Stablecoins and central bank digital currencies (CBDCs): the future of money

May 2022 | SPOTLIGHT | BANKING & FINANCE

Financier Worldwide Magazine

May 2022 Issue

When was the last time you paid for a purchase with paper currency or a cheque? Like so many other things, the future of money is digital. Digital fund transfers using credit and debit cards, automated clearing house (ACH) and other electronic fund transfers, online payment services like PayPal and peer-to-peer payment services like Venmo have surged in popularity during the coronavirus (COVID-19) pandemic.

At the same time, cryptocurrencies, and not only bitcoin, its most famous form, have also become more prevalent. Advocates like Elon Musk, the founder of Tesla, have accepted bitcoin in payment for products, and governmental officials like Ron DeSantis, governor of Florida, have promoted the acceptance of bitcoin in payment of taxes and other governmental charges. Concurrently, the adoption of decentralised finance (DeFi) protocols utilising self-executing ‘smart contracts’ on a blockchain network have made the use of private digital assets in commerce easier than ever.

Major economies such as Russia, India, Brazil, China and the US have taken note of the growth in the digitalisation of financial assets and are either in the process of implementing, or in the case of the US, placing the “highest urgency” on further research into, a central bank digital currency (CBDC), potentially pre-empting the market for private blockchain-based payment systems.

The world of international finance is on the precipice of change, a conceptual rethinking of the basics of finance not seen since the abandonment of the gold standard following World War II.

The key element of this new financial system is the digital decentralisation of currency as a unit of value. However, cryptocurrencies, such as bitcoin are notoriously volatile in value, which make their use as a medium for payment, readily convertible into a fiat currency, problematic.

Stablecoins are a non-governmental solution to this conundrum. Stablecoins are a digital asset having a value pegged to a currency or asset class less susceptible to volatile swings in valuation, such as a fiat currency like the US dollar. The total market cap of stablecoins reached about $180bn by the end of February 2022 versus about $38bn a year ago, according to Coin Metrics/The Block.

Stablecoins fix their price 1:1 to the value of an underlying financial asset with the most popular stablecoins being Tether, which has a market cap of about $80bn and is available on 428 exchanges, USD Coin, which has a market cap of about $43bn and is available on 294 exchanges, and Binance USD, which has a market cap of about $15bn and is available on 103 exchanges, but with special trading privileges on its native exchange Binance, each fixed to the US dollar. These are known as custodial stablecoins. In the case of custodial stablecoins, a financial organisation holds dollars in an amount equal to the putative value of the stablecoins. Algorithmic stablecoins use a range of blockchain-based mechanisms to maintain their fixed price. TerraUSD, which is valued at about $9.2bn and is available on 21 exchanges, is an example of an algorithmic stablecoin. TerraUSD uses Terra’s Anchor Protocol to generate 20 percent annual interest. Collateralised stablecoins use ‘smart contracts’ to procure other crypto assets as collateral for loans. From these transactions, structured as loans, automated programmes embedded in smart contracts generate new stablecoins and in this way maintain price stability to the underlying asset. Dai, which has a market cap of about $9bn and is available on 221 exchanges, is an example of a collateralised stablecoin.

To date, stablecoins have been used primarily to facilitate trading, lending or borrowing of other digital assets, predominantly on or through digital trading platforms, generally avoiding the fees associated with conversion into fiat currencies. Stablecoin evangelists preach the merits of stablecoins as a faster, more efficient, and more inclusive payment option.

Widespread adoption of stablecoins has been tempered by concerns about risks regarding market integrity, investor protection from fraud and misconduct in digital trading, privacy and cyber security risks, insider trading, and front running (trading by a broker ahead of a client trade), as well as a lack of trading or price transparency. Tether has been particularly opaque, refusing to provide audits of its custodial accounts, and triggering regulatory ire and fines from the State of New York. In February 2021, Tether, along with the affiliated exchange, Bitfinex, paid $18.5m in fines in a case involving the coverup of $850m in Tether’s stablecoins that went missing. Regulators are also concerned that the widespread adoption of trading in digital assets, particularly if leveraged, could pose risks to the broader financial system, and that digital asset trading platforms and other market participants may require regulation and supervision to foster access to stablecoins and liquidity in the stablecoin market.

Stablecoins also pose risks related to money laundering and the financing of terrorism, as well as the circumvention of financial sanctions against hostile nations.

On 1 November 2021, the President’s Working Group on Financial Markets, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency released a report on stablecoins. The report noted the potential benefits that stablecoins provide in the way of more efficient and inclusive payment options. However, the report’s primary focus was on the prudential risks presented by stablecoins and noted that only when stablecoins achieve confidence in their value, particularly during times of stress, will they become a reliable means of payment or store of value. The report also stated that consistent risk management standards are required to mitigate risks of failure across operations, including with respect to settlement and liquidity.

According to the report, regulatory gaps threatened the future of stablecoins. The report recommends that the US Congress fill these gaps by enacting legislation that would require issuers of stablecoins to be regulated generally in the same manner as banks, having their cryptocurrency and fiat currency deposits insured by the FDIC and providing access to services provided by the Federal Reserve, such as emergency liquidity. The report also notes that crypto ‘wallets’, which serve as de facto custodians of stablecoins, should be subject to federal oversight in the same way as custodians of securities, and stablecoin issuers should be subject to restrictions on affiliation with commercial entities and required to interoperate with other stablecoins, like the regulatory system governing currencies, securities and commodities.

What the report fails to do is take a stance on which agency should lead in regulating stablecoins or other cryptocurrencies. Potential candidates include the Securities and Exchange Commission (SEC), the Commodities Futures Trading Commission (CFTC), the Federal Reserve, the US Treasury and the Financial Stability Oversight Council. President Biden’s Executive Order issued on 9 March 2022, while helpful, provided no substantive guidance.

To address these concerns, in the US and elsewhere, regulators have utilised the traditional regulatory tools of enforcement and administrative fiat based on existing law and regulations, but this is only an interim approach. In a clarion call for change, the Executive Order looks to interagency cooperation and regulatory initiatives which can preserve US leadership in technology and finance and foster international cooperation and coordination of regulation of DeFi.

The Executive Order takes a balanced approach that recognises the risks and rewards of digital assets generally and of a CBDC domestically. By design, the Executive Order does not address or propose solutions to the important legal and regulatory issues presented by the growth of digital assets, including the need for clarity regarding the jurisdictional lines between US federal regulators, the role of state regulators and federal pre-emption, which are left to the results of the review mandated by the Executive Order and legislative action by the US Congress and regulatory action by the individual agencies.

The Executive Order’s focus is on consumer protection, financial stability, illicit activity, US competitiveness, financial inclusion and responsible innovation.

With respect to CBDCs, the Executive Order emphasises research and development (R&D) efforts into the design and deployment of a US CBDC, focusing on the importance of prioritising democratic values, including privacy, transparency, connectivity and interoperability. The Executive Order suggests that a CBDC’s supporting infrastructure could include both public and private sector participants, even if issued by a central bank. The report charges the Department of Treasury in consultation with other agencies to examine the potential implications of a CBDC for financial inclusion, the extent to which a foreign CBDC could displace existing currencies and alter the global payment system. Jerome Powell, chairman of the Federal Reserve, has said that the focus will be on how a potential US CBDC could improve on the US’s already effective payment system, not displace it, by creating a more efficient and inclusive system, while preserving and promoting important monetary policy, financial stability, consumer protection and legal and privacy considerations. The Fed is collaborating internationally in examining the impact of CBDCs with groups such as the Bank for International Settlements CBDC coalition.

The need to examine the possible creation of a CBDC having the full backing of the Federal Reserve, the US’s central bank, is urgent. As noted by the Atlantic Council, an independent think tank, a total of 87 countries are exploring issuing a CBDC as of March 2022, an increase from just 35 countries two years ago. Russia, China, South Korea and India have already launched pilot CBDC programmes, while nine countries, eight of which are located in the Caribbean, such as the Bahamas’ Sand Dollar, plus Nigeria, have already launched a CBDC.

CBDCs will be built on distributed ledger technology but are a permissioned blockchain, where a central governmental monetary authority controls access to the blockchain. CBDCs are the final payment and eliminate the risk of settlement in the financial system. They are a store of value which transfers value from one entity to another. CBDCs hold the potential to make the flow of funds easier, safer and cheaper.

Robert C. Brighton, Jr is a shareholder at Becker & Poliakoff. He can be contacted on +1 (954) 985 4178 or by email: rbrighton@beckerlawyers.com.

Robert C. Brighton, Jr

Becker & Poliakoff