What is the difference between stablecoins and CBDCs?

21 January, 2020

The evolution of cryptocurrency has led to two new varieties of digital currencies that are each unique in their own ways. Of course, we are talking about stablecoins and central bank digital currencies (CBDCs). Both are getting a lot of attention these days thanks to the combined efforts of Facebook and the People's Bank of China to shake up the financial sector.

It has been our experience that only those who possess an in-depth knowledge of cryptocurrency technology truly understand the differences between traditional cryptos, like Bitcoin and Litecoin, and their stablecoin and CBDC counterparts. Stablecoins and CBDCs do have a few things in common with traditional cryptos. Yet they are also different in some ways, too. Stablecoins and CBDCs even differ from each another.

This post is essentially a discussion about what makes stablecoins and CBDCs different. If you do not know a whole lot about the two, you should find this post most helpful. Needless to say that stablecoins and CBDCs are not going anywhere. They are here for the long haul.

Stablecoins and CBDCs defined

Let us begin with a basic definition of each. A stablecoin is essentially a cryptocurrency that is backed by some sort of quantifiable asset. It is through such backing that a stablecoin has any monetary value. Consider Facebook's Libra project. If it ever gets off the ground, Libra will be a stablecoin backed by a basket of fiat currencies. The U.S. dollar, British sterling pound, and Japanese yen will all be included in that basket.

The value of all of the fiats in the basket will ultimately determine how much a single Libra token is worth. A formula for determining Libra's price would be a bit too convoluted to explain here, so let us contrast Libra with the U.S. Dollar Coin (USDC).

USDC is another stablecoin backed by U.S. dollars. Its developers maintain a reserve of cash in FDIC-insured bank accounts in order to cover potential liquidations. USDC's value mirrors the U.S. dollar 1-to-1. One USDC equals one U.S. dollar. That pretty much explains the basic tenets of stablecoins.

A CBDC, unlike a stablecoin, is not a classic cryptocurrency in the truest sense. Rather, it is a digital representation of fiat. China's CBDC is an excellent example. So is Venezuela's Petro. Both are destined to become complete replacements of their respective country's minted coins and printed bills. China is so forthright about their plans that they are even referring to their CBDC as digital yuan.

The one thing CBDCs have in common with stablecoins and traditional cryptos is the technology underneath the hood. CBDCs rely on blockchain technology to work. Transaction and user information is protected through encryption. Unlike stablecoins and traditional cryptos however, CBDCs are not privately owned. They are created, maintained, and owned by central banks.

Currency value

We will now transition into a discussion about some of the more subtle differences between stablecoins and CBDCs, beginning with value. We have already established that stablecoin value is determined based on backing assets. However, the idea is worth discussing at greater length.

USDC is fairly easy to understand in terms of its value. Pegging a stablecoin to the dollar is a smart move for the simple fact that the dollar is the world's preferred reserve. As the dollar goes, so does every other fiat. Yet there are stablecoins that are pegged to other assets. For example, you could have a stablecoin backed by a basket of securities that include stocks and bonds.

Imagine Amazon were to come out with its own stablecoin (hopefully they never do). Let us say the stablecoin is backed by Amazon stock. The easiest way to determine value is to make one coin equal to one share of stock. Because Amazon stock is so pricey, the company could create lower denominations of the stablecoin that represent smaller increments of stock.

Tying the stablecoin to Amazon stock would mean is value fluctuates daily, along with the price of the stock. When Amazon stock rallies, so does their stablecoin. The coin would tank if company stock suddenly hit the skids.

Now let's contrast that to a CBDC. Remember that CBDCs are created and maintained by central banks. China's CBDC is the creation of the People's Bank of China. Its value is determined exclusively by the value of yuan against the U.S. dollar. How is that value determined? Through a combination of FOREX trading, central bank monetary policy, and China's economic output.

When the economy is good and the People's Bank of China takes a hands-off approach, the yuan tends to do fairly well against the dollar. Yet all it takes is one slight change in economics or monetary policy to influence value. The yuan, and China's CBDC as well, can be devalued overnight by central bank action or new economic news.

Currency control

Another significant difference between stablecoins and CBDCs is currency control. In other words, who or what controls the digital currency in question? In a stablecoin scenario, control is determined by how the coin is actually structured. There is no such ambiguity with CBDCs. Currency control in a CBDC scenario always belongs to a central bank.

It is possible for stablecoin control to rest solely in the hands of developers, coin miners, and coin owners - just like traditional cryptos. But it doesn't have to be. Stablecoin control can also be maintained by whatever entity created it.

Libra will eventually be controlled by a quasi-independent organization known as the Libra Association. That organization was established by Facebook and is populated by a long list of commercial organizations that have put up the funding to get Libra off the ground. However, the Association will not have full control over Libra for at least the first few years. Facebook will still exercise some control over it.

Control of China's CBDC rests solely with the People's Bank of China. The same is true for Venezuela's Petro. It is controlled exclusively by Venezuelan Central Bank officials. They created it, they control it, and no one else has any say.

Security concerns

Security is one area in which we know very little relating to stablecoins and CBDCs. What we know is limited to the understanding that both kinds of digital currencies rely on encryption and the fundamentals of blockchain technology to maintain security. Exactly how security measures are implemented remains pretty much a mystery.

It is assumed that your typical stablecoin offers pseudonymity at a bare minimum. Pseudonymity is the principle of protecting user information by encrypting it in a blockchain ledger. The information is there, but it cannot be utilized or understood by any individual or organization that lacks the necessary keys to decrypt it.

There is likely no pseudonymity attached to CBDCs. So even though you might not be able to unlock data in a CBDC blockchain ledger, you can bet government officials can. The central bank that created the CBDC can always decrypt data and will. Unlocked data can also be shared with other government agencies in need of it.

Along the same lines are what are known as 'permissions'. In the computer world, permissions designate who has access to files, data, etc. A genuine cryptocurrency is permissionless from top to bottom. Security is maintained through a combination of encryption, consensus, and proof-of-work.

It is assumed that stablecoins operate the same way. However, it is not beyond the realm of possibility that a stablecoin eliminates the need for consensus by granting permissions to a small number of approved individuals tasked with maintaining the project. It seems reasonable that permissions would be granted within the very organization that maintains a stablecoin.

Practical utility

Last but not least is the issue of practical utility. In this regard, CBDCs have the upper hand over stablecoins. That is because CBDCs, by their nature, are intended to be a complete and total replacement of fiat.

Once China's CBDC becomes the official currency of the land, its utility will be equal to that of minted coins and printed bills. Chinese citizens will be able to spend it freely with any and all merchants. They will be able to use the CBDC to buy things, pay their bills, and provide financial assistance to family members. In short, utility will not be a problem.

Stablecoin utility is considerably more restricted. Your average of stablecoin exists for a specific purpose, like facilitating coin-for-coin trades of multiple cryptocurrencies on a given exchange. A stablecoin maintained by that exchange would have no utility outside of it.

Facebook hopes its stablecoin will have utility outside of the Facebook portfolio of online properties, but the likelihood of that being the case is slim. Government regulators are not about to let it happen.

Hopefully you now have a better understanding of the main differences between stablecoins and CBDCs. Those differences are considerable on multiple levels. The main thing to remember here is that both stablecoins and CBDCs are not on the same plane as Bitcoin, Litecoin, Ethereum and other traditional cryptocurrencies. They have different purposes and ownership models. They differ in terms of control, utility, and their value.