Stablecoins vs CBDCs: How Will Nation States Adopt This Technology?

???????????As much as many would love for cryptocurrencies to become a mainstream financial platform, transitioning into such a world is difficult. Due to the many overlapping areas of CeFi and DeFi, the centralized nature of CeFi, and the global, consensus-based nature of DeFi, the two systems are not natively compatible. Thus, years of development are needed for it to be ready for the mainstream in terms of scaling, education, and security. One of the largest overlaps with the most issues in terms of regulation is stablecoins, because they act like banks but are not regulated as such. The Fed has the jurisdiction to regulate an asset that represents the world reserve currency 1:1. Thus, as the crypto space evolves, especially in terms of stablecoins, I see two different approaches in terms of the evolution of digital assets representing the USD. These consist of the Fed issuing a CBDC to supplement cash and coexist with regulated stablecoins, or more likely, the Fed skipping a CBDC entirely and regulating stablecoins in a uniform manner.

???????????The United States has several incentives for implementing a CBDC, whether it’s on a government-created, permissioned, KYC network, or less likely, on an existing network. A CBDC would improve access to a variety of financial services for all Americans. According to the Federal Reserve, over 5% of US households remain unbanked, and nearly 20% are underbanked. A uniform, fast, and low-cost platform for exchange would be immensely useful in terms of more effectively providing these services. Additionally, international payments have been historically difficult to make due to various conflicts between jurisdictions. The mechanics of forex, infrastructure differences, time zones, and the coordination of intermediaries result in high fees and long settlement times. This results in limited access to international payments or remittances for consumers and smaller businesses, which slows economic growth, ecommerce, and globalization. The condensing of intermediaries in the form of a CBDC would allow for easier coordination with other legal jurisdictions to facilitate international payments or remittances. A CBDC, depending on the network on which it’s issued, would also help the government monitor transactions and augment AML and CFT efforts with KYC requirements. It would also allow for the government to easily manage monetary policy, collect taxes, distribute tax refunds, and conduct “airdrops” for citizens, like what was done during the pandemic, but more efficiently.

In the face of other CBDCs like that of China, it would allow the United States to preserve the global reserve currency status of the USD while the usage of cash continues to decrease worldwide. However, due to the immutable and permissionless nature of blockchain technology, it will be nearly impossible to get rid of or ban the usage of stablecoins and DeFi in the US. There is the potential for the coexistence of TradFi and DeFi, with the usage of a CBDC as a supplement to cash and a bridge between the two systems. Currently, an ecosystem like this would cater to two different types of people. A CBDC and the TradFi system would have safety on its side for consumers. KYC and centralization as of now result in a more forgiving system in which user errors are tolerated and corrected, liquidity and stability are ensured to a higher degree, and deposits are insured. The current DeFi system would appeal to those who are comfortable with risks, are knowledgeable of the system, and value decentralization and trustlessness more than a safety net. Of course, in this scenario, the regulation of stablecoins would still be necessary. A CBDC could overcomplicate things versus just regulating stablecoins, as bad actors would just default to the DeFi space and skip the KYC requirements of a CBDC. A CBDC in comparison to that of China could also be viewed in a bad light by the public, as distrust in data monitoring and institutions is at an all-time high.

???????????Stablecoins have similar strengths and use cases to those of a CBDC in terms of accessibility, scalability, and lessening of international payment frictions. However, due to being located on a public blockchain network, they are much more difficult for a government to monitor and regulate, which has some risks associated with it. The lack of KYC and AML requirements results in a higher risk for crime to be conducted on the network. To counter this, I see the government developing software that scans block explorers and aggregates KYC data from CEXes and other KYC touchpoints to track suspicious activity. Additionally, one of the largest issues that comes with stablecoins is that they act like banks without being regulated as one. Every stablecoin is different, but some pose great risk due to not being transparent with their reserves. The most notable example of this is Tether. Almost 85% of their reserves are backed by “cash & cash equivalents & other short-term deposits & commercial paper”. With such a wide range of risk, lumping these assets together is very concerning. Other stablecoins like DAI are not backed completely by USD as the US government would wish, but the reserves mostly consist of ether, and its total value can be verified via a smart contract, providing transparency.

As we have seen recently in the Lummis-Gillibrand bill, there is high potential for the government to require a stablecoin issuer to undergo a registration process, require a reserve audit and be 100% backed by pre-approved assets, and potentially limit supply schedules as pseudo-bank regulations. Despite the risks that stablecoins pose, they do provide a relatively frictionless and transparent payment network. A global network like Ethereum proves to have a huge advantage over CBDCs, as they do not have to deal with intermediaries by nature. This facilitates international payments, and in conjunction with scaling solutions, does so in a very fast, cheap, and efficient way with minimal cross-border friction. DEXes prove to be powerful tools and have a massive use case for companies and individuals worldwide, avoiding a cumbersome order-book system. Thus, it’s much easier to exchange to a foreign stablecoin such as EURT or JPYT, remit earnings with reduced quote uncertainty, and give users another option to earn yield on pairs via liquidity pools besides a traditional savings account. With L2 scaling, the decentralized, global platform of Ethereum, alongside others, provides quick, easy, and cheap methods for sending money to people across the world without having to deal with conflicting intermediaries.

Another advantage that stablecoins and DeFi have over TradFi is the ability to obtain better interest rates than one would be able to in their home country. Yield farming can be a great tool, especially compared to things like a traditional savings account which offer very lower interest rates. However, these varied rates and unregulated looping systems also make it possible to use incredible amounts of leverage. While it is the investors’ right to be able to use this leverage, especially under a decentralized system, it can pose risks to the financial system. Thus, it’s important to regulate stablecoin leverage and collateralized loans to prevent liquidation spirals, like what Regulation T has done. Stablecoin lending protocols like Abracadabra could fall under the Fed’s jurisdiction as a “stablecoin arrangement”, allowing restriction of LTV ratios based on the volatility of a collateralized asset. Excessive leveraged yielding positions could possibly be prevented by reviewing block explorer data to see if coins being inputted into a stablecoin arrangement resulted from repeated swaps into a Yearn vault.

Overall, stablecoins provide many use cases, and they are such an integral part of the DeFi world. Although, as we have seen with recent developments like the UST/Luna implosion, the ecosystem is very young and is still experimenting with different solutions to the stability and scalability trade offs. Stablecoins are nearly impossible to get rid of at this point, so a uniformly regulated environment would prove to be beneficial for the US government and its citizens, providing people the freedom to choose their preferred financial system.