Why is digitized cash better than stablecoins?

by David Putts

The article originally appeared on FinTech Futures.

Since the birth of the first cryptocurrency, Bitcoin, many have sought to unlock the promise of the underlying technology innovation to streamline national currency transactions. With global payments annual revenues estimated at $1.9 trillion according to a 2018 McKinsey report, the potential prize for those who can do so is massive.

The underlying technology is distributed ledger technology (DLT). Many of the earliest efforts to apply DLT -- including blockchain, which is one form of DLT-- focused on using cryptocurrencies to circumvent established payment rails. Though attractive for those who want to stay anonymous, this approach soon revealed an inability to comply with regulations. The concept of a stablecoin was born.

Let’s make transactions more complicated - Not

To understand the challenges of stablecoins, it helps to understand how a cryptocurrency transaction typically works. First, a sender buys the cryptocurrency or stablecoins; next, they transfer them; and finally, the receiver sells the stablecoins they received. In principle, if the stablecoin is pegged to a dollar, then a stablecoin dollar is more technologically secure than unencrypted dollars, yes?

However, converting funds into and out of stablecoins requires its own additional liquidity. The price of a coin is pegged to a fixed price by varying underlying liquidity levels to adjust to changing underlying demand. In addition, stablecoins incur third party costs for the entity managing the coins related to operations, technology and compliance.  

A better approach is to match the solution to the problem from the outset.   If the problem being solved is to provide certainty to immutable transactions of regulated currency, it is more elegant -- and practical -- to design DLT solutions to fully comply with existing regulations.  Digitized cash is such an approach.

Stablecoin vs. digitized cash -- What’s the difference?

A new category of solutions is now emerging around digitized cash,  sometimes called distributed digital cash or cash-on-chain. Perhaps less known or understood, its key distinction is that it is issued and controlled by banks or regulated institutions, who can seamlessly back an encrypted digitized dollar with any government issued currency.  The bank still needs DLT technology to support such digital cash but it does not require a separate, third party exchange.  

Let’s take a deeper look at the differences between stablecoin and digitized cash. Despite claims that a stablecoin dollar is no different than a normal dollar, stablecoins are classified as a traded security with a bid-ask spread.  They are issued by a private company, and as such, they require liquidity to maintain a one-to-one pairing to a national currency. As well, someone must bear the cost of the exchange(s) in addition to a private party holding reserves to maintain price stability. 

Further, the assets backing the stablecoin should ideally be ring-fenced and stable. However, incidents such as the use of the funds behind Tether stablecoins to buy volatile Bitcoin in 2017, followed by its price crash in 2018, highlight the risks of a stablecoin.

By contrast, digitized cash requires no additional liquidity.  An encrypted dollar is issued within a permissioned network (public or private) by a commercial bank. The bank ring-fences the corresponding unencrypted funds in an undesignated client monies account. At the conclusion of any transaction with digitized cash, the one-to-one value of the cash remains. There is no fluctuation.  (And the cost to the bank to ring-fence one account in a bank managing millions of accounts is negligible.) 

Distributed Digital Cash	Stablecoin (Cryptocurrency Scheme)
Issued by bank or regulated institution	Tradeable asset, which can be purchased by bank or other institutions
Users of cash must follow regulations, e.g., anti-money laundering	Users of stablecoin use as they see fit
Permissioned, licenced issuers	Third party issuers and liquidity providers
Relies on segregated funds (no additional liquidity needed)	Relies on exchanges and additional liquidity reserves
Value of currency managed by national central bank	Asset of fluctuating value, programmed to automatically follow a defined price

Which solution will prevail? Three factors may shape the future.

1. Ability to manage personal information.   Transaction details can be classified as personal data in some jurisdictions, and subject to data protection laws. This becomes a challenge for DLT / blockchain, as the very nature of a distributed architecture is that data is distributed and nodes are processors of data. This could create obstacles for regulated institutions who cannot let unauthorized processors handle personal data, especially for networks where transactions are publicly broadcast.  Digitized cash, with its ability to be issued and governed by regulated banks and other institutions, makes it both architecturally and legally feasible to address critical data protection issues. For example, rules can authorize only certain nodes to participate in transactions -- while limiting access of non-relevant parties -- and such specification would be part of the legal relationship between a client and the bank issuer.
2. Interoperability with existing infrastructure. At the most basic level, any solution for payments must be able to readily move in and out of currency formats -- either physical cash or electronic card or other payment.  The advantage of a digital cash solution is that banks are already interconnected to both physical-to-digital (e.g., deposit at an ATM) and digital-to-physical cash networks.  As such, no additional connectivity is required and furthermore, the DLT can be used to streamline clearing in the back office between a bank and a provider of physical cash. With regard to foreign currency (FX), digitized cash levers the bank’s full balance sheet and the bid/ask spread is minimal.  The obstacles for stablecoin multiply with the addition of each additional currency due to the need to add liquidity to avoid fluctuation of stablecoin values. 
3. Regulatory challenges.  In addition to regulations regarding personal data, payment and banking regulations also govern who can hold accounts and how they use them.  Digitized cash solutions allow nodes and cryptographic key management to be tailored to existing payment and data regulations. And while no one wants to limit the power of an ecosystem, digitized cash architecture allows unwanted or malicious actors to be blocked or to facilitate the collection of additional information when necessary.  For stablecoins, there are multiple projects working to create schemes that regulators could accept. Stablecoin issuers will likely make the necessary adjustments to comply, but it is not clear if the resulting stablecoin solutions will be cheaper than traditional technology.  Future work in the area of digital identity may lead to additional features and functionality that could be more effectively provided using DLT technology for either the stablecoin or digitized cash approach.

Keeping the DLT conversation – and innovation – going.

Both blockchain (the breakthrough technology underpinning Bitcoin) and DLT (levering blockchain technologies) continue to evolve. Stablecoin cryptocurrency is the subject of ongoing discussion as regulators, policymakers, governments and financial institutions around the world debate implementation.  For less popular national currencies, this may be the innovation necessary to shift from physical to digital cash, and as such, stablecoin offers a viable solution. Fnality, the newly created consortium of banks using UBS’s stablecoin, is focused on such solutions and is making progress.   

In my role at Billon, I had the privilege in the past year to lead or support several milestones in digitized cash acceptance.  In 2017, the UK’s FCA granted permission to Billon Financial to operate as a registered electronic money institution, and in April 2019, the Polish Financial Supervision Authority granted Billon a similar e-money registration license, first of its kind in the country.  These licenses allow Billon Group to offer clients its DLT system and provide regulated services in a national currency (such as keeping electronic money accounts, issuing payment instruments, making transactions, exchanging currencies or remittance).  And in an agreement with Raiffeisen Bank International announced in November 2019, Billon is projected to be the first to digitize the Euro.

It is still early days on both approaches, though most experts seem to believe that both stablecoins and digitized cash are here to stay. 

 

Terms to Know

• Altcoin is a non frequently traded cryptocurrency. They are extremely volatile, like penny stocks.
• Bitcoin is the first broadly adopted form of cryptocurrency. It is based on the concepts of blockchain and distributed ledger technology published in an academic paper in 2008 by an entity calling itself Satoshi Nakamoto. It operates as a security, a commodity or a foreign currency in market transactions and is not legal tender.
• Blockchain is a growing list of records, called blocks, that are linked using cryptography.  A blockchain is an immutable time-stamped series of records of data that is distributed and managed by a cluster of computers.  Most, but not all DLTs, use blockchain.
• Cash-on-Coin is a synonym for digitized cash. (See below.)
• Cryptocurrency refers to the entire class of digital assets secured by cryptography and operating in a DLT architecture. It is a general term used to describe either a stablecoin or an altcoin. 
• Digitized Cash is a digital asset tied on a one-to-one basis to legal tender and operating within a DLT system.
• Distributed Ledger Technology (DLT) is a distributed database that is consensually shared and synchronized by all participants (called nodes). It is the underlying technology used for all cryptocurrency as well as for a growing number of business and document management applications.
• Stablecoin is a digital asset that operates as a security in market transactions and is not legal tender. Examples include Tether and Libra.
• Virtual Coin is a term most often associated with gaming tokens. It is distinct from cryptocurrency and does not require blockchain or DLT.