A Deeper Exploration of the Future of CBDCs (Pt. 2)
What are the interests of financial institutions and can stablecoins co-exist with CBDCs?
In the part of the world where I am from, we are celebrating our second New Year festivities. Happy Lunar New Year 🌝 🐇 for those who celebrate it and even for those who don’t, what a great excuse to eat a lot of good food and send some warmth to your loved ones (again).
The festivities came in a timely moment because before I let this slip I am dedicating some quality time to plow through my CBDC research. In case you missed Part 1 of my CBDC series, here is the link.
Let’s dive back in.
While continuing my research about CBDCs, I stumbled upon Bank of America’s latest report which stated that “central banks and governments will be at the forefront of driving the digital asset revolution”.
Would you agree?
According to the research from BoA, “CBDCs and stablecoins are the natural evolution of money and payments.” Alkesh Shah, Global Crypto, and Digital Asset Strategist at BoA said that CBDCs have, “the potential to revolutionize global financial systems.”
For those who are not aware, Bank of America is ranked #2 in the Top Biggest US Banks by Assets, with a balance sheet of $2.41 Trillion. To give you a reference on how big this American bank is, hence how influential it is, France’s nominal GDP is $2.63 Trillion. 👀
Here is a Twitter 🧵 exploring BoA’s recent statement:
The World Economic Forum’s Annual Meeting was taking place in Davos, Switzerland last week. Thus, the timing of when the report came out was perfect since a key agenda from last year has been digital currencies.
Did Shah’s statement kindle a particular curiosity?
After seeing this statement, I started asking myself: why is the BoA being vocal about CBDCs and stablecoins suddenly?
I wanted to better understand BoA’s position in the up-and-coming landscape of CBDCs. Are they siding with the Fed? What are their vested interests in the creation of a digital dollar? What are the risk points they are considering in the design of the digital dollar?
It wasn’t hard to find an interview with the man himself. This one was conducted by Yahoo Finance roughly a year ago. (Yes, it’s from last year which translates to ages in crypto time but trust me this content is still relevant 😅) Start listening from the 1:14 time mark if you want to go directly to the grain.
Shah mentions how the Federal Reserve is going through a list of considerations before deploying the digital market in the real economy but that there are two main ones that he states as the top priority.
The number one consideration, he states, is privacy.
“If you have a digital currency running on the blockchain all of the transactions are available to be seen. In the case of the digital dollar, it won’t be open to everyone but the government will be able to see it and how we preserve the privacy of the citizens should be a priority.”
He continues by stating that the second most consideration point from the Fed’s perspective is ensuring that the current banking system continues to work as well as it does now.
“Banks take deposits, lend it out, (and by doing so) they help the economy grow. If the Federal Reserve releases a digital wallet to its digital dollar, then potentially some digital dollars could be transferred to that wallet and leave the banks. Although it might be relatively small, how this might affect the banks should be considered.”
For the second statement, he even suggests that commercial banks like BoA could be the intermediaries issuing the wallets and ‘holding the wallets’ (signs that he is suggesting a custodial wallet? or half-custodial wallet?). By BoA being the ones issuing the wallets for the digital dollar, he believes, that banks will not be affected by the new outflow of payments and liquidity.
(Wondering what the Bankless duo will say about banks becoming the issuers of CBDC wallets. Ryan and David, if you get to see this post please leave a comment.)
Isn’t it clear now why mega financial institutions from the private sector, like Bank of America, want to have a seat on the discussion table for the design and deployment of the digital dollar? 🫣
Co-existence of stablecoins and CBDCs
The question that I got asked the most after posting the prequel of this series was, ‘are CBDCs trying to replace stablecoins?’
If you were one of the friends who asked me this, kudos to you because that is one of, if not the main, questions we should ask ourselves critically. Because yes, in a world of fully regulated stablecoins why would we need CBDCs?
Despite the crypto market turmoil in 2022 (or maybe due to the turmoil), stablecoins set a new record total settlement volume of $7.4 T, beating major credit card providers such as Mastercard ($2.2 T) and American Express ($1 T). This volume is up more than 600% in two years.
This post is not meant to deep dive into stablecoins and how they are being regulated so instead I leave you a good resource: “Regulating the Crypto Ecosystem: The Case of Stablecoins and Arrangements.” (Having said this, if you are interested in a stablecoin deep dive for my next post, leave me a comment 👇🏻)
When the aforementioned question was asked to Prof. Raghuram G. Rajan from the University of Chicago Booth School of Business, he answered by saying that the Fed is not, at the moment, contemplating creating substitutes to substitutes like USDC because many of the private stablecoins have been born from the US or have US origin.
The main concern of the Fed, he states, is the stability issue because we can’t afford complete meltdowns of stablecoins. That is why the question of ‘what should be regulated and how much?’ arises. If it works like a bank and talks like a bank maybe it is a bank and it should be regulated like a bank. This also means that stablecoins should be FDIC (Federal Deposit Insurance Corporation)ensured and the Fed should be holding the deposits.
“The pressure of creating a digital USD is actually coming from other central banks like our Chinese counterpart with the digital Renminbi. Concerns of the Central Banks are: if we wait too long would the space be too crowded? If we wait on the sidelines too long, would the rules of the game be crafted by someone else?”
My personal highlight of this interview was when Prof. Rajan gives the stablecoins and narrow banking analogy. Below is the tl;dr.
The definition of narrow banking is a system of banking under which a bank places its funds in risk-free assets with a maturity period matching its liability maturity profile so that there is no problem relating to asset-liability mismatch and the quality of assets remains intact without leading to the emergence of sub-standard assets.
Does this ring a bell? 🔔
Just like narrow banks stablecoins raise money from depositors and place the reserves in multiple safe assets. In the case of USDC, 65% of that is in 12 US treasury bills. Therefore, stablecoins like USDC are not in the business of lending but in the business of payments, he said.
Thus, the Fed might be happy if stablecoins promise a nicely structured narrow banking structure and stick to a pure payment function.
Stablecoins theoretically could earn large sums of money by (a) processing payment fees and (b) the spread between the deposit rate and the treasuries. Under these interest rate environments, it makes it perfectly feasible to create that type of stablecoin and allow the positive spread to finance all the other stuff the operator of the stablecoin wants to do.
But then, would the Fed be okay with stablecoins holding billions of dollars in US treasuries? What if there is a bank run?
Let’s say there is a $1.4 B-alike wipe of 2022 from the crypto market and there is a train of redemptions and stablecoins are forced to sell a whole bunch of US treasuries in a short period. This might sound alarming because as stated above we are talking about trillions of dollars worth. However, if stablecoins are well-regulated, as Prof. Rajan states, regulators should be advising to hold really short-term treasuries to hedge the duration risk.
If there is a run on the short-term treasuries, then the capital market will correct itself because ultimately the face value of the treasury is guaranteed by the United States government. But if the stablecoin reserves end up holding longer duration treasury bonds (30-year or 10-year) then this might raise a similar problem to what happened in the UK with pension funds dumping billions of pounds worth of assets.
And if you have been following the macroeconomic news from the UK, this dumping pushed up the treasury yields.
If this is the case, the asset holdings of the stablecoins will be susceptible to government policy which adds another layer of unwanted risk to the sustainability of the stablecoins.
Going back to the case of USDC case, you should understand now why they have invested 65% of their reserves in T-Bills (13 weeks, 26 weeks, and a year) rather than treasury notes or bonds.
Final thoughts: We are not done yet with this series. Clearly, there is an elephant in the room. I need to explore the dark side of CBDCs and why some believe it is a threat to our freedom. Stay tuned for Part 3…
I am still learning and building my knowledge and network in Web3, and I would welcome the opportunity to connect with more people in the space. If you are building in Web3 or have feedback on this piece, please reach out by Twitter (@minchi_p) or LinkedIn 🙋🏻♀️
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