How are CBDCs different from cryptocurrencies and stablecoins?

Inflation averaged 8.75% globally last year, impacting the quality of life of people all over the world. But price spikes of that kind are nothing compared to the volatility often found in the cryptocurrency markets, where annual jumps of 300% and similarly severe drops have left numerous everyday people facing enormous irretrievable losses.

While central banks have raised interest rates and pulled other policy levers to try and bring soaring inflation under control, there are no such options in the crypto market.

Fluctuations in cryptocurrency values are dictated mostly by supply and demand for the limited number of coins available. Sudden drops in price have left crypto firms filing for bankruptcy and dealt serious blows to the reputation of digital currencies.

Distrust of digital currencies such as crypto is partly why the increasingly discussed idea of central bank digital currencies (CBDCs) is encountering some scepticism. But there is a big difference between CBDCs and cryptocurrencies.

The main difference between a central bank digital currency and a cryptocurrency is that a CBDC is – as its name implies – issued by a central bank. This means it is also a “direct liability” of the central bank, as the World Economic Forum’s Digital Currency Governance Consortium White Paper Series points out.

“CBDCs are direct liabilities of the central bank, just as paper cash is,” adds the Harvard Business Review. “This makes CBDCs a safer form of digital money than commercial bank-issued digital money.”

For a full explainer of what CBDCs are, see the first part of this series, What are central bank digital currencies and what could they mean for the average person?

When it comes to cryptocurrencies, these are not issued by governments or other financial institutions. Instead, they are digital currencies exchanged between people and various entities on a decentralized system.

Because crypto is not backed up by a central public authority or within the banking system, it is not considered legal tender and users are not protected from price volatility, theft because of hacking, or when crypto firms collapse.

Stablecoins are a form of cryptocurrency. However, they are designed to be more stable in value by having their value tied to that of another asset.

“A stablecoin’s value may, for example, be pegged to the value of a sovereign currency such as the US dollar, other crypto-assets or commodities, or supported by algorithms,” the World Economic Forum’s Digital Currency Governance Consortium White Paper Series says. “Depending on the effectiveness of the stabilization mechanism and backing, the digital currency may or may not hold a stable value relative to its reference asset.”

Stablecoins can fall into two categories: collateralized or uncollateralized/algorithmic.

For collateralized stablecoins, the stabilization methods fall into two broad categories, described by the US Federal Reserve as:

These stabilization mechanisms operate with varying degrees of success, given the different levels of susceptibility facing the asset they are pegged to, the Fed adds.

On the other hand, uncollateralized/algorithmic stablecoins use automated “smart contracts” to maintain exchange rate stability. This often involves linking the value to another crypto asset.

However, stablecoins have suffered instability, notably when TerraUSD – which was an algorithmic stablecoin designed to be pegged to the US dollar – collapsed and caused $60 billion in losses. The problems for TerraUSD stemmed from its additional link to sister digital token Luna, whose price was set by the crypto market, according to Bloomberg.

“More than 70% of central banks are currently exploring the design and issuance of CBDC for their economies,” according to the Forum’s Digital Currency Governance Consortium White Paper Series. It cites the reasons as including “opportunities to improve – among other things – financial inclusion, digital trade, payment efficiency and access to safe central bank money in an era of dwindling cash usage”.

Some central banks also see risks around “fragmentation of the payment landscape into CBDCs, stablecoins and private crypto assets”, as the Forum’s Central Bank Digital Currency Global Interoperability Principles points out.

This fragmentation could one day threaten the stability of the wider financial system – and some emerging market and developing economies are already being “materially affected” by the substitution of currency for crypto assets, according to the International Monetary Fund (IMF).

“Such substitution has the potential to cause capital outflows, a loss of monetary sovereignty, and threats to financial stability,” the IMF says.

Nobody wants inflation of 8.75%, and certainly not inflation – or deflation – of 300%. CBDCs potentially offer a way to enhance economic stability and boost the effectiveness of monetary policy. It is now down to central banks and policy-makers to explore – and explain – exactly how CBDCs could work for everyone, including how privacy and security features will be embedded to protect individual financial autonomy.

CBDCs, cryptocurrencies and stablecoins are all distinct, and they could continue to coexist. It is therefore important for consumers to understand the differences between these concepts, as well as the ways they could interact and impact one another.