Stablecoins: A Beautiful New World?

The authors of this article are Anastasia Melachrinos and Christian Pfister, translated by Bran.

Stablecoins have become an important infrastructure in the crypto market and are playing an increasingly significant role in global financial markets.

Recently, Anastasia Melachrinos from the crypto data provider Kaiko and Christian Pfister from the Banque de France co-authored an analysis of the current state, risks, and future of stablecoins, pointing out that stablecoins pose risks to financial stability and monetary policy in various countries, especially in underdeveloped economies. The article has been translated and slightly edited by ChainCatcher without affecting the original meaning.

1. Classification and Representation of Stablecoins

Stablecoins can be defined as crypto assets designed to maintain a stable price relative to a benchmark, which is usually provided by fiat currencies, and sometimes by a basket of currencies, commodities like gold, or even another crypto asset. By using stablecoins, crypto asset investors can remain in the crypto world while gaining advantages in terms of resilience, integration, immutability, and anonymity, while benefiting from the typically stable environment borrowed from fiat currencies.

Stablecoins can also facilitate arbitrage between crypto assets while maintaining a connection to the investor's reference currency, avoiding regulatory restrictions and costs (transaction fees, often lack of liquidity, high price volatility, etc.) associated with conversions between crypto assets and fiat currencies. Therefore, stablecoins are intended to serve as tools in the world of crypto assets.

Stablecoins seem to offer a beautiful new world. From this perspective, if they fulfill their promise of stability, stablecoins will be the next natural step in the evolution of digital assets.

Stablecoins can be defined in four complementary ways:

1) According to the price stabilization mechanism: A governance system that implements rules to stabilize the value of stablecoins and entities responsible for managing the stability mechanism ensures the stablecoin's convergence toward its benchmark. This allows stablecoins to be categorized into algorithmic stablecoins, off-chain collateralized stablecoins, and on-chain collateralized stablecoins.

2) Based on whether stablecoins have potential systemic importance: This approach is adopted by the G7 stablecoin working group and is particularly relevant when assessing macroeconomic stability risks. According to this distinction, while all stablecoins carry risks, those built on a large customer base and/or cross-border foundations have the potential to scale rapidly and achieve a significant global footprint.

3) Based on target markets, stablecoins can be classified as wholesale (large transactions, typically between financial institutions or between financial institutions and large corporations) or retail (large-scale transactions between individuals or between individuals and merchants). This distinction reflects the difference between two forms of central bank digital currencies, with wholesale CBDCs targeting financial institutions and retail CBDCs targeting the public.

4) Based on benchmark currencies, stablecoins may be single (usually the US dollar) or composed of a basket as envisioned by the Libra (now Diem) initiative.

Given their price volatility, limited supply, restricted circulation, and market concentration, the success of stablecoins appears uneven, and so far, their market has emerged as an adjunct to crypto assets.

Most importantly, the arrival of large participants issuing off-chain collateralized stablecoins with the potential to cover a broad audience can provide additional confidence to stablecoin users and offer potential systemic impacts for their projects.

In the wholesale stablecoin projects, the two largest projects stand out: the USC (Utility Settlement Coin) project and JPM Coin.

USC is an initiative led by major banks aimed at creating a market infrastructure for cross-border payments to meet the recommendations of various regulatory bodies, which are often costly, time-consuming, and opaque.

Circulating on a permissioned blockchain, this stablecoin will be issued in different reference currencies and fully backed by reserves held by the central banks issuing these reference currencies (CAD, EUR, GBP, JPY, and USD), which in principle guarantees the convertibility of these fiat currencies.

The main contribution of the project is to provide users with the possibility of almost instant settlement globally at any time of the year—saving liquidity representatives of each currency by holding only one liquidity pool globally, rather than having several pools with different correspondent banks constrained by time zones.

The JPM project is similar in terms of the technology adopted (permissioned blockchain) and purpose (real-time remittance at the institutional level, 365/24). It has two significant differences from USC: at the current state of the project, the only reference currency is the US dollar, and most importantly, the collateral will consist of deposits from JPMorgan Chase rather than central bank reserves, which introduces liquidity and credit risks.

JPM Coin aims to reduce friction in the US dollar money market by facilitating transaction settlements between different clients. Another use case for JPM Coin could be in the repo market, where it can extend to same-day maturity, thus releasing collateral by ensuring faster turnover.

In the retail stablecoin projects, the most notable is Diem, whose issuance and governance are intended to be overseen by the Diem Association, responsible for verifying transactions conducted on the permissioned blockchain. Other private participants, such as Vodafone, Coinbase, Spotify, and Uber, are also part of the association.

In the latest white paper, the association proposed two categories of tokens:

1) A multi-currency stablecoin presented as a global currency. Diem will be backed by a basket consisting solely of stable currencies, which will ensure its stability through assets raised from the issuance of Diem invested in a set of low-volatility assets, including bank deposits and government securities denominated in stable currencies. More specifically, the reserves will include at least 80% short-term government bonds issued by sovereign states with extremely low credit risk, with the remainder in cash.

2) A single-currency stablecoin, "which will enable people and businesses to transact using a stablecoin denominated in their own currency, thus realizing a range of domestic application scenarios." Each currency will be supported by the aforementioned reserve system.

Compared to other crypto assets, wholesale stablecoins can facilitate the integration of financial transactions on the blockchain, reducing friction in cross-border payments; similarly, retail stablecoins can lower remittance costs and promote financial inclusion in emerging countries; furthermore, a basket of stablecoins may reduce the dominance of the US dollar in international transactions and the external adjustment difficulties it brings to emerging economies; finally, in emerging or developing economies, especially those experiencing currency instability or affected by structurally high inflation, a basket of stablecoins can serve as an alternative to fiat currencies, particularly as a means of storing value.

In this regard, whether economic agents in countries with unstable currency values will benefit from using a basket of currencies as support for their assets rather than directly purchasing hard currencies is certainly questionable. However, by purchasing a basket of currencies, these participants may reduce exchange rate risk (i.e., the volatility of the basket may be less than that of currency pairs) while potentially saving on diversification costs. Therefore, if the basket does not differ significantly from the holder's optimal risk/return combination, purchasing a basket of currencies is reasonable.

2. Risks of Stablecoins

Any stablecoin carries inherent risks, including:

1) Legal certainty, particularly regarding users' rights;

2) Governance, allowing for clear allocation of responsibilities, especially in risk review and control;

3) Financial integrity to prevent stablecoins from funding illegal activities;

4) Regulatory arbitrage, while the regulatory framework is intended to apply to the technology used;

5) Market integrity, as the pricing of the services offered must start from a stable price and be fair and transparent to protect consumers and ensure a fair competitive environment;

6) Data protection, as users need to know how their data is used by participants in the ecosystem surrounding the issuing blockchain and possibly third parties;

7) Consumer/investor protection, as the risks and obligations of the parties must be clearly defined and regulated;

8) Compliance with tax requirements, as stablecoins should not provide tools for fraud;

In principle, these risks are only likely to occur in economies with insufficient confidence in fiat currencies, limited supply of financial products, health issues among financial intermediaries, or economic systems. Therefore, these countries are often underdeveloped economies and may also be emerging economies.

A particularly serious risk is the replacement of fiat currencies with stablecoins, which could lead the stablecoin issuer to make it a self-referential currency. Then, these issuers would become central banks in the realm of private currencies: this is the theme of "loss of monetary sovereignty." For these two risks, wholesale and retail stablecoins are distinct.

• Financial Stability Risks

For wholesale stablecoins, there are some risks that could jeopardize financial stability. JPM Coin, which lacks central bank deposit backing, carries credit risk. Furthermore, the concentration of financial transactions on the blockchain will strengthen the connections between large financial institutions and large corporations globally, creating single points of failure and moral hazard issues that are too big to fail in the case of systemic stablecoins.

For retail stablecoins, the viability of their business model largely depends on the interest rate levels of the assets held. If stablecoins are 100% backed and reserves are invested in assets denominated in currencies like USD, EUR, or JPY, the historically low interest rates today significantly limit the returns on reserves.

Therefore, to maintain profitability, issuers may tend to invest in securities with higher risks in terms of credit, liquidity, swaps, or even exchange rates, even if the latter strategy does not replicate the composition of the basket. In the case of a basket of stablecoins, it could even change the composition of the basket in principle.

From the holder's perspective, what are the financial implications for stablecoin users if the issuer defaults or ceases operations? As far as investors know, these risks are reflected in the discounts on the issuance units related to the benchmark, which could lead to a crisis of confidence and a run.

For on-chain collateralized stablecoins, if investors cannot meet margin calls in the event of a significant drop in crypto asset prices, it could also lead to a run, although the issuer may choose to liquidate the positions of defaulting investors.

• Monetary Policy Risks

The impact of stablecoins on monetary policy actions could be much greater than that of crypto assets.

In the case of wholesale stablecoins, their issuance may lead to a reduced demand for reserves of the reference currency. This is especially true if the wholesale stablecoin envisioned by JPM Coin is not backed by central bank deposits as USC is.

This is because previous transactions on central bank balance sheets, such as the settlement of clearing balances, can be transferred to the blockchain of wholesale stablecoins. One consequence is that if a liquidity crisis affecting the money market occurs, the central bank's understanding of institutional cash holdings may not be detailed enough, making its intervention as a lender of last resort more difficult.

On the other hand, if wholesale stablecoins are fully or largely backed by base money, the demand for reserves may significantly increase and become more volatile, depending on the liquidity needs of stablecoin users. In this regard, since wholesale stablecoins should always be available, cash pressures may affect wholesale stablecoins supported by central bank money outside the operating hours of the issuing central bank, exposing their holders to liquidity risks. However, this issue can be addressed by shifting to real-time monetary policy.

For retail stablecoins, their widespread use may lead to the displacement of fiat currencies, creating difficulties in the transmission mechanism and implementation of monetary policy:

1) Transmission Mechanism, which can be subdivided into interest rate channels, credit channels, and asset price channels. The conversion of bank deposits into stablecoins and the final allocation of loans denominated in stablecoins will weaken the transmission of changes in fiat currency interest rates to the economy. For example, if this interest rate rises, the motivation to save and the motivation to borrow will weaken, thereby diminishing the impact on economic contraction.

On the other hand, the credit channel will be affected ambiguously. Narrower channels may be weakened because liquidity in the banking sector will at least partially reside in stablecoins, so unless the central bank intervenes in stablecoins itself, it will not be directly affected by the central bank. Conversely, if the substitutability between stablecoin and fiat currency financing is lower than the substitutability of different forms of fiat currency financing, increased financial friction will strengthen the broad channels. Finally, as long as fiat currency continues to be used as a unit of account, the asset price channel will become stronger, as interest rates will affect a larger proportion of assets.

Overall, the impact on the transmission mechanism will be ambiguous, characterized more by greater uncertainty in the effects of monetary policy, which in turn may justify further gradualism rather than undermining its power.

2) Implementation Capacity. As long as fiat currency continues to be used, there will be a demand for base money in the market, and monetary policy should still be implementable. However, a model of a digital currency competing with non-competitive national currencies could lead to a complete convergence of interest rates between them, thus depriving central banks of the ability to adjust monetary policy according to their economic conditions.

In the extreme case of global stablecoins displacing fiat currencies, foreign exchange reserves would have to be invested in global stablecoins, but the amount of liquidity that central banks can provide is limited, while they are usually not restricted when providing their own currency. Furthermore, in a fully dollarized situation and in a world without currency, seigniorage would be eliminated, forcing central banks to rely on budget allocations to cover their operating costs unless they have sufficient capital.

However, beyond reducing international transfer costs and promoting financial inclusion in emerging markets, stablecoins can also enhance monetary competition by increasing the choice of transaction and investment tools, allowing sound currencies to drive monetary competition, thus bringing benefits and eliminating drawbacks, and constraining monetary policy when appropriate. In turn, the diversification of assets and the competitive nature of currencies will encourage local investment and increase fiscal resources.

3. Reactions from Various Sectors

• Private Sector Response

The deployment of stablecoins occurs in an environment driven by two currents: the assumed supply capacity enhanced by underlying technology and changes in demand or consumer preferences in target markets. This is entirely applicable to stablecoins. However, participants in the payment industry, especially banks, can respond to the challenge by improving the quality of services they offer.

In this regard, one of the most radical shifts in recent years has been the commodification of instant payments. This is particularly evident in China, where the two giants, Alipay and WeChat Pay, captured 92% of the $41 trillion mobile payment market in 2018. In China, partly due to competition from Alipay and WeChat, banks' return on equity dropped by 35 basis points in both 2015 and 2016, reducing their return on equity to 6.7%.

In response to the disruption threat to their business, banks in the US, Europe, and Australia initially digitized part of their operations, allocating about 15% to 25% of their annual budgets to information technology as of 2016. In France, major banks joined forces to create PayLib entre amis, a system that allows users to identify themselves through their bank's online platform using their phone numbers and make instant payments to other users.

At the European level, TARGET 2 has been the real-time gross settlement (RTGS) system developed and managed by the euro system since 2008, with each country managing its national portion. In November 2018, to facilitate the comprehensive rollout of instant payments in Europe, the euro system launched a system within TARGET2 for instant payment settlements in central bank money, known as TARGET Instant Payment Settlement (TIPS) service.

This new service operates 24/7/365 and offered a price of €0.0020 per transaction for at least the first two years of operation, with no entry or maintenance fees for TIPS accounts, aiming for the euro system to ultimately cover all costs in this regard. However, more than a year after this initiative was implemented, instant payments have not yet become widespread in the euro area, mainly due to their costs to users.

Globally, in the face of inefficiencies in the correspondent banking system, central banks issuing major reserve currencies can interconnect their real-time gross settlement systems to facilitate cross-border payments. This initiative will partially compete with and partially complement wholesale global stablecoin initiatives, extending their actions to the national or currency zone level.

In fact, real-time gross settlement systems are designed to provide a secure framework for the final settlement of wholesale transactions, particularly through the use of central bank money; moreover, they compete to some extent with privately operated settlement systems, thus incurring costs. By interconnecting real-time gross settlement systems, central banks will largely avoid the need for payment service providers to arrange through correspondent banks, allowing them to save liquidity and provide customers with more reliable, faster, and potentially cheaper international transaction settlements.

• Regulatory Response

"The same business, the same risks, the same rules" and a consistent regulatory approach among countries form the regulatory guidelines proposed by the G7 Global Stablecoin Working Group. Following the work of the latter, the G20 authorized the Financial Stability Board (FSB) in June 2019 to review the regulatory issues raised by global stablecoin arrangements and to propose multilateral responses. Therefore, the first response from regulators is to coordinate to avoid regulatory arbitrage.

However, since regulation varies due to the nature of the relevant assets (such as currencies or securities), regulators must also consider the legal classification of stablecoins. In particular, the most common off-chain collateralized stablecoins have several options.

The first is to view them as money market funds, as they are fundamentally invested in low-risk, short-term assets denominated in the currencies they support, with the aim of maintaining a constant value, since each issued unit can even be assimilated as a money market fund unit in the case of a basket of stablecoins.

The second option is to classify stablecoins as electronic money, on the grounds that stablecoins are intended to serve as payment instruments, and their issuers commit to redeem them at face value. Compared to the first condition, the second condition imposes much stricter regulatory constraints on issuers, such as in Europe, where the 2009 European Electronic Money Directive includes capital requirements and the obligation for issuers to redeem holders at face value at any time.

Currently applicable regulations for traditional finance or payment instruments have not yet addressed the various risks posed by stablecoins, necessitating regulatory adjustments:

1) The widespread use of global stablecoins may be accompanied by their use for money laundering and terrorist financing purposes, which violates AML-CFT regulations. In fact, users of Libra could conduct transactions anonymously to protect their privacy, which is inconsistent with regulatory compliance;

2) Regulators may consider implementing prudential requirements for stablecoins to address the aforementioned financial stability risks, including the risk of liquidity crises;

3) Regulators may also consider protecting data from commercial exploitation by issuers. There are many concerns about Diem's use of this data;

4) Finally, regulators can ensure that the blockchain used for stablecoins has operational resilience. In fact, the scalability of the blockchain for the number of recorded transactions is still uncertain. It is within this framework that the Diem project is expected to increase tariffs based on Diem demand to reduce this demand and avoid congestion to prevent potential congestion.

In response to this measure, regulators may introduce insurance for clients regarding the maximum time limit for transferring their applications. Additionally, in the event of a cyberattack or blockchain hacking, the procedures established by stablecoin holders to limit risks should be clearly explained, along with provisions for compensating legitimate holders.

On September 24, 2020, the European Commission released a proposal for the regulation of crypto asset markets. According to this proposal, all crypto asset issuers must publish a white paper, and members of their governing bodies must meet integrity standards. Compliance with these requirements will be supervised by national competent authorities or the European Banking Authority.

Furthermore, all crypto asset service providers must have a physical presence in the EU and must obtain prior authorization from national competent authorities. This will enable them to obtain a "European passport" (i.e., the potential to provide their services throughout the EU), but will eliminate off-chain stablecoins without identifiable issuers. Finally, crypto asset service providers will also be subject to capital requirements, governance standards, and obligations to separate customer assets from their own.

• Central Banks' Response

Two measures are possible, depending on whether they are defensive (central banks adjust their policies and tools to adapt to the new environment brought about by the expansion of global stablecoins) or offensive (central banks propose their own solutions to compete with global stablecoins).

On the defensive front, emerging countries have often implemented foreign exchange controls and may view stablecoins as foreign currencies. At the international level, this requires coordination among central banks and all regulatory bodies and is a minimal response. The G7 does this because stablecoins are inherently global and to avoid regulatory arbitrage;

On the offensive front, central banks can issue CBDCs to counter stablecoins. However, this may pose challenges to their banking sectors, as their resources will be affected by CBDCs replacing deposits. Moreover, it is uncertain whether this will adequately address the risk of retail stablecoins marginalizing domestic currencies due to inefficiencies in fiat currency, national financial systems, or domestic payment operations.