets in financial systems. Clients would get faster transactions with lower costs and improved security of their payment systems. Credit risk would also be stabilized. Moreover, simplified cross-border transfers would further drive global financial market development, resulting in a significant decrease in the number of shadow operations. Cash will become obsolete as soon as digital assets are transformed into mainstream and primary methods of payments. The COVID-19 pandemic only incentivized the transition to a cashless society and further discussions about stablecoins and CBDC models, but people’s trust for the technology can’t be built in a day.

At the same time, a disruption of traditional banking may result in the loss of competitiveness among digital payment systems, with increased Anti-Money Laundering and Know Your Customer measures implemented into financial activities likely hampering the way companies do business. Finally, the involvement of the state in technological implementation disrupts the initial vital aspect of Bitcoin and cryptocurrencies — decentralization.

A stablecoin on a public blockchain frees the system from mandatory AML checks for each transaction. Excessive regulation and globalization have made the supervision function of the payment intermediary totally commercially unprofitable. The risks and potential fines that banks must pay in the event of a money-laundering scandal strongly outweigh the benefits of processing some payments. Since the regulation field has become much more complicated over the past 20 years, banks’ response to this trend is simply denying economic agents the constitutional right to move their honestly earned money and acquire goods or services globally. It is cheaper for a bank to refuse a transaction than to spend resources understanding the details. Therefore, one of the functionalities of stablecoins is their AML-free layer.

From private to official level

Since the United States Securities and Exchange Commission, among other watchdogs, went on high alert lately, things promise to get hot in the legal field. After the decay of Telegram’s TON and many ongoing problems for Facebook’s Libra ecosystem, it became evident that private companies will face countless challenges in the future. Is there a way for Libra and global stablecoins to survive in 2020 and beyond?

The chances are high, but only if they won’t mix different monetary policies of the U.S. dollar and euro zones. Why? The primary target for the Federal Reserve is unemployment, while for the European Central Bank, it is price stability. Going back in history to 2008, the Fed lowered interest rates, while the ECB, in turn, raised them.

Meanwhile, the topic of central bank digital currencies has been of major interest as stablecoins gained more popularity in the crypto world. Even before the notorious winter of 2019 occurred, more and more market participants and institutional clients became excited about the stablecoin’s model benefits. World governments and large companies surely noticed the trend and started to experiment in this area, but there had never been any common direction to follow.

What is the main challenge of creating a CBDC? Misconceptions about it have only increased, despite numerous discussions, conferences and articles written on the topic.

Nothing is arcane about the idea, but the global perception is a bit misguided, since a clear point of view must be taken to understand the CBDC model differences. From a technical, architectural point of view, there are two models: a wholesale CBDC in which central bank reserves can only be accessed and used by a small number of certain financial institutions, or a retail CBDC model in which non-banking institutions can get direct access to digital central bank funds. Many economists and central banks do not support any idea of a universally accessible digital central bank currency. The critical stumbling stone here is that CBDC implementation will result in financial instability and even worse consequences for commercial banks.

There are numerous reasons behind the slow pace of crypto acceptance in the world. The whole story is quite the same as with video streaming back in the 90s: Emerging technologies are developing faster than the actual market or the target audience is ready. Infrastructure is of critical importance. In Europe, for example, countries such as Greece and Italy need to install the needed tech infrastructure fast so that users can pay for goods or services if crypto goes mainstream.

To gain needed access to the markets and financial services of the crypto industry, the problem of institutional and technological capacity first needs to be solved, but this is unlikely to happen in the near future due to a lack of required infrastructure. It is still unclear when blockchain will scale adequately and whether CBDCs should run on a permissionless one.

Unraveling the set of global questions

What is the leading digital currency of the future? Is it digital dollar or digital euro? Or digital yuan, perhaps, as China is currently spearheading this direction. Moreover, the latest news suggests that the Italian Banking Association is also willing to pilot a digital euro. Japan has also joined the club of countries willing to research and experiment with a CBDC.

Why are we seeing so much talk and no walk so far? Apart from China, where the digital yuan has made its way from concept to development quite fast, many other government initiatives are often discussed, but no real project by central banks has made its way towards launch. Stablecoins are true die-hard assets of crypto, as out of hundreds of privately run projects, only a few have survived and continued operations in 2020 — Tether (USDT), TrueUSD (TUSD), Paxos (PAX) and EURS.

After all, all bets are on for the euro, ultimately. Macro-wise, it’s the only freely convertible currency with almost 500 million of natural populations and a positive current account.

Judging by today’s perspective, CBDCs will likely follow a wholesale variant route, which will cut off its accessibility for the retail segment. But there is still a piece of pie for private companies: The imminent launch of wholesale CBDCs and their further existence will not likely hamper the popularity of leading stablecoins.

However, a survey made by the Bank for International Settlements clearly indicates that we can expect central banks to issue a retail CBDC within the next few years. Introducing such a retail CBDC poses risks for the data privacy of clients and for financial stability. If retail CBDCs ever become a reality, the commercial banks will suffer heavy losses, since people will run to withdraw their deposits and move it to the central bank accounts. What’s the point of holding savings with commercial institutions that have their own credit risk and are fractionally reserved?

Will such a solution prevail over private projects like Tether at some point? If implemented successfully, it will be inaccessible to the general public, but rather become a wholesale asset invisible to John Citizen. Can CBDCs kill Bitcoin and other cryptos if launched successfully? Of course not, since the money supply policy will be completely different. Bitcoin supply is like digital gold, capped at 21 million, while CBDCs or stablecoins will closely correlate to the M2 money supply.

The competition between various models will ultimately determine the winner. But the legalization of stablecoins for private companies is crucial now, as allowing them to have a legal account in a state bank or government bonds will widen the market and ultimately benefit the development of the next stage of the digital economy.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.