Introduction to Stablecoins, Payment Ramps, & Transparent Donations Pt. 3

Stablecoins & Central Banks

Note: This several part series is the result of a paper I wrote in January 2019. Rather than publish it, I thought it’d be most helpful to break things down and share it with the broader crypto-community. You can find the long form PDF version of the paper here and each part here:

1. The Problem of Social Sector Transparency and an Introduction to Stablecoins (Pt. 1)
2. Stablecoin Market Trends & Societal Obstacles the Present (Pt. 2)
3. Stablecoins & Central Banks (Pt. 3)
4. Stablecoins & Fiat-Crypto Payment Ramos (Pt. 4)
5. Stablecoins & Improving Donation Transparency (Pt. 5)

TLDR

• ‘Central bank digital currencies’ = CBDC’s
• Many CBDC’s, utilize a liability-collateralized model, in which the digital currency is not fiat-backed with the funds from the bank’s reserve, but rather collateralized with the liabilities that the bank holds (i.e. loans)
• There are four core principles, according to central banks, that a stablecoin must follow
• Download the full paper here

Stablecoins & Central Banks

“Money is not an invention of the state. It is not the product of a legislative act. Even the sanction of political authority is not necessary for its existence. Certain commodities came to be money quite naturally, as the result of economic relationships that were independent of the power of the state.” ― Carl Menger

Outside of the implementation of stablecoins within the open source blockchain ecosystem, central banks across Europe are investigating models to develop their own digital currencies. Many so called ‘central bank digital currencies,’ or CBDC’s, utilize a liability-collateralized model, in which the digital currency is not fiat-backed with the funds from the bank’s reserve, but rather collateralized with the liabilities that the bank holds (i.e. loans).
CBDC’s are defined as electronic central bank money that (i) can be accessed more broadly than reserves, (ii) potentially has much greater functionality for retail transactions than cash, (iii) has a separate operational structure to other forms of central bank money, allowing it to potentially serve a different core purpose, and (iv) can be interest bearing, under realistic assumptions paying a rate that would be different to the rate on reserves. Let’s take a look at each core principle of developing a sustainable CBDC, as designates by central banks:

1. The first core principle is that the interest rate paid on CBDC should be adjustable. This allows the market for CBDC to clear without a need for either large balance sheet adjustments or movements in the general price level.
2. The second core principle is that CBDC should be distinct from reserves, with the central bank not exchanging reserves for CBDC. The policy addresses the risk of a ‘run by the back door’, whereby a single bank’s commitment to issue CBDC in exchange for bank deposits, together with its commitment to settle interbank payment in reserves, could in the absence of this condition facilitate a rundown in aggregate reserves and deposits when bank customers seek to switch into CBDC. This core principle also enables the central bank to retain control over the quantity of reserves in the financial system, which has traditionally been a key mechanism through which central banks control policy rates.
3. The third core principle is that commercial banks should never have an obligation to convert deposits into CBDC on demand. Requiring banks to convert deposits to CBDC on demand opens the door to runs on the aggregate banking system. These runs could be much faster and at larger scale than in the current system, where cash is the only central bank money available to depositors. In such a scenario, there could be substantial operational and political economy barriers to the central bank providing sufficient market-stabilizing liquidity support.
4. The fourth core principle, which complements the second and third principle, is that the central bank only issues CBDC against eligible assets, principally government securities but with the definition of eligible assets at the central bank’s discretion. This conforms to current practice for the issuance of central bank money, and is therefore conservative rather than radical. What would truly be radical, and highly undesirable, is guaranteed issuance against bank deposits, which would amount to a guarantee of automatic unsecured lending to banks.

Considerations Developing a Central Bank Digital Currency

There are many considerations to make when developing a CBDC, including potential liquidity attack vectors (i.e. a runs on the aggregate banking system), models for CBDC access to institutions and retail consumers, and interoperability with other CBDCs in foreign nations. The due diligence from these considerations alone are cause for in-depth simulation analysis, model iteration, and sandbox experimentation to see if a CBDC can be sustainably leveraged in practice. The choice of underlying blockchain or distributed ledger technology is another consideration that cannot be taken lightly. Private blockchains are more easily corruptible if their respective network size is small. Rather, banks should develop consortium blockchain networks in which multiple CBDCs can be recognized, settled, and regulated. Monetary policies should be put in place to ensure that rural banks have equal access to become consortium members just as much as their municipal bank counterparts to ensure that such collaborative efforts result in increased financial access for marginalized communities.

Next: Stablecoins and Central Banks

Next, we dive into the need for fiat-to-crypto payment ramps to achieve mainstream adoption of crypto-markets and the more regular use of cryptocurrencies to enhance modern-day solutions.

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I commonly write about crypto-economics and blockchain technology with a social impact focus, though I often times stray into lower-level, more technical analyses as well!