The Extinction of Stablecoins As We Know Them Today….
What does the future hold for stablecoins? In this article we review the different types of stablecoins currently existing and some of the most significant research in this area of financial innovation to speculate on the future of stablecoins and the role of CBDCs.
Today’s stablecoins are more likely than not to disappear in the coming months and years. As they exist today, they constitute a significant threat to financial stability and the traditional financial system. Indeed, both governments and international organizations have spent considerable time and resources understanding stablecoins to protect the sovereignty of their monetary policy. In the following article, we review the different types of stablecoins currently existing and some of the most significant research in this area of financial innovation to speculate on the future of stablecoins and the role of CBDCs.
What are stablecoins?
Global stablecoins are either classified as wholesale stablecoins or retail stablecoins. Currently, retail stablecoins are predominant in cryptocurrency markets.
Retail stablecoins are one of the essential financial infrastructure pieces to this day in the cryptocurrency industry. Until their creation and wide adoption, the crypto industry only relied on fiat currencies to access a stable store of value in times of market volatility. Due to regulatory and structural constraints, crypto-assets markets did not benefit from a liquid on- and off-ramp to a stable store of value until the creation of USD Tether, which has become the world’s largest stablecoin by market capitalization (USD 20 billion as of the end of December 2020). Stablecoins are financial instruments usually pegged to the USD dollar. These instruments are designed so that one stablecoin unit is equivalent to one U.S. dollar in most cases. However, over the years, stablecoins pegged against the Euro, Singapore Dollar, Hong Kong Dollar, offshore Chinese Yuan, etc., have started to emerge. Retail stablecoins used in the cryptocurrency markets to this day can be split into three broad categories: fiat-collateralized stablecoins, over-collateralized stablecoins, and algorithmic stablecoins.
Wholesale stablecoins have not emerged yet as a significant use case for stablecoins. Nevertheless, it is still essential to understand their role and importance. Institutional transactions, which are a substantial component of the economy’s total transaction volume, will likely leverage wholesale stablecoins. However, most retail consumers misunderstand and ignore the scale of corporate transactions, and such transactions are often invisible to preserve business secrets. Two examples of these wholesale stablecoins include Utility Settlement Coin developed by Fnality and JPM Coin by J.P. Morgan. From a legal perspective, such wholesale stablecoins are currently referred to as script, a form of non-dollar denominated money. However, new regulations are now being discussed to facilitate the emergence of regulated stablecoins issued by approved institutions in the traditional banking system.
The Scale of the stablecoin economy
The current market capitalization of the stablecoin market [AN1] [OT2] represents about USD 26 billion, according to data collected by Coingecko. USD Tether represents about 4/5 of the total stablecoin market cap of USD 20 billion as of December 2020. Other notable stablecoin projects include USD Coin (Circle) and Dai (MakerDAO), with over USD 1 billion market cap. Finally, Binance USD, Paxos Standard, TrueUSD, and HUSD’s market capitalizations range between USD 200 and 800 million, which is quite significant.
How could stablecoins destabilize the financial system?
While central bankers recognize stablecoins as a complement to cryptocurrency markets, they are extremely skeptical of their current form’s utility and stability. Regulators highlighted such risks in a recent working paper from the Banque de France written by Melachrinos and Pfister (2020). In their paper, they distinguish two categories of stablecoins (retail and wholesale as defined above) and their related risks: risks to financial stability and risks to Monetary policy. A G7 Working Group discussed these risks in a report in 2019. In the table below, we summarize these risks for both retail and wholesale stablecoin.
Regulation and CBDCs: The solution to stablecoins threats
While additional regulatory clarity has been provided by the Office of the Comptroller of the Currency (OCC) regarding the management and transaction of crypto assets, it is still unclear whether the OCC will require the chartering of cryptocurrency providers in the future. Namely, the OCC has recently clarified that U.S. chartered banks could store reserve balances for certain stablecoins and provide custodian services of crypto assets. Nevertheless, it is still uncertain whether the United States and other countries will force companies who produce cryptocurrencies to hold a banking charter.
One potential solution hinted at by Calomiris (2020), the OCC’s Chief Economist, could be to provide a clear path to charter stablecoin providers and institutions producing cryptocurrencies if it is done profitably for the institutions themselves. This path certainly offers early players in this industry significant advantages such as the possibility to “develop a new non-depository payments network separate from the existing central bank-based network.”
More importantly, Calomiris (2020) highlights the characteristics of a potentially viable stablecoin:
· Issued by a national bank (chartered or not) in a safe and sound manner
· Efficient: instant finality of payment via blockchain technology
· Convenient: creation of new services to facilitate transactions and use of stablecoins
· Stable: Contractual obligation to act as a market maker on a secondary market as well as to purchase the coin when it falls to 0.99 and sell it when it rises above 1.01. This operation could be done via a smart contract or an algorithm trading on a centralized exchange.
· Form of financial instrument: perpetual preferred stock in the bank
· No redemption option and no maturity date
· Used to purchase goods and services leveraging the Blockchain as a clearing book
· Pre-existing coin written down by 5% increments if the bank is not able to meet its buy back obligations because it lacks of cash.
· Paying interest on the coin equal to Treasury Bill rates
· Stablecoins only backed by protected cash assets (riskless assets) publicly known to coin holders, equivalent to Riskless fractional reserve banking
· Impossible to perform arbitrage trading
· Improves systemic stability due to zero default risk; low cyber-attack risk; and absence of insured deposits; harder to complete secret money-laundering transactions and avoid taxes
Calomiris also defines the issuer of stablecoins as Stable Value Coin Banks and expresses that such a bank may benefit from obtaining a charter. These benefits include market credibility, reduction of entry barriers in different states, and lower regulatory cost as long as they are not deposit issuing banks. However, the road to chartering such banks will be long and may take years before actually happening due to internal disagreements between public institutions themselves.
Based on the work of the G7, the Financial Stability Board has also started to prepare a harmonized regulatory response to reduce the chances of regulatory arbitrage. They are working in a systematic manner to address core regulatory issues. First is the process of defining the nature of stablecoins as assets. Second, they must determine the risks introduced by stablecoins, which are not covered by current laws and regulations. Regulations cover a comprehensive set of areas: the use of stablecoins for money laundering and terrorist purposes, forcing stablecoins issuers to comply with prudential requirements, user data and privacy protection requirements, the technical viability of the underlying infrastructure used to settle all stablecoin exchanges, to cite a few (Melachrinos and Pfister (2020)).
It is also worth mentioning the Stablecoin Classification and Regulation Act of 2020. While this Bill has not been enacted into law yet, it provides a clear overview of the types of requirements stablecoin issuers may have to comply with in the future. According to this Bill recently submitted to Congress for review, the issuer of any stablecoin must be a Federal Reserve System member. Stablecoin issuers will also be required to obtain written approval from the appropriate Federal banking agency, the Corporation, and the Board of Governors of the Federal Reserve System before issuing any stablecoin assets. In addition to these basic requirements, the stablecoin issuers will be required to comply with reporting standards set by the Board of Governors of the Federal Reserve System, the Financial Stability Oversight Council, and the Office of Finance Research. Finally, stablecoin issuers will be responsible for ensuring the peg of their stablecoin and other constraints set by regulators.
Central Bank Digital Currencies (CBDCs) may be another solution and could act as a regulated substitute to stablecoins. These digital assets would be backed by the full faith of the governments issuing them similar to cash. However, central banks are still conducting several pilots and feasibility studies to determine whether to continue the development of CBDCs. Another issue is that such financial instruments would be core to national economies’ functioning and require a technical infrastructure that still needs to be built.
What does the future of Financial Inclusion look like?
At Gene Finance, we believe financial inclusion is the right for anybody regardless of their gender, race, sexual orientation, geographic location, or other arbitrary criteria to have access to financial services. We also believe anybody should have access to a stable store of value and medium of exchange that does not threaten the sovereign status of national currencies or monetary policy.
For this reason, we believe the future of stablecoins will be determined by stablecoins exhibiting the following characteristics:
· Stable
· Decentralized
· Backed by the value of the assets stored in a decentralized treasury and loans made by our Ecosystem Governors.
· Efficient
· Convenient
· Used for the purchase of digital assets, physical goods and services globally
The issuance and monetary policy surrounding this asset will be designed to ensure the characteristics mentioned above and the long-term sustainability of this project. We will provide additional details about our design in the coming weeks and months.
To learn more about Gene Finance, and stay updated on the latest developments:
- Visit gene.finance
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- Join our Discord Group: http://discord.gg/xCs7Ehy
Resources
1. Chartering the Fintech Future, C.W. Calomiris, 2020.
2. Coingecko Stablecoins Page, https://www.coingecko.com/en/stablecoins
3. Stablecoins: A Brave New World? A. Melachrinos and C. Pfister, 2020, Banque de France Working Paper.
4. Stablecoin Classification and Regulation Act of 2020 & Author personal interpretation, accessed on December 16th, 2020 via https://www.congress.gov/116/bills/hr8827/BILLS-116hr8827ih.pdf
