One of the most interesting consequences of the arrival of blockchain and the cryptoasset market is that it has once again become fashionable to ask questions like ‘what is money?’ Generally speaking, the definition includes reference to the terms ‘medium of exchange’, ‘store of value’ and ‘unit of account’. That triumvirate disqualifies most pretenders from the cryptoasset or commodities worlds.
Until recently, the only things that qualified for all three categories were issued either by central banks (cash, central bank reserves, central bank digital currencies) or by banks.
Then stablecoins appeared, arising organically as a service for the cryptoasset industry. And suddenly a much bigger group of people could feasibly create money, or at least something that looks like and can be used as money.
This may be no bad thing. Transaction services businesses like PayPal have shown us for years that payment services need not be provided only by banks. It’s not obvious that the issuance of money should be different. Perhaps unbundling money from the business of mortgage lending and so forth is a healthy evolution. But, like it or not, it’s here. Ultimately, the criterion that matters is acceptance, and with a daily volume of $64bn, stablecoins are certainly accepted.
Just like banks
The model for stablecoins’ creation of ‘money’ is broadly the same as that of banks. Both take deposits and invest them to cover the costs of providing payments infrastructure. In exchange, depositors get a form of money: either deposits that they can spend with their cards or stablecoins that they can exchange with people or merchants (often, but not always, for cryptoassets like bitcoin). You can withdraw your bank deposit as cash or redeem your stablecoin token for a commercial bank deposit.
The rules governing money creation are important. Not just anyone can create money. If they could, it wouldn’t be trustworthy. That’s why I can’t go into a shop and pay with a piece of paper on which I have written the words ‘pay the bearer £10’. The rules we have are remarkably effective. We can pay with debit cards (commercial bank money) with no discounting of the value of our currency to account for the credit risk that commercial bank money entails.
If we want stablecoins to be a real, safe form of money, they need their own rules. Banks have a complex array of prudential rules governing how they invest your money and under what circumstances the state will protect depositors. At present, stablecoin issuers do not have to obey the former, and stablecoin holders do not benefit from the latter.
Nevertheless, if stablecoins are to become a systemically important form of money – which might happen whether we want it to or not – then rules to prevent runs and protect users are vital.
Not like banks at all
One simple solution would be to make a law that requires all money issuers to have a banking licence and to obey the same rules as banks. But although the model for stablecoin money creation is similar to that of banking, there are some key differences.
For one thing, stablecoins do not engage in fractional reserve banking. They aim to maintain reserves of at least the value of the coins in circulation. That alone suggests different rules are in order. A paper from Gordon Liao, Dan Fishman and Jeremy Fox-Green at Circle examines how to begin thinking about these rules and how they should differ from the rules applied to banks.
They point out the fundamental difference between stablecoin issuers and banks’ business models: ‘[Stablecoins] aim to maintain at least a one-to-one value between the value of the reserve assets and the quantity of circulating tokens. This is distinct from a bank’s balance sheet, which is designed to intermediate credit and other market risks for its customers, including maturity transformation and other asset-liability mismatches.’
They highlight a number of other features that suggest that ensuring stablecoins are adequately capitalised must be approached differently to how we treat banks.
The first difference is that commercial bank deposits basically always trade at par. When you attempt to pay with HSBC bank money, a seller will not discount your HSBC money to 90 or 80 pence in the pound because it has doubts about the integrity of HSBC’s balance sheet. That is precisely what happens with stablecoins. You can look up the secondary market value of Circle or Tether on major crypto exchanges. If all is well, it will be very close to a dollar. If, as was the case during the run on Silicon Valley Bank in 2023, which held much of USDC’s reserves, there are concerns about the issuer’s ability to honour redemptions, it might fall well below a dollar.
This is not really the same thing as ‘breaking the peg’. At no time did anyone redeem their USDC with Circle at less than par. Indeed, anyone who bought at the 2023 low of around $0.97 would have made a tidy profit by redeeming at par.
Nevertheless, this transparency of the expression of negative sentiment might result in a run. Runs can be damaging to even well-capitalised providers, since some of the assets in which they are invested might be illiquid. A run could force them to sell at a loss, damaging their ability to meet redemptions. Banks get around this issue by borrowing from central banks against their illiquid assets. Stablecoins do not have this option. Liao, Fishman and Fox-Green point out that stablecoins should therefore be required to hold more highly liquid assets than banks. That means fewer long-term loans.
On the other hand, the fact that banks’ make long-dated loans means that deposits need to be offset by capital buffers. That is, if the loans go bad, they need to have set capital aside to protect depositors. Stablecoins, with their more limited exposure to credit, would need smaller capital buffers.
Liao, Fishman and Fox-Green also point out that stablecoins differ from bank deposits in the underlying technology they use. In some respects, the transparency, immutability and core cryptography that blockchain offers might reduce the operational risks relative to those that banks face, but the authors argue this depends on how the technology is implemented and that it is difficult to generalise. This difference in operational risk profile is an important input into stablecoin capitalisation rules but whether it should make them more or less stringent will depend on the particular case.
The regulatory response
Policy-makers can say: ‘stablecoins are not really money. If stablecoin issuers want to issue money, they can apply for a banking licence’ and refuse to supervise their activities. Governments can ban them, and money issuance will remain the preserve of the banks.
But the stablecoin business model arose organically to serve a need. Perhaps a new business model for money provision will allow money to meet needs that banks struggle to, improving financial inclusion or delivering new functionality. Stamping out the model might rob us of potentially valuable innovation.
More importantly, stablecoins are already here. They arose outside of the regulatory perimeter and, short of a comprehensive global enforcement operation, could continue to operate there. At present, stablecoins have a 24-hour trading volume of $64bn. That’s $64bn of money spent each day where the issuers are not under prudential supervision, and where users’ holdings have no state insurance.
Whether we like it or not, money has broken out of banks. It still needs rules.
Lewis McLellan is Editor of the Digital Monetary Institute, OMFIF.
These topics and more will be further explored in OMFIF’s forthcoming Digital assets 2024 report. Register to attend the launch event here. Read last year’s report here.
