Paths to the Future: What Stablecoins and the CBDC Mean for the Global Financial System

The global financial, monetary and regulatory landscapes are being reshaped by the rise of digital currencies. Private digital currencies have the potential to be a marketizing force, as they lower payment costs and increase the accessibility of the financial system as well as the speed and verifiability of settlement transactions. But new technology brings new challenges. Market forces can bring great price volatility, and new technologies bring operational challenges; digital currencies must be resilient in the face of threats like cyber attacks, and backed by laws and regulations that effectively tackle issues of loss, counterfeiting, privacy, money laundering, and consumer protection in this novel context. Understanding the workings and likely impacts of the digital currencies that are in development will help us prepare for these disruptions to the global financial system.

Most people are somewhat familiar with cryptocurrencies like Bitcoin, but a new article by Professor Wei Shen and Herbert Smith Freehills China International Business and Economic Law (CIBEL) Centre co-director Professor Heng Wang explores the emergence of two underexplored paths for the future of digital currencies as a whole: stablecoins as represented by Diem, a private digital currency originally backed by Meta, and China’s CBDC, a digital form of fiat currency issued by their central bank. The article explores the pathways chosen by new digital currency issuers to expand their influence and increase the currency’s adoption, and explains their likely financial and economic impacts. Their findings are summarised below.

Diem:  A Private ‘Stablecoin’

Diem – previously called Libra – was a cryptocurrency project backed by Meta and other members like Uber and Shopify. The Diem Association recently sold their intellectual property and are in the process of winding down, but their project nevertheless provides a useful case study of how privately-backed digital currencies may work in the near future. The Diem Association’s plan was to offer ‘stablecoins’: cryptocurrencies backed either by a single fiat currency, or a basket of fiat currencies. Their first, ‘Diem USD’, was to be linked to the value of the US dollar. ‘Stablecoin’ refers to privately issued currencies that are redeemable for, or backed by, assets with intrinsic value. While they market themselves as less prone to price volatility than other cryptocurrencies, they are yet untested. Each cryptocurrency or stablecoin has its own underlying rules. Diem, for example, was to be governed by the rules of the Diem Association. It was based on a ‘centralized blockchain’ with a ‘permissioned system’ – that is, unlike Bitcoin, it would only run from the servers of the Association’s members, and only authorized validators would be allowed on the network.

Central Bank Digital Currencies (‘CBDC’)

Some central banks like those of the United States and China are exploring the idea of issuing a digital counterpart to their fiat currencies. China’s CBDC, also called ‘e-CNY’, the Digital Currency/Electronic Payment, or digital yuan, is at a more advanced stage of development than other existing CBDC projects. China’s CBDC will be legal tender circulated by the central bank, fixed in nominal terms and backed 1:1 by fiat reserves. It will not rely on blockchain – although some blockchain technology may be used for security reasons and will operate using a two-tiered structure for issuance and redemption of the currency. This structure allows it to replace paper money without subverting the existing systems that issue and circulate funds. The first tier will see the PBOC issuing and redeeming the currency through commercial banks, and the second tier will have institutions like commercial banks redistributing the currency to retail market actors. Retail use is further promoted by the availability of offline payments, and the fact that digital wallets will not require a commercial bank account to operate in certain circumstances. The CBDC will be entirely centralised, and while there will be ‘manageable anonymity’, transactions will be visible to the central bank. In China’s two-tiered system, transactions will be visible to the central bank but the second-tier institutions will be responsible for compliance such as that with anti-money laundering laws.

China has prohibited the trading of private digital currency, which works to preserve and enhance the role of government by preventing paper money from becoming obsolete. Providing a public digital currency alternative furthers China’s monetary sovereignty and allows for effective transmission of monetary policy, while avoiding some of the risks associated with private currencies like tax evasion and capital outflow. There are also calls for enhanced transparency of China’s CBDC.

Macroeconomic Impacts

The macroeconomic impacts of digital currencies concern their effects on banks, and the ability of a state’s central bank to control the supply of money. A CBDC, if properly managed, may help increase macroeconomic stability by allowing for more accurate calculation of metrics like the inflation rate and real-time monetary flow data, as well as by creating new levers for monetary policy to exploit. It could also potentially allow government expenditure to bypass commercial banks entirely, thus reducing systemic risks associated with commercial banking and lessening the impact of a financial institution’s collapse. CBDCs have the potential to change the entire role of banks as intermediaries in the economy – although China appears to want to avoid any disintermediation for now and the effects of such efforts are to be seen.

Stablecoins, on the other hand, would reduce central banks’ capacity to control monetary policy. If private actors reduce their deposits in commercial banks and instead favour stablecoins held in digital wallets, banks’ capacities to provide credit to economic actors will also be undermined. So shift payments, deposits and loans may move into the private sector where they are less regulated. On a global level, the international nature of such a currency makes it difficult for a state to impose capital control and prevent ‘capital flight’ (the rapid outflow of large amounts of assets or money from one state to another). If Diem had seen enough uptake, the Diem Association may effectively have exercised powers akin to those of a central bank, but without the same public responsibilities and political oversight.

Solutions like inventive public-private partnerships and strong legal regulations may mitigate some of these risks. Critically, the latter involves choosing how to legally characterise currencies like Diem: should they be commodities, securities, or some other instrument? Shen and Wang explore how the US and Swiss governments have begun to characterise them, noting that global consensus on these issues will be needed to reduce opportunities for speculative and regulatory arbitrage.

International Monetary Order

Diem had the potential to become a ‘global stablecoin’ considering Facebook – under the Meta umbrella – has billions of users around the world. A global stablecoin would revolutionise the international monetary system. It would promote greater access to the financial system globally, and having an internationally available currency may reduce mistrust associated with unfamiliar foreign currencies. All of this, write Shen and Wang, would be a ‘major global social good’. On the other hand, stablecoins could begin to rival national currencies, particularly of smaller states, and create competition between currencies. Both global stablecoins and China’s CBDC have the potential to challenge the dominant role of the US dollar.

Further, the fact that stablecoins are backed by other currencies will mean those economies with currencies inside a widely-accepted stablecoin’s basket would experience increased demand, leading to higher exchange rates and lower interest rates. The opposite would be true for currencies outside the basket. Tension would also exist between the value of stablecoins and CBDCs if both tend to secure government securities as assets  to issue new liabilities or support their value.

We are entering an era of disruptive technological change in the financial sphere. Stablecoins and China’s CBDC are representative of two very different paths that digital currency developers may take, and understanding both will help us navigate the complex technical and legal issues that will likely arise. Shen and Wang advise that regulators need to take an active approach to understanding and predicting the risks these technologies bring, in order to fully reap their benefits; it is crucial to monitor this space.

Full text of the new article by Professor Wei Shen and Professor Heng Wang is available here. 

CIBEL co-director Professor Heng Wang’s research may be found at ResearchGate, SSRN, Twitter @HengWANG_law, and LinkedIn.  

For more news from the Herbert Smith Freehills China International Business and Economic Law (CIBEL) Centre, click here.