Stablecoins, Offshore Dollars & CBDCS: Further Reflections on BIS Paper 'On par: A Money View of Stablecoins' by In?aki A., Perry M. and Daniel H. N.

Stablecoins: A Diverse Spectrum of Perceptions

Stablecoins have become a pivotal component of the ever-evolving financial landscape, bridging the worlds of traditional finance and cryptocurrency.

Yet, understanding stablecoins can be somewhat subjective, where various observers perceive them through the lens of their own monetary beliefs and experiences.

Depending on who you ask, stablecoins can evoke comparisons to different financial instruments and concepts - some liken them to money MMFs, while others see them as akin to casino chips, wildcat banks, ETFs, currency boards, or fixed exchange rates.

These diverse analogies reveal how stablecoins are a chameleon in the world of finance, capable of taking on different roles depending on the perspective of the observer.

The Money View: Stablecoins as Eurodollars

For many, the monetary view is the most apt lens through which to analyze stablecoins, drawing striking parallels to Eurodollars.

Eurodollars are offshore dollars (TradFi), existing outside the boundaries of domestic financial institutions.?

Similarly, "onchain" refers to the cryptocurrency ecosystem. Transactions within these domains are relatively seamless, but moving funds between them poses challenges.

Both Eurodollars and stablecoins are forms of credit, representing promises to pay dollars (either onshore or off-chain), with an ultimate commitment to settle at a fixed rate of one (par) - essentially both facilitating settlements within their respective spheres without necessitating reliance on onshore or off-chain dollars.

Liquidity Perspectives: Offshore vs. Onchain

The offshore dollar system predominantly views the stability challenge through a liquidity lens, while stablecoins often approach it from a solvency perspective.

Stablecoins assume that the value of the issuer's assets or collateral supports the stablecoin's value.?

Stablecoins emerged as a response to the need for a 'stable store of value' within the crypto ecosystem, allowing speculators to remain on-chain without constantly transitioning between Bitcoin and off-chain fiat currencies.

Liquidity Dynamics: Onchain vs. Offshore

In the onchain world, market liquidity plays a pivotal role due to limitations in funding liquidity. In contrast, the offshore system revolves around funding liquidity and exhibits greater elasticity.

Three types of liquidity are crucial in the stablecoin ecosystem:

• Monetary Liquidity: Holding actual monetary reserves.
• Funding Liquidity: The ability to borrow.
• Market Liquidity: The ability to convert asset holdings into money.

Stablecoins rely heavily on market liquidity due to their dependence on selling assets to address deficits during settlement. The critical question isn't just the value of assets relative to liabilities, but whether these assets can be swiftly liquidated in the event of a run to meet settlement deficits.

The Historical Context: Origins and Development

While Eurodollars have a long history, stablecoins are relatively nascent in comparison.?

Eurodollars emerged as a response to the postwar reconstruction of financial markets following World War II, originating in the United States and later extending to Europe.

The offshore dollar system gained prominence mainly in the 1970s and integrated with the onshore system in the 1980s, with par settlement serving as a crucial integration point.

The stability of par settlement in the offshore dollar system hinges on, keyword: interest rates, particularly the disparities between onshore and offshore rates creating arbitrage opportunities.

Crisis Response: Central Banks and Exchange Rates

Exchange rates between different currencies and the dollar play a crucial role in managing pressure within the offshore dollar system.

The US Federal Reserve serves as lenders of last resort, offering emergency liquidity through liquidity swap lines during times of crisis to ensure the stability of the global dollar settlement system.

For instance, during the 2008 crash, the demand for Eurodollar redemptions surged, causing offshore interest rates to spike. In response, the Fed opened liquidity swap lines to other central banks, creating offshore dollars to alleviate the redemption pressure.

The offshore dollar system functions as a hierarchical system, with the Fed at the apex, major central banks at the next tier, and others further down. However, this monetary hierarchy established since the Bretton Woods accord in 1944 has generated perennial dissatisfaction, leading to calls for international monetary reform in pursuit of a more equitable system, latent in the wake of the current geopolitical scenario.

Evolution of Stablecoins: Four Distinct Stages

The history of stablecoins can be categorized into four stages:

• Origins with Bitcoin (2009): Stablecoins emerged as a solution to the volatility of cryptocurrencies, providing a stable unit of account within the crypto ecosystem.
• Libra/Diem Proposal (2019): Facebook's Libra (later Diem) project brought stablecoins to the forefront of regulatory discussions, raising awareness about their potential.
• Acceleration During COVID-19 and ZIRP (2020-2021): The COVID-19 pandemic and zero interest rate policies (ZIRP) led to a surge in stablecoin use, particularly in decentralized finance (DeFi) platforms.
• Impact of Rising Interest Rates (Ongoing): Rising interest rates mark the current phase in the stablecoin narrative, with increasing pressure on their market capitalization and sustainability.

The Mechanisms of Stability: Three Approaches

Stablecoins offer three primary mechanisms to maintain stability and uphold par value:

• Backing with Safe Assets: Some stablecoins are backed by equivalent value short-term safe dollar assets. This backing provides confidence in the stablecoin's value.
• Collateral Support: Others are supported by collateral worth more than the stablecoin itself, serving as a buffer against fluctuations in value.
• Algorithmic Protocols: A third approach involves algorithmic trading protocols that adjust the quantity of a paired token in response to deviations from the stablecoin's par value.

The Challenge of Maintaining Par

Interest rate differentials between on-chain and off-chain systems have driven the expansion and contraction of stablecoins. Retail customers and professional carry traders have exploited these differentials, leading to the development of on-chain interest rates. The stability of par relations is critical in this context.

Two derivative problems further complicate the stablecoin landscape:

• Maintaining Par Across Stablecoins: Ensuring that different stablecoins on-chain maintain parity with each other.
• Maintaining Par Across Blockchains: Overcoming challenges when the same stablecoin is issued on multiple blockchains.

Central Banks and the Future

Some prominent international banks and central banking authorities are delving into stablecoin projects, moving towards the creation of tokenized deposits that are supported by Central Bank Digital Currencies (CBDC). The main objective of these endeavors is to seamlessly integrate traditional institutional frameworks with the realm of blockchain and cryptocurrencies. This integration seeks to maintain rigorous regulatory oversight while offering native 'on-chain' guarantees, departing from the reliance on off-chain Treasury Bills (T-Bills).

Conclusion

Integrating insights from the Bank for International Settlements (BIS) Working Paper No 1146, our discussion highlights the nuanced role of stablecoins in shaping the future financial landscape.

Positioned as the latest chapter in the cyclical nature of financial innovation, it signals a transformative period akin to the establishment of the Eurodollar market in the 1970s. This historical perspective provides valuable context for understanding the potential of stablecoins in modern finance.

Moreover, by facilitating more efficient and reliable cross-border transactions, stablecoins lower costs and shorten settlement times, making it easier for individuals and businesses around the world to engage in the global economy.

Regulatory clarity, robust legal frameworks, and interoperability across jurisdictions represent significant challenges to the widespread adoption of stablecoins. These issues underscore the importance of a collaborative approach among nations, financial institutions, and regulatory bodies. Additionally, the development of user-friendly products and informative media is absolutely crucial.

In summary, stablecoins have the potential to mitigate systemic vulnerabilities by providing a stable and accountable medium of exchange. This capability helps to address risks associated with monetary policies, currency devaluation, inflation, and economic instability.

In a volatile geo-political landscape characterized by heightened uncertainty, the unique properties of stablecoins place them as a valuable tool for enhancing economic stability and resilience, contributing to a more secure and equitable global financial system.

Links:

https://www.bis.org/publ/work1146.htm

https://www.bis.org/publ/othp81.htm