The Board of Governors of the Federal Reserve System has published a paper on the growth potential and impact on banking of stablecoins 1. The paper explores what stablecoins are, their risks and their possible uses, including a look at the future. It is sometimes suggested that if central banks issue CBDCs, then the role and need for stablecoins will wither away since CBDCs will fulfil their role. This is, therefore, a useful summary and the reader can consider whether there is room for CBDCs and stablecoins.
Stablecoins are recorded on DLT, usually using blockchain. They are pegged to a reference value such as the US Dollar, or other fiat currencies. Alternatively, they can be linked to a basket of currencies, other cryptocurrencies or commodities such as gold. They can fulfil both the store of value and medium exchange functions of money and can be exchanged and/or integrated with other digital assets.
Traditionally electronic money has been where a financial institution, such as a commercial bank, keeps a digital record of money. There are two key differentiators of stablecoin. First, they are cryptographically secure allowing near instant settlement without double spending or using intermediaries that facility settlement.
Second, they are usually built on Distributed Ledger Technology (DLT) standards which means they can be programmable. This means they can allow the ‘composability of services’, ie. stablecoins can act as self-contained building blocks that interoperate with self-executing programmable contracts, smart contracts, to create payments and other financial services.
At the end of September 2021 the circulating supply of the largest US Dollar-pegged public stablecoins were worth almost $130 billion. Products such as Ethereum, Binance Smart Chain and Polygon are backed by cash-equivalent reserves such as bank deposits, treasury bills and commercial papers. These stablecoins are also known as custodial stablecoins because these organisations are custodians of these reserve assets which offer a one-to-one redemption of stablecoin liabilities.
Custodial stablecoins require the reserves to be properly accounted for and maintained. Tether paid a fine of $41 million to the US Commodities and Futures Trading Commission to settle an alleged claim that they had misrepresented the sufficiency of the dollar reserves.
Another type of public stablecoin are algorithmic stablecoins. These use another mechanism to stabilise their prices, which are maintained by systems of smart contracts that operate exclusively on public blockchains. Part of this solution involves governance tokens that are used to control the smart contracts. These tokens are specialised used to vote on changes to protocols and governance parameters. They can also be used as direct, or indirect, claims on future cashflows from the use of the stablecoin protocols. The design of these tokens can either use collateralised mechanisms or algorithmic peg mechanisms.
Traditional financial institutions have developed reserve-backed stablecoins, known as ‘tokenised deposits’. These are based permissioned, private DLT and are used for efficient wholesale transactions such as intraday repo settlement or to manage internal liquidity. The best known of these is probably JPM Coin from JP Morgan. It is also possible to achieve the same result using a centralised database, as is done by PayPal and Venmo.
When central banks consider stablecoins a range of issues present themselves, including the stability of their pegs, consumer protection, know-your-customer and anti-money laundering compliance, and the scalability and efficiency of settlements. Some of these issues may be resolved with appropriate institutional safeguards, regulations, and technical advancements.
The paper looks at how stablecoins have performed during past episodes of crypto and broad financial market distress. The conclusion is that the price of dollar-pegged stablecoins in the secondary market temporarily rise above the peg during times of extreme market distress, which incentivising the issuance of more stablecoins. This is symptomatic of stablecoins being regarded as a safe asset. The paper also draws attention to the risk of a “run” on certain stablecoins that are backed by non-cash-equivalent risky assets.
The final part of the paper considers possible scenarios for bank reserves, credit intermediation, and central bank balance sheets should stablecoins gain broader traction. If asset-backed stablecoins operate in a two-tiered, fractional reserve banking system, the report believe they can operate without a negative effect on credit intermediation. The stablecoin reserves would operate just as traditional bank deposits do.
Backing stablecoins with central bank reserves minimises the risk of “runs” but could potentially reduce credit intermediation. If stablecoins replace physical cash, this could result in more credit intermediation.
1. Investors
Stablecoins are used extensively for transacting in cryptocurrencies on public blockchains in order to take advantage of their near instant and constantly available nature. That they don’t rely on non-DLT payment systems or custodial holdings of fiat currency balances is also attractive.
2. Digital market transactions
Digital market stablecoins are used to trade digital assets with a record kept in the blockchain. It creates a trail from fiat currency to the digital asset.
3. Payments
The strengths of stablecoins that make them particularly useful for peer-to-peer and cross-border payments are that transactions are instant, do not involve intermediate parties and have low fees.
4. Internal transfers and liquidity management
The added advantage beyond those of payments generally, is that they can also manage regulatory requirements.
5. Support of decentralised blockchain-based cryptocurrency markets and services
The programmability and composability of stablecoins enable decentralised finance (DeFi). Protocols enable market making, collateralised lending, derivatives, asset management and more. At the end of September 2021 $60 billion was staked in digital assets in DeFi.
1. More inclusive payment and financial systems
The instant payment and low costs of payments using stablecoins may lower payment barriers and increase competition particularly for cross-border payments. They may also spur payment innovation.
While DeFi is seen as an important part of the solution, DeFi does face a number of challenges - a complex user experience, a lack of consumer protection, frequent hacking, protocol dysfunctions, and market manipulations. In addition, most DeFi protocols only support the trading or lending of cryptocurrencies or non-fungible tokens (NFTs).
2. Tokenized financial markets
Tokenised financial markets are seen as a ‘good thing’. If securities are converted into digital tokens on DLT, they can then be traded and serviced with stablecoins delivering real-time settlement at low cost. For delivery-versus-payment transactions, for example security purchases such as real estate, this could increase liquidity, transaction speeds, and transparency while reducing counterparty risk, trading costs, and other barriers to market participation. This would also allow fractional ownership of tokenized assets and a better ability to compare prices.
For payment-versus-payment transactions, such as a cross-currency swap, tokenization would also allow for near-instantaneous execution instead of the market’s current convention where a swap’s payments is settled two business days after the swap is struck.
For both kinds of transactions, programmability could be used to automate security servicing and regulatory requirements such as required holding periods.
An innovation which is on the horizon, and which is much talked about is Web 3, a possible move away from centralized web platforms and data centres towards decentralized networks. The idea is that internet services and social media platforms would move from a model where revenue is earned from advertisements to coming from fees on microtransactions. For example, a search engine or video streaming platform supported by micropayments instead of advertising revenue and the sale of user data. To really work, this needs the efficient, integrated online payment systems perhaps offered by stablecoins.
1 - International Finance Discussion Papers number 1334: ‘Stablecoins: Growth Potential and Impact on Banking’ by Gordon Y. Liao and John Caramichael.
