Could a digital dollar make stablecoins more stable?

Circle

Central bank digital currencies and stablecoins have often seemed to be distinct — one developed by governments, the other by private companies — but they both share a goal of moving money faster and bringing more people into the financial system. 

CBDCs can also mitigate stablecoin risk by partly backing the digital currency, according to Circle, which issues the USDC stablecoin. The fintech made its case at a conference last week at Warwick College, amid the context of the banking crisis that followed the collapse of Silicon Valley Bank, which catered largely to technology firms.  

Circle had $3.3 billion in reserves at Silicon Valley Bank that could not be immediately accessed, causing USDC to temporarily decline to $0.88, losing its one-to-one peg, or ratio between the stablecoin and its backing reserves. At the Warwick conference, Circle advocated for holding dollar reserves directly with the Federal Reserve to back the stablecoin. That would be a short-term solution, with a long-term model involving a CBDC as part of the stablecoin's backing. Circle did not provide comment by deadline. 

"It would be using the technology of a CBDC but it's still private money," said Ganesh Viswanath Natraj, assistant professor of finance at the Gilmore Centre for Financial Technology at Warwick College. The stablecoin issuer would hold reserves at the central bank but the actual stablecion would remain distinct. "So by having a CBDC as backing, you would lose the run risk," Natraj said. 

Stablecoins are a type of cryptocurrency designed to reduce the impact of crypto's notorious valuation shifts by backing the stablecoin with more traditional assets in an attempt to make holders "whole" in the event of a mass withdrawal. This backing is usually done with traditional currency such as U.S. dollars or euros, but in some cases stablecoins have run into trouble with regulators by backing with riskier assets such as commercial paper.

One of the potential roles of CBDCs is to provide a government-backed alternative to stablecoins, according to McKinsey, which notes that stablecoins and CBDCs share a lot of the same use cases and promise to address many of the same pain points. But rather than make stablecions less relevant, a CBDC could facilitate the growth of stablecoins by adding an extra layer of backing, thus boosting confidence in stablecoins and digital assets in general, Natraj said. 

Circle's USDC is backed by U.S. dollars, with 80% of its reserves being U.S. Treasury bills and the other 20% in cash distributed among banks. A theoretical wholesale CBDC would likely augment that 20%, shielding it from a potential future bank run. 

"Backing with central bank money is fine, but expensive in terms of tying up assets, in a way that deposits aren't," said Martin Hargreaves, chief product officer at Quant, a distributed ledger technology company. "But the idea of a central bank guarantee is quite powerful."

If a certain percentage of the backing is with the central bank, and the central bank then guarantees redemption, that is essentially a risk-free stablecoin without being a CBDC. "Why would central banks want to offer this — and what level of oversight would they want over banks in that scheme — are probably quite key questions, however," Hargreaves said. 

There are other questions about CBDCs that need to be answered first, such as whether the U.S. will even have one. Organizations in the U.S., including the Federal Reserve Bank of New York, are conducting a number of CBDC experiments, including tests to see how a digital dollar can co-exist with non-digital currencies and CBDCs from other nations. 

But these tests do not take a position on a U.S. CBDC, there has been little movement on Congressional authorization of a digital dollar, and opposition to a CBDC from some conservatives. 

"Stablecoins and CBDC working together and collateralized by [government] notes may imply conflicts of interest and more concentration to the system," said Ilya Volkov, CEO and Co-Founder of YouHodler, a blockchain technology firm. 

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A potential argument for a heavier government hand in backing stablecoins is the challenges the private sector has had with stablecoins. Facebook sold the assets tied to the Diem stablecoin to Silvergate Bank after years of political pressure. Silvergate discontinued Diem and the bank folded shortly after SVB's collapse. 

"Even if the Fed were to have backstopped USDC, it wouldn't have saved Silicon Valley Bank. SVB came unstuck due to poor risk management and insufficiently severe stress testing," said Alla Gil, CEO and founder of Straterix, a risk management technology and consulting firm. "If stablecoins had proper risk management strategies in place, that factored in all possible scenarios, they wouldn't need to be backstopped by the Fed."

There are other structural challenges. The CBDC model Circle floated at the U.K. conference would be a wholesale CBDC, which is designed for movements of funds between large parties, generally banks in different countries. The wholesale CBDC is designed to cut costs and time from very large payments, rather than provide speedy, cheap processing for a steady flow of smaller payments. 

Retail CBDCs are designed for a larger number of small transactions, and as such are considered the most likely form of CBDC to be used for payments between consumers and businesses at the point of sale—potentially limiting the utility of a wholesale CBDC-backed stablecoin.

"The biggest use case would be for cross-border foreign exchange," Natraj said, adding a stablecoin with wholesale CBDC as part of the reserves could make currency exchange easier and less expensive.