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OLET1208 Assignment
Question 1: Stablecoins have emerged as a new class of
cryptocurrencies at the intersection of regulatory compliance and as
stable mechanisms of value transfer.
Discuss how stablecoins achieve price stability, outlining (and
describing) different price stability mechanisms (e.g., collateralized,
algorithmic) and their effectiveness in achieving this purpose.
Extreme volatility and price fluctuation appear inherent to cryptocurrency markets in its
current youthful and immature state. The traded volume of coins can regularly exceed
market capitalisation and price changes can vary from thousand-percentage gains to a value
of zero. These rapid price changes, as a result of speculation, have led to a new class of
cryptocurrencies known as Stablecoins that attempt to offer price stability via the backing of
a reserve asset.

Stablecoins attempt to peg their value to an external asset, such as fiat currencies,
commodities and other cryptocurrencies. The advantage of asset-backed cryptocurrencies is
its comparative price-stability and as such reduced financial risk. While backed stablecoins
are subject to the same volatility and risk of its more financially secure underpinning asset,
these risks are still much lower than having direct exposure to the direct cryptocurrency
market. By avoiding the short-term volatility that makes other coins unsuitable for everyday
use by the public, these coins provide a safe medium of monetary exchange and storage of
value. Through its unmatched stability when compared to the broader market, maintenance
of relative purchasing power and minimal inflation, these coins offer mobility and
accessibility for everyday use in consumer purchasing and trading between other
cryptocurrencies.

While all stablecoins feature asset backing allowing price stability, the method in which this
is achieved can vary widely. Fiat-backed cryptocurrencies achieve price stability through the
backing of monetary reserves or collateralisation. For every token in circulation, there is
often one given unit of currency in reserve such as the U.S. Dollar. This form of stablecoin is
widely used today with Tether (a dollar backed cryptocurrency pegged to the USD) being
one of the most traded cryptocurrencies and a vital exchange between the USD and BTC.
Tether’s value is guaranteed to remain pegged to the USD as every time it issues a new
token it allocated the same amount of USD to its reserves. This is similar to Crypto-
Collateralised stablecoins which are backed up by other cryptocurrencies. However, where
it differs is it may be over-collateralised, meaning that a larger number of crypto tokens is
maintained as reserve to issue a lower number of stablecoins. This is due to the reserve
cryptocurrency also being prone to high volatility.

Another form of achieving stability in stablecoins is through an algorithmic mechanism

which doesn’t involve the use of collateralisation. These stablecoins mirror the functions of
a reserve bank in order to retain a stable price. This system uses a mechanism which
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balances the supply and demand of the asset in circulation. The algorithm or protocol helps
in increasing the supply during a deflationary tendency of the token or reducing supply
during a decline in purchasing power. These rules are often executed through smart
contracts. The benefit of these stablecoins lies in its capital and asset efficiency, not relying
on holding large swaths of currency at a given time.

Stablecoins have been extremely successful in facilitating both the storing of value and
transactions across the blockchain. Many coins such as USDT (Tether) and USDC (USD Coin)
play a key role in trading between cryptocurrencies and have become some of the most
traded currency pairs. The USDT-BTC currency pair makes up nearly 70% of bitcoin trading
activity, facilitating liquidation into fiat currencies. However, despite their effectiveness in
facilitating market activity, stablecoins have their fair share of problems. They have been
suggested to not be stable at the high-frequency intraday level and become more stable
only at the daily level. Further, many coins have been accused of not maintaining a true one-
to-one backing and have been in the spotlight recently over the use of commercial papers
rather than direct currency.

Stablecoins have played a pivotal role in the rise of the cryptocurrency market. The use of
multiple price stability mechanisms seeks to improve the volatility prevalent in the
cryptocurrency markets with varying effectiveness. It is only the infancy of stablecoins as we
know it and only time will tell how they evolve to provide simplicity and stability to broader
market.

Question 2: New cryptocurrencies are emerging almost daily, and

many are wondering whether central (reserve) banks should issue
their own versions. Discuss what central bank cryptocurrencies
(CBDCs) might look like and whether they might be useful?
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Central Bank Digital Currencies (CBDC) refers to a virtual form of fiat currency regulated and
issued by a nation’s monetary authority or Central Bank. The goal of CBDC’s is to provide
monetary users with access to the convenience and security of a digital currency while
maintaining a reserve-backed asset with circulation of the traditional banking system.
Similarly, to traditional currency units, they are functioning as a store of money, a system of
exchange for transactions and a unit of account.

CBDC’s can consist of two separate types: Wholesale and retail. A Wholesale CBDC is
intended for the settlement of interbank transfers and related wholesale transactions. This
could include the settlement of payments between financial institutions and could
encompass the use of digital assets and cross-border payments. This form of CBDC uses the
existing tier of banking and finance to conduct and settle transactions. The distributed
ledger technology within this form of currency would prove vital in extending the concept of
this cross-border payment system and could seek to expedite money transfers considerably.

Retail CBDC’s instead involve the transferring directly with individuals and consumers. A
retail CBDC could be structured as ‘an account based’ or a ‘token-based’ system. An account
system requires the keeping of record balances and transactions of all holders of the CBDC.
This system would involve transferring CBDC balances between accounts and would be
dependent on the ability of the system to verify that each individual had the authority to
use the account and sufficient balance. On the contrary a token-based system would involve
the use of a digital token that is issued by the central bank and would function as the digital
equivalent of a banknote. This would mean that tokens could be transferred electronically
from one holder to another and means that whoever holds the token at the time would be
presumed to own them.

A hybrid system between these forms would be possible as well. This could involve the
device-to-device token transfer ability as well as some periodic communications between
the tokens and the central entity itself. This provides the safety of counterfeit token
detection as well as the freedom of token transactions themselves.

CBDC’s could be extremely useful in simplifying the process of both monetary policy and
government functions. This is through the automation if interbank transfers and the
creation of a direct relationship between consumers and central banks. Further, they can
minimise overhead in the distribution of welfare benefits and seek to simplify the processes
of taxation. Another key function is the removal of third-party deposit risks. If this system of
banking is introduced any residual risk that exists in the system rests with the central bank,
minimising impacts of events such as a run on the bank. It also seeks to remove key
blockages by making traditionally expensive banking infrastructure much cheaper to provide
to the unbanked and typically poorer population. Finally, CBDC’s can easily track and
prevent illicit activity because all transactions exist in a digit format with a public ledger.

However, despite many advantages costs do occur in a digital transformation. Many of the
costs that come with this system involves the loss of privacy and anonymity in the financial
system. CBDC’s and online banking infrastructure requires digital identifications. This allows
transactions to be tracked and individuals vulnerable to targeted attacks. It also fails to
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resolve the issue of decentralisation, which has become a popular feature of many
cryptocurrencies. This may lead to comparisons between CBDC’s and cryptocurrencies, with
many question what the direct benefits are over the traditional payment system. Lastly,
with such a massive undertaking, regulation will be difficult when introduced and may lag
for years before it catches up successfully.

While it may be many years before a CBDC is introduced, there is no doubt that in the future
a system such as this may become prominent. The debate over the future of fiat currencies
is currently taking place and CBDCs may play a vital role in modernising global financial
systems and preventing the growth of other cryptocurrencies.