Stablecoins – the future of finance or a cause of future fragility?

There is much talk about stablecoins, which were originally meant to link the crypto and the traditional finance worlds.  As the name says, stablecoins aim to have a stable value relative to traditional financial assets, such as the US dollar or the euro, which can be achieved by holding reserves in these currencies.

The clearest use for stablecoins seems to be in the area of payments, especially cross-border ones. Rather than going through the banking system, payments can be made on a blockchain in the form of an ‘atomic settlement’ – swapping tokenised money for a tokenised asset, reducing the costs of such transactions. However, it is not clear why this has to be done outside the traditional banking and central banking system, as such a tokenised system can run with tokenised bank accounts, stablecoins or central bank digital currencies (CBDCs). There is obviously a strong argument that innovation often comes from outside the financial system, but with such innovation outside the regulatory perimeter come stability risks.

The new US administration has been at the forefront of welcoming new stablecoins, and embracing the crypto world more generally. This is a fiscal policy objective as the expansion of stablecoins would require it to hold US treasury securities, thus helping finance the increasing US government debt. It would also help promote the international use of the dollar for payment and invoicing purposes at a time when geopolitical changes might undermine the global role of the US dollar.

Ultimately, stablecoins seem to be new money market funds (MMFs), which have an important role in the US financial system as alternatives to bank deposits. The most stable MMFs, investing primarily in sovereign and (possibly) high-rated corporate papers and bank deposits, offer a higher-yield alternative to bank deposits, and they became especially attractive as interest rates dropped to zero before the recent bout of inflation. In 2008, however, MMFs ‘broke the buck,’ i.e. investors could no longer redeem their shares at par. Ultimately, the Federal Reserve had to step in and take MMFs under the financial safety net umbrella, fearing contagion effects, including in the banking system. Somehow, the structure of stablecoins pegged to the US dollar and investing in US securities looks scarily similar. Rapid interest rate movements or the failure of one of these stablecoins could result in risk of a run and contagion effects in other parts of the financial system, including the banking system.

Regulators have a tendency to see risks whenever they see innovation. Financial innovation is critical for the financial system (as it is for any other sector). However, given the connectedness within the financial system and externalities in terms of financial stability not being taken into account by individual players, careful monitoring of the development of such new institutions and players is certainly called for. This is even more true in a world in which cross-border cooperation is not as obvious as it was in 2008. As ECB President Lagarde pointed out in a recent speech there is important concern about stablecoins issued in USD dollars but also licensed in the EU if the regulatory framework is different between the jurisdictions. This has been explored further in a recent ESRB report on systemic risks from crypto-assets. While not advocating a Luddite attitude, a sceptical approach might serve us best in Europe.