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.
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.
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 |
|Relies on exchanges and additional liquidity reserves|
|Value of currency managed by national |
|Asset of fluctuating value, programmed to automatically follow a defined price|
Which solution will prevail? Three factors may shape the future.
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.