Introduction and Background
Cryptocurrencies are nominal assets that exist only in virtual as opposed to physical forms. While the total market capitalization of cryptocurrency continues to grow, the prices of free-floating cryptocurrencies remain extremely volatile. For example, their total market cap stood at $2.82 trillion on November 7, 2021 and subsequently fell to $2.22 trillion on December 16, 2021. Overall, the total market capitalization is up from $643 billion from a year earlier, but the short-term volatility represents a 21 percent decrease in a little over a month. Today, most of the value of cryptocurrencies is held as investments that are especially popular among younger investors. According to a recent survey by CNBC, more than half of millennial millionaires have at least 50 percent of their wealth in cryptocurrencies. A lack of more broad adoption of free-floating cryptocurrencies as media of exchange is likely related to their extreme price fluctuations.
Some cryptocurrencies, such as bitcoin (BTC), put limits on the total quantity that will be produced. Other cryptocurrencies such as ether (ETH), “burn” or destroy some of the outstanding volume in order to match demand with supply. However, attempts to limit supply have not resulted in price stability because it has proven difficult to match demand with supply in real time when the former undergoes abrupt shifts. Of course, it has been a long-standing and central challenge in monetary policy for central banks to set the optimal money supply to preserve the value of the fiat currency that they issue by stabilizing inflation. In some cases, monetary authorities use an external nominal anchor to stabilize the value of their currency. For example, Saudi Arabia pegs its currency—the Riyal (SAR)—to the U.S. dollar (USD). In other cases, governments rely on another country’s currency. Panama, for example, uses the USD. More recently, El Salvador announced that BTC would be one of its legal tenders this year. While there are many challenges in implementing BTC as an authorized and mandated legal tender, El Salvador provides a laboratory to study if a non-state issued cryptocurrency can replace or sit beside a fiat currency as legal tender—especially one that is volatile.
What Are Stablecoins?
Stablecoins are cryptocurrencies that peg their values to a fiat currency such as the USD or another reference asset. Therefore, as the name suggests, they are associated with significantly reduced volatility compared with free-floating cryptocurrencies and are becoming more popular for payments and decentralized financial (DeFi) applications. Examples of stablecoins include Tether (USDT), USD Coin (USDC), Binance USD (BUSD), and Dai (DAI). The total market capitalization of the top 20 stablecoins is over $150 billion as of December 17, 2021. While their market cap is only a small proportion of the total cryptocurrency market cap, the velocity (the number of times it circulates between users) of many stablecoins is significantly higher than non-stablecoins. Higher volatility suggests broader use cases beyond investment or speculation. In addition, stablecoins are popular to pledge as collateral because they receive lower haircuts than other cryptocurrencies due to their lower volatility.
In this blog, I discuss the roles for stablecoins and their ability to increase the use of cryptocurrencies for both payments and DeFi applications. I also discuss different ways to regulate stablecoins to maintain financial stability while not stifling innovative solutions geared toward achieving greater financial inclusion.
Bank-Based Payments and Their Disruptors
Today, banks (defined broadly as regulated depository financial institutions) create private money which is denominated in fiat currency that can be used to pay for goods and services. Banks accept demand deposits that their customers can access to make purchases either through checks, debit cards, automated clearing house (ACH) payments, via fast payment networks. In addition, banks lend out funds from their deposits. Because banks invest a portion of their deposits in long-term assets, such as loans, they may be prone to bank runs; particularly during times of financial panic. To prevent bank runs, governments have set up saftey nets such as deposit insurance and access to the discount window at the central bank. In exchange for safety nets, banks are supervised and must meet various prudential standards such as capital and liquidity requirements among others. These standards have been significantly strengthened since the financial crisis of 2008-2009. Banks argue that being regulated, often by multiple agencies, allows them to offer financial services with the least risk to the financial system as a whole.
Many financial technology (FinTech) firms have started to compete with banks and other traditional payment services providers. These new entrants are challenging incumbents in several areas. First, some FinTech offerings increase the speed of transactions especially for cross border transactions that can otherwise take days to clear. Second, some of their offerings reduce the price of these transactions especially for remittances that represent significant source of funds for residents in many developing countries. Third, some offerings increase access to financial services especially to some of the 1.7 billion unbanked individuals globally.
Cryptocurrencies, a part of the FinTech ecosystem, can provide a 24 hours a day and 7 days a week access to funds that can settle within seconds and provide quicker access to recipients subject to on- and off-ramps between cryptocurrency and fiat. Generally, exchanges such as Binance or Coinbase and, more recently, some banks offer individuals and businesses to convert fiat currency into cryptocurrency and back again. The process of converting fiat into cryptocurrency is often called an "on-ramp" and the conversion back into fiat is often called "off-ramp." However, today, payments made by cryptocurrencies are generally converted back to fiat relatively quickly. Generally, fiat currency is inferior to other assets in terms of return and, for the most part, does not by itself serve as a store of wealth or a form of investment, but rather a unit of account for valuing these other assets. In the case of cryptocurrencies, transactors convert to fiat currency quickly, but investors hold the asset; which is the opposite of fiat currency for the most part.
DeFi applications allow individuals and businesses holding cryptocurrency, to earn a return on their holdings beyond appreciation of the cryptocurrency itself. Harvey, Ramachandran, and Santoro (2021) provide a summary of how they believe DeFi will change the future of finance. DeFi applications take advantage of what is commonly referred to as “programable money.” The Ethereum network allows users to write code to determine when funds are collected and released automatically without intermediaries based on certain events. These coded instructions are often referred to as smart contracts. For example, imagine an insurance contract that pays out when certain events occur and pays nothing otherwise. The states of the world when payouts occur for the insurance contract can be specified in the code and the underlying cryptocurrency would be automatically transferred in those states of the world.
Automated market makers and lending protocols make full use of smart contracts to improve the efficiency of various types of financial transactions. Automated market makers (AMM) accept deposits of cryptocurrencies in pairs (for example ETH and BTC simultaneously) from liquidity providers (LPs) (holders of cryptocurrency) to create liquidity pools for cryptocurrency pairs. Using an algorithm, the AMM serves as a market maker for participants that want to buy one cryptocurrency for another. Lending protocols allow LPs to “deposit” funds. These protocols, based on algorithms lend out funds at an algorithmically-determined interest rate and pay LPs a return on their deposits. DiFi applications often eliminate intermediaries that are traditionally involved in financial transactions thereby reducing the cost, increasing the speed, and reducing potential disputes using the distributed ledger technology underpinning cryptocurrencies. Like payments, DeFi applications may improve financial inclusion. In this regard, the fact that stablecoins trade more frequently than other types of cryptocurrencies except ETH could be a sign of things to come.
Regulation of Stablecoins
Economic history may provide some insights into the evolution of privately-issued money and its regulation. In the Free Banking Era of the United States which lasted from 1837 to 1864, private banks could issue banknotes that had to be backed by specie—usually gold or silver coins. White (2015) discusses free banking eras in several countries with banknote issuance. The question becomes what should issuers of stablecoins be required to hold against the value of their outstanding coins? Should issuers be allowed to hold securities other than government debt? Would seigniorage be sufficient revenue for stablecoin issuers?
Stablecoin issuers have recently been fined for not having sufficient backing for their cryptocurrency. In fact, the President’s Working Group on Financial Markets in its Report on Stablecoins recommends that stablecoins be issued only by insured depository institutions. There is much debate regarding this recommendation with non-bank issuers of stablecoins arguing that they would be more like narrow banks and would welcome regulations on capital and liquidity. Narrow banks do not lend reserves but back 100 percent of its deposits with government securities. On the other hand, regulated financial institutions argue that allowing non-banks to issue stablecoins would decrease financial stability. Alternatively, stablecoin issuers could be required to have lines of credit at banks that can be accessed for liquidity events.
More recently, non-banks have provided digital payment solutions in closed loop environments where there are on- and off-ramps with fiat currency. In closed loop payment networks, payors convert bank deposits or physical currency into monetary value on a network before making payments. In some cases, these closed loop networks face a 100 percent reserve requirement, e.g. WeChat Pay and Alipay in China. However, regulation is often light when financial innovations are introduced and later tightened, e.g. Kenya with M-Pesa, a closed loop digital money network.
Partnerships between new entrants and banks, along with private and public partnerships, continue to emerge. Banks are increasing their roles in the cryptocurrency ecosystem along with payment networks such as Mastercard and Visa. A recent survey by Visa and LRW (2021) found that consumers believe that financial institutions need to embrace cryptocurrencies for these instruments to become widely accepted. Furthermore, consumers would like to link crypto balances to payment cards that are converted to fiat to make payments (an internal and automated off-ramp). Partnerships have existed between private and public participants for wholesale payments to achieve a safer and more efficient payment clearing and settlement process. For example, the Clearing House’s large-value interbank payment system, known as CHIPS, is prefunded with Fedwire transfers at the beginning of the day.
As with any financial innovation, there are often benefits that outweigh the risks especially if the risks are appropriately managed. Policymakers around the world continue to grapple with how best to regulate this promising financial innovation that currently and primarily resides outside of the regulated financial system. Given the global nature of this market, international cooperation between regulators and market participants is critical. Cryptocurrency offers an opportunity to increase financial inclusion, reduce transactions costs, and speed of financial transactions. Stablecoins are an important step to fully realize the benefits of achieving the fast and efficient flow of money globally similar to how the Internet enables for the fast and efficient flow of information.