Stablecoins: Background and Potential Impact on the Banking Industry
Mustafa Syed
Senior Manager | Solution Architect | PhD Doctoral Researcher | Postgraduate Finance & Enterprise Solutions | CBDC/ Stablecoins/ Digital Assets SME | Digital Compliance/ E-invoicing SME
Authored by Mustafa Syed
Prologue
Today, authorities all around the world are grappling with the rise of Digital Currencies, Stablecoins and Decentralised Finance (DeFi) based on emerging technologies, in particular various combinations of distributed ledger technology (DLT) and blockchain have entered this space creating a number of different questions that need to be addressed.
Stablecoins in particular appear to be ‘the talk of the town’ at present due to the recent turmoil being experienced by the market, caused by Luna and its sister coin the Terra. The recent Terra (UST) debacle has definitely shaken the crypto market’s confidence in other stablecoins as well, like Tether (USDT) but what are stablecoins and how are they designed? And what are the potential impacts to the traditional banking sector? Let's explore the fundamentals first and then dive into the details.
Stablecoins have emerged as an alternative to crypto-assets, whose severe price volatility has made them difficult to use as payment instruments. They can also be viewed as a new form of private money that can add value to cross-border transactions for firms and banks. Although they are still in their early days and it is unclear how widely used, they are as money. This may partly be due to the fact that they are not sufficiently differentiated from fiat cryptocurrencies; for example, stablecoins still trade on the same exchanges as fiat cryptocurrencies and are used to buy and sell fiat cryptocurrencies.
Numerous types of private digital money have emerged to date across the world, but with the introduction of Libra stablecoin (June, 2019) a few years ago, we started to see increased debate by regulators and policy-makers on its wider ramifications. It is my view stablecoins has room to grow and evolve. The main question is how policymakers will adjust our regulatory framework to handle their growth and evolution in the coming years.
It is generally cited that stablecoins are digital currencies that peg their value to an external reference, typically the US Dollar (USD). Stablecoins play a key role in the digital markets (in particular in the Cryptocurrency space), and their growth has been touted to spur innovations in the broader economy.
In the past year, USD-pegged stablecoins circulating on public blockchains have seen explosive growth, “with a combined circulating supply of nearly $130 billion as of September 2021 – a more than 500% increase from one year ago” [1].
As highlighted by the BIS in their paper on stablecoins [2], "like the proverbial phoenix, stablecoins had risen from the ashes of the 2018 cryptocurrency bubble until the recent aforementioned market fiasco". After its introduction in 2009, Bitcoin saw at least three distinct periods of boom and bust, first in late 2013/early 2014, ending with the high-profile hack of crypto-exchange Mt. Gox, and second in late 2017/early 2018, when the market capitalisation of Bitcoin, Ether and other crypto-assets peaked at USD 830 bn and then recently in 2021/11 when we saw increased institution-based interest and the introduction of DeFi and NFTs which led to an increased growth in liquidity in the market.
As stablecoins have gained increasing attention in public discourse, a host of issues have been raised, “including the stability of their pegs, consumer protection, know-your-customer and anti-money laundering compliance, and the scalability and efficiency of settlements” [3]. It is particularly pertinent to highlight the current Luna crash, the cryptocurrency associated with the stablecoin TerraUSD (otherwise known as UST) which is now worth $0 as the stablecoin has dramatically lost its $1 peg [3].
The recent (albeit temporary) demise of the controversial algorithmic stablecoin Terra has resulted in a meltdown in the crypto market, which has erased billions of dollars in value over a single day and continues to cause further disruption to the cryptocurrency space. It can be argued that this single incident alone has had a profound impact on market sentiment and interest since the last major incident, the Mt. Gox hack that took place in 2014 (in terms of order of magnitude). Most obviously, there is the straightforward financial cost of investing in new technology.
“I think we’re seeing this Cambrian moment for stablecoins,” Marco Santori, chief legal officer at Kraken Digital Asset Exchange, said to TechCrunch. “They’ve really come into their own, in terms of finding a foothold in the market.” [4]
Whilst it is also interesting to note that recently United States Secretary of the Treasury Janet Yellen called on U.S. lawmakers to develop a "consistent federal framework” on stablecoins to address risks to financial stability. Yellen reiterated her previous position calling for a regulatory framework on stablecoins and quote, “I think the situation with TerraUSD simply illustrates that this is a rapidly growing product and that there are risks to financial stability and we need a framework that’s appropriate,” [5]. At the same time, she also mentioned that the stablecoin market is still too small to pose systemic risk.
Systemic risk refers to the risk of a breakdown of an entire system rather than simply the failure of individual parts. In a financial context, it denotes the risk of a cascading failure in the financial sector, caused by linkages within the financial system, resulting in a severe economic downturn.
Others have cited that Stablecoins can promote financial inclusion (as covered in one my earlier articles [19]). But arguments based on financial inclusion, though made by the likes of U.S. Treasury Secretary Janet Yellen has pointed out that they are weak.
In the United States alone, 6% of households without bank accounts and therefore also without debit or credit cards may lack sufficient income. But to operate a stablecoin app, they will have to have income sufficient to purchase a cellphone and a mobile-phone contract. Other unbanked individuals, lacking citizenship or engaged in legally dubious business practices, may prefer to fly under the radar, in which case they will also be reluctant to do business on the central bank's private or permissioned network [18]. Also, the banking sector is increasingly becoming uncompetitive and some would argue it behaves as an oligopolistic marketplace [6].
With it comes a number of issues including billions of dollars in fees, lack of banking options for customers, and lack of competition that will put the US at a disadvantage in the near future. So, the jury is out on how effective a stablecoin would be for certain countries around the world. Whilst they are a rapidly growing and evolving aspect of the crypto asset ecosystem, it is important to differentiate the different types of stablecoin and their individual features, mechanics and ramifications to the current banking sector.
In this article, we will focus our discussion on the potential impact of stablecoins on the banking system and on the concept of credit intermediation. While a range of stablecoin-related issues may be resolved with appropriate institutional safeguards, regulations, and technical advancements, sustained growth in stablecoins in circulation would ultimately impact the traditional banking system in significant ways that are important to understand. I will attempt to dissect this topic by examining what stablecoins are, what purposes they serve and how they can potentially impact existing banking institutions.
Introduction
Stablecoins are digital currencies recorded on distributed ledger technologies (DLTs), usually blockchains, that are pegged to a reference value. The ECB (2019) have defined them as digital units of value, that are not a form of any specific currency (or basket thereof) but rather, rely on a set of stabilisation tools/mechanisms which try to minimise fluctuations in their price in such currencies.
The majority of outstanding stablecoins are pegged to the U.S. dollar, but stablecoins can also be pegged to other fiat currencies, baskets of currencies, other cryptocurrencies, or commodities such as gold. Stablecoins serve as a store of value and a medium of exchange on DLTs, which enable stablecoins to be exchanged or integrated with other digital assets.
Stablecoins are a specific category of crypto-assets that aim to maintain a stable value relative to a specified asset (typically US dollars), or a pool or basket of assets, and provide perceived stability when compared to the high volatility of unbacked crypto-assets (FSB, 2022).
However, relative price stability may not be the case for all stablecoins owing to variations in the ways in which they are pegged, the nature of reserve assets (if any), and their governance structure. Stablecoins differ from traditional digital records of money, such as bank deposit accounts, in two primary ways:
These two key features underpin the current use cases of stablecoins and support innovation in both the financial and non-financial sector. Initially, stablecoins evolved in order to address the failure of Bitcoin and other cryptocurrencies to provide an effective monetary and payment instrument. This reflected the preference of main market participants to base transactions and payments on sovereign fiat currencies, in particular the US dollar. It also reflected weaknesses in Bitcoin and other cryptocurrencies, as means of payment, store of value or unit of account.?
With respect to stablecoin use cases, they have been designed to meet a myriad of requirements. The most important current use case of all is the role in transacting cryptocurrency on public based blockchains. Investors often prefer to use public stablecoins instead of fiat balances to trade cryptocurrency, because this allows for near-instantaneous 24/7/365 trading without relying on non-DLT payment systems or custodial holdings of fiat currency balances [3]. Other use cases include peer-to-peer payments, performing internal transfers, and for DeFi (see figure 2 below).
Public stablecoins are programmable and composable, they are used heavily in decentralized, public blockchain-based markets and services, as previously mentioned by DeFi. DeFi protocols allow users to use stablecoins to directly participate in a variety of cryptocurrency-related markets and services, such as market-making, collateralized lending, derivatives, and asset management, without traditional intermediaries. However, as no digital form of the dollar or other sovereign fiat currencies was available, market participants developed the stablecoin structure as a means to address this issue, as well as to provide an instrument to support hedging between crypto-assets and fiat currencies. The need was for a bridge between DLT and fiat currencies, with stablecoins seeking to fill this need. This was particularly relevant in the context of high volatility in the price of Bitcoin (and other cryptocurrencies), making it less useful as a payment instrument and more of an investment speculative standpoint [1].?
From a market-mechanics standpoint, stablecoins are supposed to maintain a value of $1. They are mostly used on crypto trading platforms, which typically don't allow dollar-based accounts. Most stablecoins you and I may have heard about in the news are dollar-backed, meaning each token is backed by traditional money. But in contrast, for example the UST is an algorithmic stablecoin, meaning it derives its value in part from computer programs leveraging smart contracts that automatically adjust supply of the coins in response to rises and falls in demand (more about this later on in this article).
At first glance, it might not be clear why there is so much demand for stablecoins as a means of currency stability given that the dollar itself could serve directly for rebalancing portfolios [13]. Indeed, there are institutional features, however, that induce investors to use stablecoins. These features are highlighted as follows:
Stablecoins circulating on public blockchains have seen massive demand and scale, with the supply of fiat-backed, crypto-backed and algorithmic stablecoins totaling more than $180 billion as of April 26, up 112% from $85 billion on the year-ago date, according to data compiled by The Block (see illustration below highlighting the total stablecoin supply increase). Note, this figure should be revised in consideration of the recent Terra coin crash.
This fast growth can be explained by two factors:
While on paper stablecoins can be supported or stabilised by anything, the focus of this discussion and the current stablecoin payment debate centers around stablecoins backed on a one-to-one basis by the US dollar. It might seem like creating a crypto asset that is backed by the dollar and intended to trade/behave like the dollar would be redundant, but that misses the broader points to how it should try be managed, governed and backed. Let's take a look at the different types of stablecoins in existence right now.
Current Types of Stablecoins
As previously mentioned, stablecoins are relatively nascent, and a broadly defined technology that can potentially take many different forms. This technology is currently implemented in specific forms including the cryptocurrency industry and has been summarised in the table below (Figure 3).
Stablecoins are digital currencies minted on the blockchain which are typically identifiable by one of four underlying collateral structures: fiat-backed, crypto-backed, commodity-backed, or algorithmic. While underlying collateral structures can vary, stablecoins always aim for the same goal: stability [8]. It is also important to highlight the current implementations of stablecoins discussed below, as well as their current status in the regulatory landscape, do not reflect all potential deployments of stablecoin technologies [1].
In order to embed integrity in the design, most stablecoins are linked to a reserve of external assets of some kind, whether it be a stash of fiat currency, commodities like gold or debt instruments like commercial paper. In most cases, the company or entity that develops the stablecoin owns reserves equal to the amount of stablecoins it has in circulation. This is such that any stablecoin holder should be able to redeem one stablecoin token for one dollar at any time.
One must remember that stablecoins are exposed to similar vulnerabilities as money market funds (MMFs), and there is currently a lack of transparency regarding stablecoins’ reserve assets.?Stablecoins, like MMFs, need to be backed by liquid reserve assets if users are to see the conversion back to a fiat currency as credible. Losses on reserves could trigger a loss of user confidence and prompt large-scale redemption requests, while the liquidation of underlying – usually traditional – assets to cover redemptions could have negative fire-sale contagion effects on the financial system [18].
An illustrative of the asset/liability structure (balance sheet) can be depicted by the following diagram which distinguishes between stablecoins vs traditional financial institutions which was developed by Sébastien Derivaux (2022).
With the idea behind algorithmic stablecoins, one can take a simplistic view by comparing it to how a bank writes a loan, where it simultaneously creates a matching deposit on the liability side of its balance sheet. Reserve-backed stablecoins employ a similar mechanic, being IOUs backed one-for-one by a balance sheet liability. But with algo stablecoins, a governance token replaces the balance sheet and the IOU is written into the protocol. It is argued by some in the purest sense, creating money from thin air [14]. In essence, this would imply that liquidity see-saws programmatically and automatically between the IOU token and the quasi-balance sheet liability token to create arbitrage opportunities at negligible cost.
Most existing stablecoins circulate on public blockchains, such as Ethereum, Binance Smart Chain, or Polygon. Of these public stablecoins, most are backed by cash-equivalent reserves such as bank deposits, Treasury bills, and commercial paper. These reserve-backed stablecoins are also referred to as custodial stablecoins, as they are issued by intermediaries who serve as custodians of cash-equivalent assets and offer 1-for-1 redemption of their stablecoin liabilities for U.S. dollars or other fiat currencies.
The full backing and soundness of some public reserve-backed stablecoins have been called into question. In particular, Tether, the largest stablecoin by circulating supply, agreed to pay $41 million to settle a dispute with the U.S. Commodity Futures Trading Commission, which alleged that Tether misrepresented the sufficiency of its dollar reserves. Other widely used reserve-backed USD-pegged public stablecoins with varying levels of financial audits include USD Coin, Binance USD, TrueUSD, and Paxos Dollar [7].
The remaining fraction of existing public stablecoins use other mechanisms to stabilise their price instead of relying on the soundness of underlying reserves. These stablecoins are often called algorithmic stablecoins. While reserve-backed stablecoins are issued as a liability on the balance sheet of a legally incorporated firm, algorithmic stablecoins are maintained by systems of smart contracts that operate exclusively on a public blockchain.
The ability to control these smart contracts is often conferred by the possession of a governance token, a specialised token primarily used for voting on changes to protocol or governance parameters. These governance tokens can also potentially serve as direct or indirect claims on future cash flows from the usage of a stablecoins protocols.
Whilst the public algorithmic stablecoin sector is highly innovative and difficult to categorise, one can generally think of the design of these stablecoins as based on two mechanisms:
Collateralized public stablecoins, such as Dai, are minted when a user deposits a volatile cryptocurrency, such as Ethereum, into Dai’s smart contract protocols. The user then receives a loan of Dai (which is pegged to the dollar) against their crypto collateral, at a greater than 100% collateralization ratio. If the value of the Ethereum deposit falls below a certain threshold, the loan is automatically liquidated.?
A high-level overview of the main global stablecoin providers has been illustrated in the diagram below.
Stablecoin Peg Mechanism
As highlighted earlier, an algorithmic stablecoin derives its value in part from computer programs that automatically adjust supply of the coins in response to rises and falls in demand (via smart contracts for example). But why is this such a contentious subject at the moment and why did UST recently crash? The algorithmic peg mechanism deployed uses automated smart contracts to defend the peg by buying and selling the stablecoin against an associated governance token [7].?
However, these pegs may experience instability or design flaws that lead to de-pegging, as exemplified by the temporary collapse of Fei, a public algorithmic peg stablecoin that briefly de-pegged after its launch in April 2021, as well as the recent collapse of UST in May 2022. UST was designed so that the amount of the coin that could be created or destroyed i.e. "minted" and "burnt," in crypto-speak which changed through the response to prices. But UST was essentially backed by another cryptocurrency, something called Luna [9]. More on this later on in the article.?
Now going back to the whole Luna and Terra stablecoin debacle, it's poignant at this moment to highlight the stability of a stablecoins peg to its reference value is this a central issue that is invoking wide debate [1]. Presently, peg instability for public reserve-backed stablecoins can be illustrated in two ways:
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As highlighted recently by Fitch Ratings (2022), this failure of the algorithmic peg mechanism fixing the price of Terra’s USD stablecoin (UST) and the unmooring of Tether from its USD peg highlight the fragile nature of private stablecoins, and will accelerate continued calls for regulation. As previously mentioned, the US Treasury Secretary, Janet Yellen, has already said it shows the importance of having an appropriate regulatory framework for stablecoins. Also, the EU’s Markets in Crypto Assets regulation is now nearing finalisation, which states that it will not permit the issuance of algorithmic stablecoins and requires bank-like regulation and reserves for systemic stablecoin issuers [2].
Also, there could also be significant negative repercussions for cryptocurrencies and digital finance as a whole if investors lose confidence in stablecoins. The latter plays an important role in catalysing the crypto ecosystem more broadly, by providing a stable bridge to fiat-currency financial markets which is why it is a concerning topic for established banking institutions.
What Happened with Terra Coin (UST)?
Going back to this topical subject, Terra’s design involved a proof-of-stake governance token called Luna along with a bunch of Terra coins designed to maintain a 1-to-1 ratio peg with real world currencies, including TerraUSD, TerraGBP, TerraJPY etc. It aims to maintain its peg to the U.S. dollar through a network of arbitrageurs, who buy and sell Terra’s volatile cryptocurrency, LUNA (also, confusingly, known as Terra). LUNA is also a?governance token, and grants holders voting power over the protocol. A person could swap Luna for a pegged Terra coin, and vice versa [14].
Terra's whitepaper claims that the elasticity of LUNA’s supply means that the stablecoins will never fall out of kilter [16]. Still, its success depends on arbitrageurs' continued interest in UST. If arbitrageurs decide that UST is doomed to fail, or move their money to another project, some analysts fear that they might not arbitrage UST back to its peg of $1. Like a lot of crypto projects beholden to free markets, the community spirit is paramount.?
To simplify this discussion, one could imagine the whole Terra economy as two pools: one for Terra and one for Luna. To maintain the price of Terra, the Luna supply pool adds to or subtracts from Terra’s supply. Users burn Luna to mint Terra and burn Terra to mint Luna, all incentivized by the protocol’s algorithmic?market module [15].
With UST, it gets even more complicated when you look at the algorithmic mechanics of how it works with Luna. It is worth highlighting that this is conceptually different than regular stablecoins like USDT or USDC that are backed by fiat or fiat equivalents.
When UST value fell below $1, traders could "burn" one UST and be paid to do so with $1 worth of Luna. The traders then pocket the small difference between the sub-$1 price of UST and the $1 worth of Luna, in a seemingly low-risk kind of trade known as arbitrage. So, what we would see is rising demand for either coin increases its supply. But because one Terra coin is always worth its peg value in Luna, so there would be an arbitrage on offer to switch to Luna whenever it’s trading below peg. And whenever the Terra coin is above its peg, the incentive is to switch back by burning Luna. So, the larger the difference to the peg is, the more profitable the arbitrage would be. In theory, if the peg is lost and the price of UST crashes below 1 USD, users can burn UST for LUNA and sell at a greater profit [15].
In the aggregate, all of this arbitrage trading would shrink the supply of UST which would help raise the price back to $1. In theory, this could work if Luna was really worth something. But why would Luna be worth anything? Well, as we're seeing this week, the market has decided it is not. UST was designed to use algorithms and trader incentives in relationship with Luna to keep a 1-to-1 peg with the dollar, but these mechanisms broke down as selling hit UST, triggering even deeper declines in Luna.?
So why should we care? As mentioned, UST's de-pegging has attracted renewed attention from regulators. In a hearing on May 10, U.S. Treasury Secretary Janet Yellen?cited?UST’s collapse as yet another reason that stablecoins need to be regulated in 2022.?If stablecoins were to see broad adoption throughout the financial system, they could have a significant impact on the balance sheets of financial institutions. Regulators, market participants, and academics are particularly focused on the potential for stablecoins to disrupt bank-led credit intermediation [1]. This recent incident has led to the stablecoins taking a backstep for wider adoption but one may look at this as a temporary hurdle but not a long-term challenge.
The Potential Impact of Stablecoins on the Banking Sector
An overarching consideration when being faced with any innovations is that authorities must consider how best to apply regulation so that similar economic and financial risks emerging from varying technologies and participants are treated similarly, avoiding regulatory arbitrage [10]. Still, the “regulatory dialectic” of regulation, regulatory avoidance and re-regulation may be unavoidable.
One also has to consider the costs associated with the commercial banking system. If the interest rate paid on a retail account at the central bank is similar to that at commercial banks (which for the moment means that they need pay no interest at all), individuals may prefer the former for their greater safety, causing commercial banks to be disintermediated [17]. The central bank will then find itself involved in private credit allocation. It will either have to go into the business of private lending itself, or else it will have to devise criteria for allocating the proceeds of its retail deposits to private financial institutions.
"There may also be heightened bank-run risk if depositors are free to flee to deposits at the central bank at the first hint of trouble. These risks could be addressed by limiting the amount of CBDC permitted for retail accounts to small denominations, but this in turn would limit the utility of the unit" [17].
If stablecoins were to see broad adoption throughout the financial system, they could have a significant impact on the balance sheets of financial institutions [11]. There is a need to set out to "analyze several plausible scenarios in which reserve-backed stablecoins see widespread adoption in the financial system" which was highlighted in the recent Federal Reserve Bank of New York paper where they tried to estimate the impact on bank lending under three different regulatory frameworks for stablecoins.
In fact, the Fed chair Jerome Powell recently remarked (in 2021) that there in an urgent need for regulation of stablecoins and the case for the Federal Reserve exploring a central bank digital currency?(CBDC) in response to stablecoins seems to be getting stronger. This moment is particularly important because regulators typically only pay this level of attention to systemically important segments of the financial system, such as banks and money market funds. These statements add to a growing body of evidence that unlike cryptocurrencies like Bitcoin and Ethereum (which widely fluctuate in value), stablecoins have the potential to play an important (if yet to be defined) role in the future of global finance. They could even become a backbone for payments and financial services [12].
While cryptocurrencies have not evolved into major alternatives or direct competition to existing sovereign monetary arrangements, as previously mentioned stablecoins have raised new challenges and questions. They also offer opportunities for specific use cases, with private stablecoins striving to be adopted as a means of payment for online purchases, peer-to-peer and micro-payments and a range of potential future applications. They also have the potential to serve as a digital monetary instrument, embedded in DLT applications, including programmable money or smart contracts.
The researchers in the aforementioned Fed paper had set out to "analyze several plausible scenarios in which reserve-backed stablecoins see widespread adoption in the financial system" [11]. These scenarios included "Narrow Banking" where under this framework for stablecoins, physical cash would be tokenized and issuers would be required to back their stablecoins with central bank reserves. With regards to the impact on bank lending, the paper highlighted "credit provision" and "credit intermediation" which would largely be minimal. But when it comes to deposits, however, there could be negative impacts because the deposit-backed funding for lending would be reduced as regular commercial bank deposits would move to separate accounts at the central bank.
“A narrow banking framework minimizes the risk of 'runs' on stablecoins but can potentially reduce credit intermediation” [1].
The second scenario analysed was with regards to two-tier intermediation. For this scenario, the paper highlighted that stablecoins would be backed by deposits held at commercial banks and then banks could then lend the stablecoins to new borrowers. But in order for this to work, the treatment of stablecoin deposits would have to be the same as that for non-stablecoin deposits when it comes to regulatory limits. In contrast to the narrow-bank scenario, large inflows into stablecoins could potentially have a positive impact on lending, while the overall balance sheets and asset holdings of commercial and central banks would remain unchanged.
Finally, the third scenario examined security holdings. Under this framework, the article stated that it would require cash-equivalent securities to be held as reserved collateral for stablecoins. The central bank's balance sheet would shrink slightly with lower banking reserves. The impact on lending would be neutral because commercial bank deposits would be recycled back into the banking system.
Policy-makers will need to coordinate across different agencies, sectors and jurisdictions, to support responsible innovation in payments while ensuring a globally consistent response to mitigating risks [2]. In doing so, certain international organizations and standard-setting bodies have already begun issuing guidance, principles and standards for the supervision and regulation of existing payment arrangements, including crypto assets, which address many of the challenges listed above.
One could also look at capital markets and banking regulations and standards needing to be applied to various aspects of the stablecoin arrangement. The BIS has also cited that international organizations and standard-setting bodies should continue to assess the adequacy of their current frameworks to address any new issues and challenges that stablecoins could present.
Another principle that needs to be adhered to for stablecoins to become a medium of exchange, is the NQA principle – 'no questions asked' – needs to be satisfied. It means they should be accepted in a transaction without due diligence on its value. Zhang & Gorton (2021) presented policies to address the NQA problem and run risk presented by stablecoins [20]. They observed that the federal government has two sets of options:
The authors point out a couple problematic examples: Stronghold USD and Facebook Diem stablecoins have unknown market cap, Tether (USDT) and Centre (USDC) can delay money redemption due to KYC. In addition, limited credibility is inherent to the backing of the produced tokens for almost any issue. The researchers thus dub stablecoin issuers as “essentially unregulated banks”. This would be a bad thing because any bank exists on the premise that no majority of its deposit holders will suddenly decide to withdraw all their money at the same time but stablecoin providers have no such confidence in their tokens’ backing.
In the table above (figure 6), the last three options would appear to produce equivalent results in that they would all make stablecoins safe and satisfy the NQA principle. Indeed, insuring stablecoins or requiring them to be backed one-for-one either by central bank reserves or Treasuries would essentially transform stablecoins into a national currency. However, there are nuances. For example, the option of requiring stablecoins to be backed one-for-one by Treasuries essentially ties two forms of money together at a fixed ratio. (Treasuries have a convenience yield and are a form of money for storing value safely.) Consequently, there is likely to be a shortage of one of the forms of money [20].
Next Steps
The fact that regulation should treat similar risks arising from differing technologies similarly does not preclude public authorities themselves from embracing innovation. Authorities are applying technology in their own functions, whether in the context of regulation and supervision or in the provision of public goods. These public goods include appropriate monetary instruments (constantly evolving with technology) and supporting payment and liquidity infrastructures. Whereas “financial regulation” is the process of setting the rules that apply to the regulated entities, “financial supervision” is the compliance monitoring and enforcement of these rules, which has to be dynamic and adaptable.
At the same time, there are open questions as to whether central bank digital currencies (CBDCs) and other initiatives could fulfil these functions even more effectively than privately developed stablecoins. CBDCs would enjoy the backing of the central bank and would not be subject to the same conflicts of interest around the asset backing and stabilisation mechanism. Their value could be fixed by design to the currency they reference (in particular in systems where the CBDC was actually the digital representation of the currency), thus eliminating fluctuations in value. The question is how a CBDC could be designed to offer robust interoperability with novel decentralised financial solutions [2].
Meanwhile, a number of improvements to existing payment systems could be an alternative or complement to both stablecoins and CBDCs. In particular, appropriately designed public sector and public-private initiatives, like retail fast payment systems (FPS), supported by public digital identify (ID) infrastructures, are already greatly improving the speed, availability and universal access of payments in many countries. In theory, FPS could offer additional functionalities or become interoperable with DLT applications. This could help to achieve some of the same policy goals [2].?
Summary
Stablecoins have grown tremendously over the past year as digital assets gain broader adoption and the use cases of programmable digital currencies are clarified. This rapid ascension has raised concerns that there might be negative impacts on banking activities and the traditional financial system. If stablecoins were to see broad adoption throughout the financial system, they could have a significant impact on the balance sheets of financial institutions. There is a need to set out to analyze several plausible scenarios in which reserve-backed stablecoins see widespread adoption in the financial system.
We have discussed how the links between crypto markets and regulated financial markets currently remain weak. One may expect this to limit the potential for crypto market volatility to spill over and cause wider financial instability but this is still open to debate with many regulated financial entities having increased their exposure to cryptocurrencies, DeFi and other forms of digital finance in recent months, some issuers could be affected if crypto market volatility becomes severe.?
Some policy makers now seem to be converging toward the idea that only a digital coin that is 100% backed by perfectly safe and liquid assets is viable. However, such a design may be a double-edged sword. On the one hand, it should help limit credit and liquidity risk to stablecoin holders, so long as there is legal and operational certainty that the liquid assets will remain available to meet the claims of these holders. On the other hand, tying up safe and liquid assets in a stablecoin arrangement means they are not available for other uses, such as helping banks satisfy their regulatory requirements to maintain sufficient liquidity, for example. This could lead to disruptive shortages of safe and liquid assets.
We also highlighted that policy-makers will need to coordinate across different agencies, sectors and jurisdictions, to support responsible innovation in payments while ensuring a globally consistent response to mitigating risk.
Finally, we can argue that stablecoins are an iteration of crypto assets that have drawn criticism from virtually every angle. Bitcoin and proponents of more decentralized options decry the centralized nature of stablecoins, and proponents of a US issued crypto dollar are not fans of privately issued competition to the dominance of sovereign currency.
Setting aside these critiques, as difficult as it might be in the current environment, stablecoins have an integral role to play in the payment and banking sectors moving forward. The only question is whether or not policymakers will realize these facts soon enough.
Citations
[4]: https://techcrunch.com/2022/04/26/stablecoins-are-here-to-stay-but-will-they-see-wider-adoption/
[15]: https://cryptopotato.com/here-is-what-happened-to-luna-and-why-the-price-can-continue-crashing/
Senior Manager | Solution Architect | PhD Doctoral Researcher | Postgraduate Finance & Enterprise Solutions | CBDC/ Stablecoins/ Digital Assets SME | Digital Compliance/ E-invoicing SME
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