The last years have seen a huge increase in the popularity of the so called crypto-assets[1]. Among these, probably, the two main categories that we find are the crypto-currencies and the stablecoins. In this article I will try to shed some light on the concept of stablecoins and the possible challenges for the financial system. Concerning cryptocurrencies, they probably deserve some attention due to the technology behind them, although, for the purpose of the article[2], they will not be taken into account.
Adopting the definition given by the Financial Stability Board, stablecoins are cryptocurrencies that aim to maintain a stable value relative to a specific asset or a pool of these. If it is true that some common points are found among the different stablecoins, they can differ markedly regarding their exchange rate policy, their redemption pledge and the nature of claims that users have. The origin of the stablecoins dates to 2014, the year in which Tether and USD Coin, were created. The main aim of these new category of assets was to address the volatility inherent to Bitcoin, the major cryptocurrency. In addition, the new stablecoins wanted to complement the already existent crypto assets increasing their usability across different crypto exchanges, offering hedging and reducing the intermediation costs associated with the trading of cryptocurrencies and dollars.
Despite the technology and the hype around stablecoins, they are nothing new due to the fact that private digital money[3] already exists. The existence of this private digital money has to do with the deposit intermediation activities of banks and their role creating money. The level of trust deposited on these deposits, explained by the regulatory treatment of banks and the access that these have to public safety nets when it comes to liquidity and deposit insurance, makes bank private money to be equal to central bank’s money.
Within the stablecoins, it is possible to differentiate between two subcategories taking into account the level of systemic importance associated to them. In this light, the stablecoins can be classified between systemic and non-systemic important stablecoins. The systemic stablecoins, due to their potential reach and use across multiple jurisdictions, could easily increase their importance in and across one or many jurisdictions bringing high risks affecting the overall financial system as well as the market participants. The main example of systemic stablecoin is Diem, Facebook’s cryptocurrency, announced in 2019 under the name of Libra.
The main way in which the stablecoins preserve their value is through the assets to which they are pegged. The likely minor deviations from the peg are corrected through a supply and demand mechanism. From the supply side, electronic algorithms are in charge of accommodating the changes in demand via changes in the amount of currency supplied. From the demand side, the arbitrageurs are the ones accommodating the deviations from the peg. In theory, a simple supply and demand mechanism seems to be appropriate to maintain the fixed parity but in reality, other aspects need to be included into the equation. Examples of these are found in the governance, the underlying mechanism (distributed ledger technology, smart contracts, FMI technology) and the management entity[4] behind the stability mechanism. The stabilization mechanism of the stablecoins differs markedly from a currency peg because in the latter, a credible monetary authority stands ready to support the fixed parity. In this light, it is possible to say that a stablecoin is as good and/or stable as the governance behind its backing promise.
In case a stablecoin is able to keep a low level of volatility, it can address some of the main drawbacks of the current payments system. More specifically, they can increase the access to the payments system and increase the efficiency of the cross-border retail payments, characterised for being slow, expensive and opaque.
In the last years, the increased popularity of the stablecoins and, most importantly, the different risks associated to the global stablecoins, have acted as a wake-up call for the monetary authorities across the globe. Until now and, from a macroeconomic point of view, the authorities have been able to detect some major risks associated with stablecoins that can be narrowed down in seven categories.
The first source of concern has to do with competition. Normally, increases in competition are linked with reductions in market power and hence, better outcomes for customers. However, when it comes to global stablecoins, the effects can be completely different arriving to the point at which the competition in the market can be undermined. The explanation of this has to do with the advantages that some big companies can have over other firms in terms of network effects, large fixed costs needed to stablish operations and the access to data. It is not difficult to imagine the level of market power that some big tech companies will have if they were to launch a global stablecoin.
Another source of risk that can arise from a global stablecoin has to do with currency substitution. This problem has been known for a long while in economics and it has affected mainly countries characterised for having weak economic fundamentals or constant political turbulences. Normally, the majority currency substitutions that have taken place have implied the use of the dollar and thus, currency substitution has been mainly related to “dollarization”. When it comes to global stablecoins, the benefits in terms of stability of the stablecoin can have the same results. In case a “stablecoin dollarization” takes place, assuming that there are not any frictions or transaction costs to access the stablecoin, the country whose currency has been substituted will suffer large outflows of money, putting pressure on its exchange rate. In addition to this and, apart from the undermining of the monetary sovereignty, the monetary authorities will have less control over the level of liquidity of the economy, complicating the conduct of monetary policy.
The use of a global stablecoin will also have some effects on the banking sector due to the possible disintermediation that will occur. In our current financial system the majority of the money at which we have access to is in the form of deposits, a liability in the balance sheet of a bank. With the stablecoins, market participant will no longer depend on a bank to have access to their money. The possible switch from bank deposits to stablecoins, is likely to create some negative effects on the banking system, one of which will be the increase in the cost of bank lending and the possible reduction of bank financing to the real economy. As a consequence, banks will probably be encouraged to take a higher risk profile and to become more reliant on wholesale funding, implying higher financing costs and more regulatory requirements for them. Although, the degree at which wholesale funding will impact the financing costs of the banks and the overall financing conditions is still not clear and it will depend on the sources of wholesale funding available for banks, among others.
Concerning the conduct of monetary policy, global stablecoins will also influence the monetary policy transmission mechanism. Some of the main ways in which a global stablecoins can interfere with monetary policy is through the interest rate channel, increasing or decreasing the degree at which central bank’s rates influence the credit conditions. In addition to this and, because of capital mobility, rate differentials will become more important. It is also important to mention that, if the use of the stablecoin is extended within a country, a private company, whose interests are far from those of a central bank, will be the one determining the monetary policy stance.
A wide usage of stablecoins will also entail some challenges for financial stability. The risks for financial stability come from different sides and are likely to appear if global stablecoins remain in a benign regulatory environment. When it comes to financial stability, the majority of risks associated with global stablecoins are the governance mechanism behind them, their level of reserve holdings and their capital and liquidity buffers. Starting with the governance mechanism supporting the value of a stablecoin, it is difficult to foreseen when the private companies behind will stabilise the stablecoins and if they will not exit the market in periods of extreme financial stress. Also, it is interesting to mention that, as private entities which a high degree of opacity, they may be tempted to invest in risky assets or lend their reserves in order to achieve higher returns[5]. When it comes to their reserve holdings, the lack of regulatory or third-party audits, makes it possible for the companies to disclosure false information, as it was shown in 2019 by Tether and, more recently, by USD Coin.
Adding another layer of complexity to the reserves, it seems like no stablecoin has considered the possibility of an event of fire sales taking place. It may be true that stablecoins are able to back all their tokens in normal market conditions but, what if suddenly there is a huge depreciation of the value of the assets backing the tokens? The depreciation of assets can easily happen since the companies backing the stablecoins hold, if any, small amounts of liquidity and capital buffers to redeem their tokens at a pair value. If a stablecoin needs to redeem a lot of tokens at once, the lack of liquidity will have to be solved through the sales of assets. If this sale of assets is big enough, a depreciation in the value of these will be likely to occur and, with this depreciations, other companies beyond the stablecoin sphere can be forced to sell their assets. In addition to this, during this process of fire sales, token holders, due to the lack of support from monetary authorities and the inexistence of any “insurance” for consumers resembling the deposit guarantee for banks, will run to redeem their tokens increasing the pressure on the stablecoin. Note that there is no mechanism in place eliminating the first-mover advantage for token holders. A possible result of this can be the inability of stablecoin companies to fulfil their par value promise. Furthermore, through this mechanism, a small shock in the stablecoin market can be easily transmitted to other market participants. In this sense, the stablecoin companies resemble other market participants included in the wide category of Shadow Banking, more precisely the Money Market Funds. It is important to mention that, for the reasons already mentioned, any kind of liquidity, credit and market risk affecting these companies can lead to the same outcome.
Another issue related with the reserves is related with the safe assets. The huge amounts of safe assets needed to back the tokens will add some pressures to the aforementioned assets coming from the demand side. In a context of global scarcity of safe assets, this will not have positive effects.
The last risk arising from the global stablecoins has to do with the payments system[6]. The first consequence of the wide use of a global stablecoin will be the fragmentation of the current payments system and the likely increase in transaction costs. Apart from this, the failure of one of the companies behind one of the global stablecoins would create a shock affecting the payments system, affecting every level of economic activity. If this was to happen, it would undermine the confidence in money, payments and the entire financial system.
As seen, the possible benefits that stablecoins can bring will not come without a cost. In this article the risks have been treated from a macroeconomic point of view but, apart from these, there are others that have to do with market and financial integrity, legal aspects, balance sheet effects and consumer and investors protection, among others.
The only way to grasp all the benefits of the stablecoins will require the creation of an adequate regulatory environment that is able to eliminate or, at least, minimise the likelihood of some of these risks. Special attention should be drawn to the adequate disclosure of reserves and the management of the risks arising from the core activities of the companies backing the stablecoins. It is also worth mentioning that the benefits of private stablecoins can also be achieved through the use of Central Bank Digital Currencies and/or with improvements of the payment infrastructures, in a more efficient way. According to the Bank of International Settlements, “it is not clear that stablecoins are necessarily needed to provide some of the benefits that they purport to serve. While a digital representation of value could hold great potential in many applications, CBDCs may offer these benefits without the inherent fluctuation in value or conflicts of interest entailed by stablecoins. Improvements to existing payment infrastructures, or new infrastructures that do not rely on distributed ledger technology, may also be able to fulfil many of the use cases for stablecoins”.
[1] Following the definition provided by the European Central Bank, crypto-assets can be defined as “types of asset recorded in digital form and enabled by the use of cryptography that are not and do not represent a financial claim on, or a liability of, any identifiable entity”.
[2] One of the main arguments against cryptocurrencies is related with their failure fulfilling the necessary conditions to be defined as money since they do not serve as means of payments, store of value and units of account. In addition, other characteristics such as the lack of scalability, the concentrated and opaque market structure, the issues related with governance and regulation and their use for illicit activities, makes them not to be a credible alternative when it comes to money.
[3] As an example, according to the ECB, just around 15% of the money in the Euro Area takes the form of coins and notes directly printed by the central bank.
[4] Among others, they are in charge of the issuance and redemption of the stablecoins as well as the custody of assets.
[5] A historical example of this can be found in the Bank of Amsterdam during the 18th century.
[6] The payments system can be defined as a combination of technical, legal and commercial instruments, rules and procedures that ensure the transfer of money among different market participants.
Sources:
- Stablecoins: risks, potential and regulation. – Bank of Spain (2021)
- What will shape the future of crypto-assets? – Bank de France (2021)
- Stablecoins - what’s old is new again. – Bank of England (2021)
- Digital currencies and the future of the monetary system. – Carstens, A. (2021)
- New Forms of Digital Money. – Bank of England (2021)
- Distrust or speculation? The socioeconomic drivers of US cryptocurrency investments – Auer, R. & Tercero-Lucas, D. (2021)
- What keeps stablecoins stable? – Lyons, K. & Viswanath-Natraj, G. (2020)
- Digital money across borders: macrofinancial implications. – International Monetary Fund (2020)
- Update on Digital Currencies, Stablecoins, and the Challenges Ahead. – Federal Reserve (2019)
- G7 Working Group on Stablecoins: Investigating the impact of global stablecoins. – Bank of International Settlements (2019)
