Introduction to Money, Cryptocurrencies, CBDCs, and Stablecoins
Mohammad (Mo) Zia* and Nathan Truong**
“The quickest way to double your money is to fold it in half and put it in your back pocket.”
Earning money is one of the most common challenges we all share. We are constantly exposed to new ways of earning, saving, and managing our money. Money helps channel goods and services and fuel our economy. It also plays an important role in shaping decisions and priorities and can impact our ability to navigate social groups. But when most of us think of money, paper money comes to mind. Why don’t we use gold anymore or other physical objects? What about digital payments? And where do cryptocurrencies, CBDCs, and Stablecoins fit in?
I. Why do we use paper money?
Let’s explore these questions with the example of Manny, an apple farmer.
Manny lives in a small city without any formal currency to exchange goods. Along with his neighbors, he needs to come up with a way to match the demand for the goods/services everyone is producing with the supply available. They turn first to barter, a system where neighbors directly exchange goods/services. Based on this barter system, Manny was able to get a new pair of comfortable shoes after a long season of harvesting apples. He took a few shirts he didn’t wear anymore to the market with the hopes of exchanging them for a pair of shoes that could weather the next season of apple farming. After finding shoes he liked, Manny and the shoe vendor had to figure out how many shirts and what type of shirts would be an agreeable value to exchange for the shoes.
As Manny grew older, society advanced and became more interconnected; barter, as a result, became an inefficient system of exchange. Manny’s neighbors didn’t always want his old shirts. They needed a new medium of exchange that everyone would accept that could expand trade in Manny’s town and with other towns. They needed a form of exchange that is durable, portable, divisible, limited in supply, and widely accepted. They needed to develop money.
Manny and his neighbors decided that apples would become this new medium of exchange.
Manny was very excited since he could literally grow money on trees!
Unfortunate for Manny, apples didn’t last long as a form of money. Apples become rotten after a certain amount of time so they aren’t very durable. Apples are also heavy so they aren’t very portable. Imagine buying an expensive house with apples. Transferring a payment in apples across mountains, rivers, or the ocean would prove to be very difficult.
Divisibility is another challenge. We could theoretically determine exactly how much each type or size of apple is worth but this would become more and more complicated with varieties of apples and debates on exact divisibility of each of these varieties. As we mentioned before, apples grow on trees so their supply is more difficult to control. Theoretically, anyone could start growing their own money and eventually apples would lose their value as apple supply overtakes the supply of available goods and services. We would also have to convince everyone in our society that apples have value and are a legitimate form of exchange.
II. Coin and Paper Money: From 600 BC to the 21st Century
The example above highlights several challenges that led societies to turn first to coins and later to paper money. Historians believe that coin money originated in modern day Greece around 600 BC. Coins can be heavy and aren’t the most portable form of money so soon societies added an even more portable option — paper money. Historians believe that paper money originated in China around 997–1022 CE during the reign of Emperor Zhenzong. Over five hundred years later, paper money reached Europe and by the 18th and 19th century, paper money became widely used. People turned to paper money because of its durability, divisibility, portability, supply controls, and wide acceptance. For a millennium, paper money has been widely accepted as a form of exchange.
We consider modern day paper money or cash to be fiat money, currency that has value because a government issues it as legal tender. This means it is a legally recognized currency that can be used to pay off debts and taxes. Simultaneously, a country’s court systems enforce that ability. Government issued money also allows the government to manage the money supply. When there is more money in the economy than goods, inflation results and the government can increase interest rates to reduce the money in the economy. When the opposite occurs, the government can reduce interest rates to encourage more borrowing and money in the economy.
Paper money is how most people hold fiat currency. Practically speaking, holding paper money is one of the safest forms of storing value for future transactions or purchases. Paper cash will always be accepted in the country in which it is legal tender. Some forms of paper cash, such as the United States Dollar, will even be accepted in a foreign location partly because the country that issues the currency has a strong and trusted reputation.
Let’s discuss our modern-day interactions with money: a modern-day Manny is now using paper money to trade with his neighbors. Well, more realistically, Manny is currently buying farming supplies from across the globe to expand his farming business. He might even begin importing and growing foreign fruits like guava, and learning new farming practices from a foreign business partner. Instead of holding paper money at home, modern-day Manny uses a commercial bank to store his farm’s money and to pay for all his farming expenses, like his employees’ salaries or his equipment. And given the proliferation of the internet, Manny today uses a website and digital platforms to place orders and interact with suppliers and customers.
III. Paper Money vs. Digital Money
The modern world has transitioned from a localized economy of neighbors to a global enterprise connected by digital threads where we can source supplies and ideas from across oceans. Along with the evolution of the world’s trade and economy, the form of money has also evolved becoming increasingly digital.
Globally, at least 69 percent of adults store their money in an account at a financial institution or mobile money provider. These accounts allow people to store money in digital form, and use payment services to carry out transactions digitally without the use of cash. But wait, if we already use digital platforms to pay others, don’t we already use digital money? While digital payment platforms and services are commonplace, our definition of digital money continues to develop with the evolution of the underlying digital infrastructure supporting payments and money. Let’s break this down first and later tackle new frontiers of digital payments — cryptocurrencies, CBDCs, and stablecoins.
IV. Digital Money
We will start with money held in a commercial bank account, the most popular conception of digital money. When we store our money in a bank account, we can pay a merchant for their goods and services. While this might feel like we’re digitally handing paper cash to a merchant, this isn’t actually what is going on behind the scenes.
Money that we store in a commercial bank account is actually a demand deposit. This means that when we store money in a bank, we are lending out that currency to the bank. When we “demand” to withdraw the money, the bank is legally obligated to give us cash, fiat currency, in return. But while we hold our money at the bank, the bank is free to do whatever it wants with it. Typically, the bank will loan out our money and gain interest off our loan. They make money off of our stored money. Of course, if everyone wants to withdraw their money all at once, a bank typically cannot fulfill its promise to redeem our deposits for cash because they’ve usually loaned out most, if not all of our money. There are reserve requirements to hold a certain amount of cash and insurance to address this, allowing customers to reclaim their cash in the case of such an emergency.
So, when we pay modern day Manny by using our mobile phones or a credit card, what’s actually happening is that our bank is passing its obligation to pay us back for our “loan” to Manny’s bank. Because we are so used to the role of commercial banks in our economy and society, and governments typically impose reserve requirements and provide bank insurance, using our bank accounts feels like a near-substitute for cash, just in a more convenient digital form. Now we even have mobile services and applications, such as Venmo or Wise and Remitly for cross-border payments, that can store money and initiate payments peer to peer using their own accounts or by communicating with our banks. These services also rely on transference of demand deposits.
As the world increasingly adopts the internet and the digital technologies, platforms, goods, and services it enables, paper money is slowly being replaced by digital payments. In the UK, payments in physical cash accounted for only one in six transactions in 2020. E-commerce and the COVID-19 pandemic have sped up this process even further, especially in Asia. India, South Korea, China and Thailand account for the most digital payments in 2021. India led the pack with over US $25 billion in digital transactions.
With the increasing use of digital money, societies are re-imagining their relationship with paper money. China is once again at the forefront of these trends. China began introducing their version of digital money, a central bank digital currency (CBDC), into the market in 2014. The Bahamas has taken things even further by becoming the first country to have a legal digital currency, known as the Sand Dollar, which is now an alternative to the traditional paper based Bahamian dollar. Moreover, countries like El Salvador have declared Bitcoin, the world’s most popular cryptocurrency, as a form of legal tender.
So, at this point you might have the following questions in mind. What is a cryptocurrency and how does it differ from other digital money? What is a central bank digital currency (CBDC) and where does a stablecoin fit in?
In the next few sections, we will dive further into all of those questions.
Cryptocurrency is any form of payment that exists digitally and does not have a central issuing or regulatory authority managing its supply and use. This is the critical difference between cryptocurrency and other forms of currency such as a physical U.S. dollar bill or US $100 that exists in a commercial bank account. Cryptocurrency doesn’t have the backing of a regulatory authority like the United States Treasury. Also, cryptocurrency uses technologies such as cryptography, hash functions, and consensus mechanisms to secure and record transactions. For more information on the basics of blockchain, please check out our brief, Introduction to Blockchain.
Cryptocurrency, unlike the commercial bank transactions described above, doesn’t depend on a third party like a bank to verify a transaction. Instead, a peer to peer system enables participants to send and receive payments directly. These payments are recorded and secured on a distributed ledger and cryptocurrencies are stored in digital wallets. Cryptocurrency units are created through mining, a process that involves computer software systems that solve complicated math problems to generate units/coins. Cryptocurrency owners own digital units of Bitcoins but these are not tangible assets. Essentially, cryptocurrency owners own a unit that they can transfer to other parties or keep and claim ownership without spending on a third party. Founded in 2009, Bitcoin is the first and most popular cryptocurrency. Ethereum is another popular cryptocurrency founded a few years later in 2015.
Price volatility is perhaps the most widely-known challenge in the cryptocurrency sector. In Summer 2017, one Bitcoin was worth around US $2,500. Three years later, one Bitcoin hovered to nearly US $50,000. As of mid-June, 2022, one Bitcoin is worth US $23,000.
Over the span of three years from 2017–2020, Bitcoin’s price grew by an impressive twenty times. Since 2020, however, Bitcoin’s price fell by over 50%. Bitcoin’s volatility makes it very difficult for it to be a reliable form of payment for day to day transactions or for long term contracts that involve payments over a multiple year timeframe. Price volatility is an issue for many cryptocurrencies not just Bitcoin.
Moreover, acceptance is a significant challenge. Traditional payment systems have developed their reach into all types of transactions to make them user friendly. For example, most credit cards offer contactless payments in national currencies like the US dollar. Most businesses also accept major credit cards such as Visa or MasterCard. In comparison, very few merchants accept cryptocurrency payments. As payment infrastructure is developed for the cryptocurrency economy, these issues will become less relevant but cryptocurrency is far from having near ubiquitous reach to truly challenge traditional digital payments.
Cryptocurrencies also suffer from various reputational issues, namely their standing as facilitating criminal activity. Legislators in the U.S. have heavily scrutinized cryptocurrencies for their connection to money laundering and corruption. The first bills to regulate cryptocurrency in Brazil also squarely focused on these issues. Reports of the Russian government evading sanctions by accepting cryptocurrency payments have further fueled cryptocurrency skepticism.
Experts at the Brookings Institute warn that these fears are based on an “inaccurate understanding of how the technology works” and they fail “to address the complex dynamics currently at play between cybercriminals, sanctioned entities, and law enforcement agencies.” The Brookings Institute adds that “although Bitcoin and related cryptocurrencies offer some anonymizing feathers, they are in fact highly traceable.” Over time, perceptions may change as law enforcement improves its ability to track illicit funds from cryptocurrencies but cryptocurrency still has a long way to go in reshaping public perceptions on its connection to criminal activity.
Although cryptocurrencies face many more challenges, taxation and regulation are two of the final issues we would like to highlight. Current regulations have created a patchwork of compliance regimes for investors in many countries. Navigating this patchwork of regulations makes it difficult for investors to mitigate risks and invest with certainty. New rules are being debated and implemented across taxable assets ranging from wages to capital gains to partnership income. New reporting standards also need to be implemented especially given the potential for cryptocurrency and tax evasion.
Additional regulatory issues include decisions on treating crypto asset as commodities or securities. U.S. courts primarily use the Howey Test to determine whether an asset should be regulated as a security or a commodity. Cryptocurrency has created many challenges for the US Securities and Exchange Commission (SEC) as it grapples with different cryptocurrency cases that are pushing the boundaries of the agency’s established frameworks for regulating assets. The SEC’s approach is also being carefully followed by regulators across the world as cryptocurrency use continues to grow.
Now that we understand the differences among fiat currency, commercial bank money, and cryptocurrency, we can begin to conceptualize where a Central Bank Digital Currency or “CBDC” fits in. A CBDC is basically trying to capture the legal tender status of paper cash, with all the safety and backing of a government, and put it into digital form. Imagine the benefits of being able to store cash, money that you could always use even in the direst of economic circumstances, in a digital account. You could access all the benefits of digital payments such as sending money from a foreign country to your parents at home across the world. You could immediately pay your friend back after she covered your meal a week ago without having to meet her. But now you could do it with the assurance that your digital money is as good as handing over paper cash with no fear of a bank run leaving you without your hard-earned money.
It doesn’t stop there. CBDC could come without bank fees for holders or merchants that accept it. Payments could be made faster and more efficient, simplifying the process of transferring money between digital accounts and wallets. The world could become more financially inclusive and connected through the adoption of a CBDC and the lowering of financial barriers. With countless design possibilities, central banks could issue their own e-wallets through partnerships with existing institutions or take on a larger role in providing access to central bank currency through accounts. These e-wallets or accounts can overcome obstacles that lower income and marginalized groups face in accessing financial services. For example, Nigeria has introduced the e-naira which offers a digital currency to those without IDs or formal home addresses. These types of programs can also serve as an entry point for building credit and securing loans for underbanked populations.
A CBDC could also help maintain privacy and anonymity by limiting which institutions, if any, have access to your digital identity information. It could conversely help prevent illicit use of money by streamlining tracking of financial flows for government authorities. CBDCs also enable governments to maintain their ability to manage the money supply, a critical function especially in times of high inflation. The possibilities are manifold, but it all hinges on how we design the features and architecture of a CBDC. A country’s central bank could take on a more active role in conducting monetary policy to stabilize economies. With the degrees of freedom allowed by programmability of digital products, also comes countless policy and design choices.
Design structure, privacy concerns, and cybersecurity risks are three significant challenges for CBDC implementation. Key questions include how a CBDC is designed to allocate responsibilities between a country’s central bank and the country’s commercial banks and financial institutions. Will a CBDC allow a central bank to access or even require digital identification information or will it prioritize anonymity — similar to paper cash — despite the potential for larger volumes of digital currency transactions?
Skeptics of CBDCs point to its enhanced transaction tracking as a threat to privacy and a vehicle for government surveillance. On the other hand, central bank access to user identity could facilitate anti-money laundering objectives and more effective monetary policy and economic data collection. Assigning this burden of privacy protection remains a contentious issue. Will a CBDC be designed such that commercial banks will issue and record transactions or will that responsibility fall onto the central banks? Central banks taking on this role would greatly increase public and government involvement in commercial activity, while commercial banks continuing in this role introduces questions around trust in private institutions.
Additionally, introducing a CBDC will require central banks to take on a momentous task in maintaining digital and physical infrastructure, introducing new points of cybersecurity risk. CBDCs introduce many more questions than the design of paper money, but alternatively offer much more potential for adopting to a new age of economic and digital activity.
As blockchain based cryptocurrencies and CBDCs continue to develop, there is a growing need for a more stable blockchain native currency. The original blockchain native cryptocurrencies such as Bitcoin and Ethereum natively power their respective blockchain ledgers and decentralized applications in Ethereum’s case. While the digital economy is still determining if these cryptocurrencies will adopt all the traditional functions of money (store of value, medium of exchange, and unit of account), or aspects of these functions, their values relative to the USD continue to fluctuate greatly in the present moment. They are too volatile to substitute for traditional fiat currency. In the meantime, the evolution of web3 and blockchain applications and use cases continues to grow with the adoption of NFTs, Decentralized Finance (DeFi), the metaverse, and a whole host of decentralized applications (DApps) in the increasingly digital economy. This ecosystem demands a blockchain native currency to fuel economic activity.
Stablecoins offer a potential solution.
Stablecoins are generally blockchain native cryptocurrencies with their values pegged to the market value of a stably priced external reference, typically a fiat currency. Popular stablecoins include Tether, USD Coin, and TerraUSD. Stablecoins maintain their value and peg through various measures. Popularly, they are backed by fiat currency such as the dollar. This type of stablecoin is known as a fiat-collateralized stablecoin. These stablecoins, such as Tether and USD Coin, maintain a fiat currency reserve that is maintained by a centralized institution or authority that promises that all stablecoins that are produced or ‘minted’ are backed by an equivalent value of fiat currency. Therefore, theoretically, individuals can redeem their stablecoins for fiat currency. Other forms of backing or ‘collateral’ exist, such as gold commodities or even Bitcoin. Some stablecoins are not even backed up by collateral and instead rely on algorithms and structured market incentives to maintain their value or peg to a stable fiat currency or value.
Stablecoins offer a private market-produced solution to the issue of a stable value currency to use to purchase goods and services in the blockchain digital economy and real-world economy, but they are not without issue. Stablecoins currently are largely unregulated and pose significant risks surrounding this lack of oversight. The main issues with stablecoins is their management structure. In the case of fiat-collateralized stablecoins, the managing central authority may not be backing the supply of stablecoins with an equivalent value of fiat currency. They might be backing their stablecoins with less liquid assets or riskier assets that jeopardize the redeemability of stablecoins for fiat currency. Algorithmic stablecoins also introduce potential for their stablecoins to rapidly lose value depending on the vulnerabilities of their algorithmic and incentive mechanisms. Additionally, stablecoin accounts or wallets are widely not insured or protected by government-backed insurance or regulations developed over decades.
CBDCs are being developed in part to respond to the risks of stablecoins. CBDCs, as a digital form of central bank currency, will likely carry the protections of cash discussed above. A question that continues to linger is if CBDCs will also take on the functions of stablecoins in their architecture. Will CBDCs be interoperable with blockchain technologies or will they remain confined to retail use in the traditional economy? Will we be able to purchase goods and services in the digital economy with CBDCs? These questions remained unanswered and depend largely on the policy choices in designing a CBDC.
We are living in a new moment. The digitization of our economy and its integration with traditional goods and services continues to change how we engage with each other as neighbors and participants in an interconnected world. Governments and private parties all have a stake in innovating new solutions to adapt to new economic activity and exchange. Cryptocurrencies, stablecoins, and CBDCs are various responses to new digital frontiers as well as reforming how we interact with traditional ones. Many questions remained unanswered, but the topics we discussed here lay a foundation for key factors all of us will grapple with and consider going forward.
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** Incoming Corporate Associate @ Hogan Lovells LLP