Stablecoins and Central bank digital currencies are two digital currencies hot for investors and banking authorities. This article will provide a comparative analysis of stablecoins and central bank digital currencies.

Stablecoins and CBDCs are currencies in the digital market that are fast-rising in value, making them get a lot of attention from individuals in the market space.

What are their values, risks, and future? We will provide all that information in a bit.

What are Stablecoins?

A stablecoin is a cryptocurrency whose value is determined by a reference asset, such as a fiat currency such as the U.S. Dollar (USD) or the Euro, or a more established cryptocurrency such as Bitcoin.

A price peg determines the value of a Stablecoin. A reserve of assets used to underpin the value of the Stablecoin can keep this price peg going.

Stablecoins can also be algorithmic and backed or not by a reserve. An algorithm that manages the supply of the Stablecoin maintains the price of the Stablecoin.

This currency was mainly designed to provide an alternative method of investing in and purchasing cryptocurrencies and convert altcoins and crypto into tokens that are as useful as feasible (since they are less volatile than big-name cryptos like Bitcoin and Ethereum).

Furthermore, with the correct balance of regulation, stablecoins can open up new avenues for crypto to be utilized as a means of exchange.

What Makes Stablecoins so Important?

Though Bitcoin remains the most popular cryptocurrency, its price, or exchange rate, is very volatile.

For example, Bitcoin’s price increased from under $5,000 in March 2020 to over $57,836 in April 2021 before plummeting about 50% over the next two months. Intraday swings can also be extreme; the cryptocurrency frequently moves more than 10% in a few hours.

This volatility may benefit traders but transforms regular transactions, such as purchases, into risky speculation for the buyer and seller.

Long-term cryptocurrency investors want to avoid becoming renowned for buying 10,000 Bitcoins for two pizzas. Meanwhile, most merchants want to avoid incurring a loss if a cryptocurrency’s price falls after being paid for it.

A currency that is not legal tender must be reasonably stable to operate as a medium of exchange, ensuring those who accept it will retain purchasing power in the short run.

Daily fluctuations of even 1% in forex trading are uncommon among traditional fiat currencies.

Stablecoins, as the name implies, seeks to address this issue by guaranteeing that the cryptocurrency’s value will be kept stable in various ways.

Let us briefly take a look at the types of Stablecoins that are available.

Types of Stablecoins

Given the widespread availability and acceptability of the U.S. dollar, some argue that stablecoins are a solution to a problem.

On the other hand, many cryptocurrency supporters feel that digital currency that central banks do not regulate is the way of the future.

Stablecoins are classified into three varieties based on the mechanism employed to keep their value stable.

Crypto-Collarized Stablecoins
Fiat-Collateralized Stablecoins
Algorithmic Stablecoins

Crypto-Collarized Stablecoins

Other cryptocurrencies back crypto-collateralized stablecoins. Because the reserve cryptocurrency may likewise be volatile, such stablecoins are overcollateralized, which means that the value of cryptocurrency kept in reserves exceeds the value of the stablecoins produced.

A cryptocurrency worth $2 million could be retained as a reserve to issue $1 million in a crypto-backed stablecoin, guaranteeing a 50% drop in the reserve cryptocurrency’s valuation.

For example, MakerDAO’s Dai (DAI) stablecoin is pegged to the U.S. dollar but backed by Ethereum (ETH) and other cryptocurrencies worth 150% of the current DAI stablecoin.

Fiat-Collarized Stablecoins

Fiat-collateralized stablecoins keep a reserve of a fiat currency (or currencies), such as the U.S. dollar, as collateral to ensure the value of the Stablecoin.

Other forms of collateral can include precious metals like gold or silver, as well as commodities such as crude oil. However, the majority of fiat-collateralized stablecoins have U.S. dollar reserves.

These reserves are managed by independent custodians and are audited regularly. Tether (USDT) and TrueUSD (TUSD) are popular stablecoins backed by U.S. dollar reserves and denominated in U.S. dollars.

Algorithmic Stablecoins

Algorithmic stablecoins may or may not contain reserve assets. Their biggest differentiator is maintaining Stablecoin’s value by managing its supply via an algorithm, which is a computer program running a predefined formula.

In some aspects, this is similar to central banks, which do not rely on a reserve asset to maintain the value of the currency they issue.

The difference is that a central bank, such as the United States Federal Reserve, determines monetary policy openly based on well-defined parameters, and its role as a legal tender issuer adds to the legitimacy of that policy.

Algorithmic stablecoin issuers can’t rely on such benefits in a crisis. The price of the TerraUSD (UST) algorithmic Stablecoin dropped more than 60% on May 11, 2022, vaporizing its peg to the U.S. dollar, as the price of the linked Luna token used to peg Terra slumped more than 80% overnight.

Now that we know what stablecoins are about, let us look at the other digital currencies, such as CBDCs.

What are Central Bank Digital Currencies (CBDCs)?

Central bank digital currencies (CBDCs) are those issued by a country’s central bank. They are comparable to cryptocurrencies because the central bank determines their value and is equal to the country’s fiat currency.

CBDCs are being developed and implemented in many countries. Because so many countries are looking into digital currencies, it’s critical to grasp what they are and what they signify for society.

Understanding Central Bank Digital Currencies (CBDCs)

Fiat money is a currency created by the government that is not backed by a tangible commodity such as gold or silver. It is legal money that can be used to exchange goods and services.

Fiat money was traditionally issued in the form of banknotes and coins. Still, technological advances have enabled governments and financial institutions to supplement physical fiat money with a credit-based model that records balances and transactions digitally.

Physical cash is still extensively exchanged and acknowledged; however, in several affluent countries, its use has declined, and this trend has intensified during the pandemic.

The advent and expansion of cryptocurrencies and blockchain technologies have heightened interest in cashless societies and digital currencies.

The Goal of Central Bank Digital Currencies (CBDcs)

CBDCs’ primary purpose is to provide privacy, transferability, ease, accessibility, and financial security to businesses and consumers.

CBDCs could also minimize the cost of maintaining a complicated financial system, cut cross-border transaction costs, and provide lower-cost options to people who now utilize alternative money-transfer methods.

CBDCs would also lessen the dangers associated with current digital currencies or cryptocurrencies. Cryptocurrencies are highly volatile, with their value fluctuating all the time.

This volatility may cause considerable financial hardship for many people and impact an economy’s overall stability.

CBDCs, backed by the government and administered by a central bank, would provide a safe way for households, consumers, and companies to exchange digital currency.

Types of Central Bank Digital Currencies (CBDCs)

CBDCs are classified into two types. These are;

Wholesale CBDCs
Retail CBDCs

Wholesale CBDCs

Wholesale CBDCs are analogous to central bank reserves. The central bank opens an account for an institution to deposit funds or use to settle interbank transfers.

Central banks can then affect lending and set interest rates using monetary policy tools such as reserve requirements or interest on reserve holdings.

Retail CBDCs

Retail CBDCs are digital currencies backed by the government and utilized by consumers and businesses.

Retail CBDCs minimize intermediary risk, which is the chance that private digital currency issuers will go bankrupt and lose their clients’ assets.

If you have come so far, it is safe to say that we understand the two digital currencies, stablecoins and CBDCs very well.

Now, let us go over their differences.

What is the Difference Between Stablecoin and Central Bank Digital Currency?

Although both employ blockchain technology, the fundamental difference between CBDCs and Stablecoins is that CBDCs use private (permissioned/authorized) blockchains, while Stablecoins use public (permissionless) ones.

Some other differences between the two digital currencies are;

Issuance and governance
Legality
Geographical scope
Technology infrastructure
wallets

Issuance and Governance

CBDCs are centralized, which means a central bank must issue them. Meanwhile, both licensed banks and non-bank businesses can issue stablecoins.

Both registered banks and non-bank companies can govern stablecoins in terms of governance. In theory, CBDCs would be governed by central bank authorities.

Legality

One of the greatest differences between CBDCs and Stablecoins is the present legal status of each currency. CBDCs are still mainly considered theoretical among central banks.

Still, Stablecoins are beginning to see more widespread legal classification throughout the United States and Europe, with greater regulation coming with fears of de-pegging (proof of reserves and wallet transparency necessary).

Geographical Scope

Stablecoins have no geographical limitations and can be purchased or used anywhere. CBDCs, on the other hand, are being designed primarily for domestic use, with cross-border interoperability capabilities.

Overall, stablecoins are more convenient to spend globally, whereas CBDCs (for the most part) have region-specific use.

Technology Infrastructure

CBDCs would use permissioned or proprietary technology because they are a product of a centralized banking system.

Stablecoins, on the other hand, can leverage several open-source, non-proprietary, and permissionless blockchains as their primary tech backbone.

This also grants Stablecoins access to the blockchain’s distributed ledger technology.

Wallets

Another significant distinction between CBDCs and Stablecoins is how they are stored. Stablecoins can be held in any digital wallet that supports the currency being purchased or sold.

CBDCs, on the other hand, would have to be stored in a proprietary wallet solution provided by the government or authorized banking intermediaries.

Final Thoughts

While CBDCs are still in the early stages of being ready for public investment, stablecoins have been available to anybody with the means to purchase them for several years.

Anyone interested in Stablecoin investments must understand how to safeguard their assets.

Stablecoins are constructed on blockchains, so you’ll need a digital wallet to buy, sell, and manage your Stablecoins. This wallet can also house any other cryptocurrencies, NFTS, or digital assets you own.

Keeping your wallet secure is critical, especially as more blockchain equivalents for real-world commodities emerge.

Stablecoins vs. Central Bank Digital Currencies (CBDCs): A Comparative Analysis

What are Stablecoins?

What Makes Stablecoins so Important?