Cryptocurrencies, stablecoins and central bank digital currencies (CBDCs) are gaining traction globally. Market watchers expect lawmakers to tighten cryptocurrency regulation in the years to come.
Several nations are likely to follow in China’s footsteps and ban cryptocurrencies and stablecoins all together. Others are likely to follow in El Salvador’s footstep and make digital dosh like bitcoin their legal tender. At the same time, countries like China, Sweden and the UK are actively looking to set up their own digital money.
Cryptocurrencies, stablecoins and CBDCs are likely to be top of mind for years to come. However, far from everyone is clear what these digital monies are or what separates them from each other. Don’t worry, we’ve got you covered. To understand all these terms, we must first explain what a blockchain is.
What is a blockchain?
A blockchain is a distributed electronic ledger. It is a continuously maintained database of all transactions.
People define blockchains with four key features: decentralisation, cryptography, validation and immutability.
No central organisation is in charge of validating the transactions. All participants, or nodes, in the network jointly hold and maintain the blockchain.
The network use a complicated process to validate new blocks in the ledger. A block is a record of all transactions, both old and new ones, ever done on the blockchain. A majority of the network nodes must approve each block.
Once they have been approved, a new block in the blockchain will be created. Coupled with cryptographic security, this makes the ledger tamper proof or immutable – at least in theory.
What are cryptocurrencies?
Cryptocurrencies are tradable digital currencies or assets built on blockchain technology. They only exist online and are mostly unregulated, but efforts have been made to introduce new laws to better police the industry prices can be incredibly volatile. It is common for cryptocurrencies valuations to swing around 10% in a day.
Encryption techniques are used to control the creation of currency units and verify the transfer of funds. Confirmed transactions are added to the new block.
Bitcoin is the most famous cryptocurrency, but not all cryptocurrencies are bitcoin. Other popular cryptos include ethereum and solana.
What are stablecoins?
Stablecoins are a type of cryptocurrency. Unlike the likes of bitcoin, stablecoins maintain a stable value by tying their value to one or more assets. Assets may include fiat currencies such as the US dollar. Stablecoins could also be tied to commodities likes gold or another cryptocurrency.
Stablecoins are therefore theoretically untouched by the dramatic price fluctuations other cryptocurrencies experience. Stablecoins can facilitate fast and secure transactions between crypto assets and fiat currencies without incurring extra fees.
However, stablecoins are not always stable. Many traders learned that lesson the hard way in May 2022 when TerraUSD slipped below its 1:1 peg against the dollar. Its value plummeted from its $1 value to 5 cents.
Other stablecoins like Tether, USDC and the Binance Dollar are not algorithmically traded but instead backed by reserves. Each unit of these US stablecoins is matched against a US dollar in a bank account. This second stablecoin category is arguably more financial stable than algorithmically traded stablecoins.
What are CBDCs?
CBDCs are a type of fiat currency issued by central banks. The managed digital ledger may or may not run on blockchain. Many governments are exploring developing CBDCs for various reasons. CBDCs would allow individuals and corporations to carry out real-time, feeless transactions with currencies backed by central banks.
The pros of CBDCs are that they may help fight financial exclusion and reduce the number of unbanked citizens. Digital currencies could be made available to unbanked populations by granting access to digital wallets on smartphones. Central banks or their partner banks could provide the digital wallets.
Digital currencies can also offer greater transparency and oversight of transactions taking place through the system. This would help reduce fraudulent activities such as tax evasion and money laundering.
There are already CBDCs up and running around the world. In October 2020, the Central Bank of the Bahamas launched the Sand Dollar and a year later Nigeria launched the eNaira. China is running a pilot of the digital yuan, sometimes known as the e-Renminbi or e-CNY. The digital yuan does not run on blockchain. UK chancellor of the exchequer Rishi Sunak has announced that the government is working on a similar project colloquially referred to as Britcoin.
CBDCs also present some huge challenges to government. For instance, their heightened traceability has raised concerns around privacy. CBDCs will be identity-linked money. Unlike current digital banking and payment systems, CBDC transactions could be observed, tracked and censored by governmental institutions. The fear is that governments could use CBDCs to monitor and infringe upon a population’s privacy.
Market watchers are advising central banks to take data monitoring and privacy issues seriously as they develop CBDCs.