Will CBDCs solve crypto’s problems? Or make traditional finance even worse?

Chris Middleton Profile picture for user cmiddleton May 20, 2022 Audio mode
Summary:
Grappling with the big digital questions in the world of money – that thing that fewer and fewer people have much of. We assess the role of cryptocurrencies in a world of CBDCs.

An image of some bitcoins over an image of the earth
(Image by Tamim Tarin from Pixabay )

As we all know, events earlier this month shook the world of cryptocurrencies, stablecoins, and decentralised finance (DeFi) to their silicon cores. Billions of dollars were wiped off the values of many popular coins, reversing a year of gains. Many investors have been licking their wounds ever since.

Meanwhile, the cost of energy has soared, so mining for coins has become much more expensive, which makes establishing their true value harder. (Laptop running hotter than usual? Perhaps you’ve been cryptojacked, but there’s good news: at least you can switch off your radiator.)

As previously reported, even some stablecoins – tokens supposedly immune from rollercoaster changes in price – were affected by the shakedown. Since 9 May, one stablecoin, UST, has lost nearly 100 percent of its value, falling from its dollar peg and tumbling to a low of $0.074.

Another, Tether – still the world’s third most popular token after Bitcoin and Ethereum – also lost its one-to-one dollar peg and has been trading in the high nineties (cents) since. This is significant, as theoretically, Tether is backed by equivalent real-world assets rather than an algorithmic balancing act, though the precise nature of those assets remains opaque – like so much in the DeFi realm of promised, blockchain-backed clarity.

But not everything in the complex world of DeFi has been calamitous. According to Coinmarketcap.com, there are currently 10,080 different digital tokens available for trading or use, with some making huge gains at the time of writing. For example, Nekocoin has increased in value by over 1,700% in the past 24 hours, while another, MetaPay (the Facebook-baiting coin of the Metaxion virtual universe), has increased by over 1,500%.

At the time of writing, 15 coins have increased in price by over 100% in the past 24 hours, while 30 have soared by over 60%. It’s likely that investors are looking for relatively obscure tokens that offer the promise of huge gains.

For example, a single Neko may have exploded in value, but (at the time of writing) is still only worth $0.00000000077. A cynic might say that Elon Musk should buy some booming coin or other, tweet about it to his millions of acolytes on that platform he not-quite owns, and thus make enough real money to build another fleet of space rockets. And guess what? Somehow that would be legal. (Got any Doge, Elon?)

While all of this is going on, nations are debating whether increased regulation of the crypto and DeFi space is now essential, given its increasingly complex links with traditional finance. After all, asset- or fiat-backed stablecoins are essentially hedge funds, and you must be hoping that your bank didn’t invest your wages in UST a fortnight ago.

The real-world economy is on a knife edge without crypto’s instability: inflation is soaring, a full-blown recession is possible in many countries, and the system that evangelists claim is here to replace it turns out to be a Wild West (and East) of empty promises, industrial-scale BS, money laundering, and high-risk speculation from gamblers claiming to be the people’s champions. High fives all round!

The role of cryptocurrencies in a CBDC world

Meanwhile, most nations are also debating the launch of central bank digital currencies (CBDCs) – stablecoin versions of traditional currencies. There are many reasons for doing so. One is that China is already further down this road than anyone with the limited launch of the digital yuan. This is significant, because if the world’s second-largest economy obliges other nations to use the digital yuan to trade with it – for all those cheap goods, tech components, and outsourcing services that multinationals rely on – then this may begin to encroach on the dollar’s primacy as the world’s main reserve currency.

Other claimed pros for CBDCs include potentially faster and cheaper money transfers, greater financial inclusion (including among the unbanked), programmable transactions, simpler cross-border trading, better fraud protection, and a viable alternative to cash – assuming you have a phone.

Potential cons include higher costs than efficiency gains, economic paternalism, increased surveillance and privacy intrusions, greater exclusion for those who remain offline, and overall risks to financial stability. It’s also likely that private companies, such as FinTechs and IT service providers, would become tightly intertwined with national currencies, which may make both traditionalists and fans of alternative finance uncomfortable.

The US, UK, and the European Union are among the many actively pursuing CBDC programmes via working groups and alliances, with likely timescales of five to seven years for their adoption – years in which China will retain its first-mover advantage.

All of this begs an interesting question: fast-forward to 2030 when the digital dollar, the BritCoin, the e-uro (apologies), and other CBDCs are now in circulation. What would be the point of those 10,000+ cryptocurrencies and other digital coins, beyond being the tokens of proprietary metaverses, perhaps? Will they just be the pet names given to binary processes that people huddled around mining rigs for warmth in Putin’s nuclear winter hope will pay for a $10,000 tin of beans? Will each be anything more than a favourite slot machine?

In short, will CBDCs do all the things that cryptocurrencies are supposed to do, but minus the risk? But plus all the traditional finance problems of corruption, insider trading, state control, and lack of trust in central banks that DeFi evangelists claim they are trying to solve? (If we ignore multibillionaires being able to tweet up their wealth, obviously.)

What’s your worldview? 

I put this question to a panel of finance experts at a Westminster eForum this week on DeFi and CBDC policy. At present, many crypto tokens fulfill useful payment systems roles that other methods are too slow or expensive to provide. But what about the future? What would the point be of crypto in a CBDC world?

The answer is that this is far from a debate about empirical pros and cons. It comes down to your prevailing worldview. Jarome Ajdenbaum is VP of Cryptocurrencies and Digital Currencies at France-based identity tech provider IDEMIA, and author of the book Who Will Win the Cryptocurrency War? He said:

Why would we need cryptocurrencies if we have a CBDC? This is a fascinating question. I believe the answer is really, where are you speaking from? If today, you are a true believer in Bitcoin, a Bitcoin maximalist, then you will say that a CBDC is crap, because you cannot trust a central bank.

Don't forget that in the very first block of Bitcoin Satoshi Nakamoto wrote a manifesto showing his distrust in central banks. So, from the beginning, this was a very political concept. There is a political claim to be independent, to create money without authority.

But if you are a stablecoin believer, then you believe in the private sector. You are saying you believe that the private sector is better placed to issue money, by making it simple to issue currency. For example, Facebook, though their project is now scrapped, launched a very important stablecoin initiative [Libra, later Diem, was a permission-based stablecoin backed by a consortium, including Meta]. So, if you're on that side, you believe that the private sector has the key to everything.

And finally, if you believe the government should offer currency and have a central bank, then you believe that the public sector should be responsible for controlling money, for it to be trusted. In the US, for example, there is now a very clear split between Republicans, who are pro stablecoins, and the Democrats who are opposed to them. I believe we will, at least for a certain time, live with different visions, with different populations supporting different options.

Ganesh Viswanath-Natraj, is Assistant Professor of Finance, Warwick Business School. He said:

I agree that, in principle, a fed coin that operates on the blockchain would be dominant over other stablecoins. But I think there are lots of technical hurdles, because the Federal Reserve would still have to control supply of the coin, but then at the same time, it would need to be programmable.

Worldviews aside, how many years out are we from having an international system of interoperable CBDCs that allow fast, seamless cross-border payments? Kunal Jhanji, Managing Director and Partner at Boston Consulting Group, said:

In the absence of last week's events, I would have said three to five years max. But now, I would say anywhere from five to eight years, but I think probably more at the five-year end. Because recent events have had two different outcomes. One is that the regulators are becoming concerned that they need to act, so the speed may accelerate to drive a CBDC outcome.

But on the other hand, they're also saying there is a lot of risk to be considered, so we should slow down our response. That's the balance. You will see the regulators, central banks, and policymakers all trying to find the answer. But last week's events have certainly driven the conversation in the CBDC space quite actively, because the central authorities now want to play a role to minimize risks to the market and to consumers.

Viswanath-Natraj added:

I think that regulation of the crypto sector will come first, before a multi-country CBDC system, which is probably the end goal. But I think a lot of the push in the CBDC area is China trying to increase their role as a reserve currency.

If there's a lot of competition from China, then that could, in turn, lead other advanced countries like the UK and US to pursue their own CBDCs. But yeah, crypto regulation will come first, followed by CBDCs in response to this political economy.

My take

The challenge facing crypto evangelists is that, for all their undoubted innovation in FinTech, cross-border trading, technology, and competition, the very instability, corruption, and opaqueness of the system they propose to sweep aside instability, corruption, and opaqueness in traditional finance has now caught the regulators’ eyes worldwide.

Authorities want to step in and prevent harm to consumers. After all, harm to consumers is what traditional finance is now doing. They don’t want any upstarts stealing their thunder.

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