Stablecoins and the Future of Money

Last week, U.S. Securities and Exchange Commission Chair Gary Gensler made a strong statement: It’s time to regulate cryptocurrency markets. He is not the only regulator who believes this. Jerome Powell, chair of the Federal Reserve, issued an urgent call for regulation of stablecoins — cryptocurrencies that are pegged to a reference asset such as the U.S. dollar — and Federal Reserve Governor Lael Brainard signaled that the case for the Federal Reserve exploring a central bank digital currency (CBDC) in response to stablecoins seems to be getting stronger.

Regulators typically only pay this level of attention to systemically important segments of the financial system, such as banks and money market funds. These statements add to a growing body of evidence that unlike cryptocurrencies like Bitcoin and Ethereum — which widely fluctuate in value — stablecoins have the potential to play an important (if yet to be defined) role in the future of global finance. They could even become a backbone for payments and financial services.

To state the obvious, this means that major changes might be afoot for central banks, regulators, and the financial sector. These changes could bring a host of benefits, but also new and very real risks.

To economists, the benefits of stablecoins include lower-cost, safe, real-time, and more competitive payments compared to what consumers and businesses experience today. They could rapidly make it cheaper for businesses to accept payments and easier for governments to run conditional cash transfer programs (including sending stimulus money). They could connect unbanked or underbanked segments of the population to the financial system. But without robust legal and economic frameworks, there’s a real risk stablecoins would be anything but stable. They could collapse like an unsound currency board, “break the buck” like money market funds in 2008, or spiral into worthlessness. They could replicate the turmoil of the “wildcat” banks of the 19th century.

While the pros and cons of stablecoins may be debatable, their rise isn’t. More than $113 billion in coins have already been issued. The question is what should be done about them — and who should be responsible for doing it. Responses range from arguing that the current system is fine, to accelerating research into CBDCs, to emphasizing that stablecoins may be a natural evolution of the combination of public and private money that we have relied on for centuries. While it is hard to defend a system where 15% of U.S. adults in the bottom 40% of the income distribution are unbanked and where low-income account holders — particularly Black and Hispanic customers — pay more than $12 a month for basic access to the financial system, it is also clear that new technology can bring new risks.

Making major changes to how money works is complex, but governments do not have to tackle this all at once. In fact, such an approach is unlikely to succeed. The public sector, both in the United States and elsewhere in the world, has not been particularly successful in deploying digital services. (China is the exception here: it has already cleared over $5.3 billion in transactions through its digital renminbi.) But there are also risks with private sector involvement, especially as stablecoins move beyond cryptocurrency trading and decentralized finance (DeFi). Any solution would need to address consumer protection, financial stability, and financial crime prevention. These are the same concerns we always face in the provision of money.

So how should central banks and regulators respond? There are three simple ways we could “upgrade” money that play to the strength of both the public and private sector. They’re different but not mutually exclusive, and each presents significant opportunities for existing financial institutions, as well as fintech and crypto entrants. These opportunities will continue to drive partnerships between established and new players, but also will result in more fierce competition.

Upgrading Money

Modern money is a combination of public and private money. Public money includes central banks-issued cash and digital claims against central banks. Private money includes deposit claims against commercial banks. While the public sector protects the stability of money, up to 95% of money in developed economies is private.

Stablecoins are a form of private money. This is not a new concept — the idea of separating monetary and credit functions traces back 80 years. By lowering the cost of digital verification, blockchain technology can expand the role of both the public and private sector in the provision of money. While the public sector could attempt to connect with consumers and businesses directly, the private sector is likely to be more efficient in meeting the public’s needs and increasing choice.

Succeeding in this transformation will require the right balance between the public and private sectors. Countries that overemphasize the public approach will likely end up falling short in speed to market, competition, and innovation. They will also be unable to nurture the fintech players of the future. The history of the Internet is instructive — countries that harnessed the technology’s “powerful commercial engine” came out ahead — and the history of financial markets is too: Countries without robust regulatory frameworks may see under-reserved “wildcat stablecoins” and a race to the bottom on consumer protection.

Consistent with the history of modern money, there is high option value in allowing for experimentation between competing approaches. Public and private experiments are strong complements here, not substitutes. Technology-neutral regulation that follows a “same risks, same rules” approach can lift quality standards and encourage competition between safe solutions.

Different solutions will present different challenges in terms of how they may accelerate the unbundling of payments, credit, and financial services. While such unbundling is eventually inevitable, we’re already starting to see how different approaches might play out. By deploying the digital renminbi, China is the first country to make a bold statement about the future of global payments and the type of data the government should have access to. It is now on other countries, particularly the United States in its role as keeper of the world’s reserve currency, to develop their own thesis of what that future should look like, and what role they play.

Three Paths to Sound Money

Having spent three years working through these issues and collecting feedback from regulators, we believe there are three ways to safely harness the technology: “true” stablecoins, deposit coins, and CBDCs.

True Stablecoins

True stablecoins are non-interest bearing coins designed to have stable value against a reference currency — say USD $1. Stability is achieved through two commitments. First, the issuer agrees to mint and buy back coins at par. Second, the issuer holds assets to back its obligation to redeem the outstanding stablecoins. This “reserve” provides comfort that the issuer can buy back all outstanding coins, on demand. Reserve assets should be denominated in the currency of the reference asset, remain highly liquid during a crisis, and incur extremely small losses in a run or stressed market conditions.

True stablecoins are a variation on the concept of narrow banks. They should hold 100% reserves in high quality, liquid assets — like U.S. treasuries or cash at the Federal Reserve — against their coin liabilities, plus an additional capital cushion against operational losses, asset price declines, or a run. Like narrow banks, true stablecoins should not engage in maturity transformation. Furthermore, they should isolate reserve assets from their other assets, so that in insolvency or bankruptcy, coin holders can be prioritized over other creditors.

As with narrow banks, the economic benefits of true stablecoins may be … narrow. It is expensive to hold full reserves at scale. While capital requirements for state trust banks may be compatible with a full reserve approach, OCC national trust banks currently face leverage ratios of 4% to 5%, and therefore may not be a viable structure for issuers that do not engage in maturity transformation.

Even with these limitations, however, true stablecoins have utility as a medium of exchange. They would be optimized for efficiently moving value as opposed to storing value or earning interest. Their cost structure makes them viable when their coin velocity is high and can support a large volume of payments with a small reserve. When it comes to store of value, deposit coins have an advantage, as they have a much lower cost of capital.

Deposit (Stable)coins

Deposit stablecoins are demand deposit claims against insured commercial banks, on blockchain rails. They represent an amount a person holds on deposit with an insured bank and therefore an unsecured deposit liability of that bank. Holders are protected by the legal framework governing deposits, including bank capital requirements and FDIC insurance up to $250,000.

Deposit coins combine the benefits of real time, (possibly) lower cost payments and new functionality with FDIC deposit insurance protection. A bank can use deposit coin proceeds for a wide variety of purposes, including lending. Thus deposit coins keep payments and maturity transformation activities bundled.

Like improvements to existing systems, deposit coins preserve the status quo and keep the system of private money, payments and banking intertwined. But they also suffer similar limitations.

Absent new technology and legal infrastructure, deposit coins may not be fully interoperable. Each holder would need to be onboarded by the issuing bank, and transfers between different deposit coins would have to be supported by intra-bank liquidity and infrastructure, in the same way that ACH and Fedwire support deposit payments.

The interoperability challenges, however, are likely to be temporary. The larger limitation is that only depository institutions can offer deposit coins and that fully backed models are not commercially viable without adjustments to capital requirements. Indeed, it is unclear why a depository institution would ever issue a true stablecoin over a deposit coin.

Central Bank Digital Currencies

To be truly transformative, CBDCs need to bring the benefits of cash on more efficient digital rails, and could represent the public sector’s response to decreasing demand for physical cash.

In the United States, those who have access to banks, debit cards, credit cards, and digital wallets tend to think of those forms of money as cash. But they aren’t — they’re liabilities of their private sector issuers. Cash is a liability of the central bank. While there is digital, central bank money in the United States already, only financial institutions can access it.

A CBDC would make digital cash available to the public. A vibrant debate is taking place about whether a digital dollar is necessary, useful, or even sensible. The answer largely depends on key design decisions about how the CBDC is distributed, to whom it is made available, and whether it should carry an interest rate.

If a CBDC is distributed only through Federal Reserve members, the solution would have similar reach and trade-offs as deposit coins. And it would place the Federal Reserve in competition with its members. The tension arises because a CDBC would be the safest asset available. Without adjustments such as balance limits (e.g., the FDIC insurance limit) or zero or negative interest on CDBC balances, consumers might rationally choose a CBDC over bank deposits.

Even a well designed CBDC that addresses these risks, is made available to everyone at a low cost, and can be used for instantaneous payments has the potential to be disruptive for providers that rely on high fees. While these fees may have to come down eventually anyways, a CBDC would accelerate the unbundling of credit and payment services.

The public sector may also struggle with serving citizens and businesses effectively. Given the incredibly high bar in terms of resilience and security, it will likely take years for a CDBC to be developed and adopted. Of course, the Chinese example may well prove to be the exception to this rule.

This is where CBDCs and stablecoins are strong complements, not substitutes. The public sector could focus on issuing digital coins and delivering on sound money, while the private sector could build rails and applications. Competition with legacy networks would further ensure a higher degree of resilience and innovation.

Simple Fixes For a Complex Problem

True stablecoins, deposit coins, and CBDCs could each deliver on what economists Gary Gorton, of the Yale School of Management, and Jeffery Zhang, of the Board of Governors of the Federal Reserve System, refer to as “no questions asked” money. Any material legal uncertainty for true stablecoins could be addressed by incremental changes to existing law. As currently being considered, true stablecoin regulation should include: requirements for permissible reserve assets and for the issuer to honor direct redemption claims; and limits on risky maturity transformation activities. Laws that bolster reserve segregation and coin holder claims in bankruptcy or insolvency should be considered. Through a sensible regulatory approach, true stablecoins can fulfill their promise without introducing new risks.

The question for central banks and regulators then becomes which combination of the three approaches can also improve competition, lower cost, and increase access to the financial system. While it may be tempting to preserve the status quo, such an approach is unlikely to deliver the same benefits.

Blockchain technology can reshape market structure and improve competition. CDBC rails are one way to achieve this and may be the only way to ensure that consumers have direct access to central bank money. But CBDCs are unlikely to come to market quickly, and there is a high chance that they will be more limited in functionality and programmability.

A much stronger combination would be the public sector focusing on regulation of stablecoins first, and then on CBDC issuance on multiple rails later to complement potential shortcomings. Countries that follow this hybrid model and focus on clear risks and market failures are more likely to actually meet consumer and business needs faster, and see a new generation of financial institutions thrive within their borders. Interoperability across different rails, privacy, and identity are areas where private sector incentives may not be aligned with broader societal goals. Public sector guidance and standard setting can be incredibly useful in promoting the right solutions in these areas.

While it may be tempting to label blockchain technology as yet another instance of “software eating the world,” regulatory frameworks will define if and when the technology can deliver on its potential. In the case of money, the public and private sectors can play to their relative strengths, solidify their public-private partnership, and improve societal outcomes in the process.