the-blindspot.com/crypto-reflexivity-and-the-ultimate-stablecoin-reading-list/
You may or may not agree with her stance on Bitcoin but this post offers a useful list of what Izabella has identified as the more informed contributions to the debate about stablecoins.
I have read most of these already but it offers a useful reference point for anyone trying to make sense of this corner of the financial universe.
Tony – From the Outside
Anyone moderately familiar with crypto assets is no doubt aware that the Terra stablecoin has been experiencing problems with its algorithmic smart contract controlled peg mechanism. There are lots of lessons here I am but I think Matt Levine flags one of the more interesting ones in his “Money Stuff” column (13 May 2022).
Safe assets are much riskier than risky ones.
Matt goes on to expand on why this is so …
This is I think the deep lesson of the 2008 financial crisis, and crypto loves re-learning the lessons of traditional finance. Systemic risks live in safe assets. Equity-like assets — tech stocks, Luna, Bitcoin — are risky, and everyone knows they’re risky, and everyone accepts the risk. If your stocks or Bitcoin go down by 20% you are sad, but you are not that surprised. And so most people arrange their lives in such a way that, if their stocks or Bitcoin go down by 20%, they are not ruined.
On the other hand safe assets — AAA mortgage securities, bank deposits, stablecoins — are not supposed to be risky, and people rely on them being worth what they say they’re worth, and when people lose even a little bit of confidence in them they crack completely. Bitcoin is valuable at $50,000 and somewhat less valuable at $40,000. A stablecoin is valuable at $1.00 and worthless at $0.98. If it hits $0.98 it might as well go to zero. And now it might!
The takeaway for me is to once again highlight the way in which supposedly safe, “no questions need be asked”, assets can sometimes be worse than assets we know are risky due to the potential for them to quickly flip into something for which there is no liquidity, just a path to increasingly large price falls. This is a theme that I regularly hammer (so apologies if you are tired of it) but still for me one of the more important principles in finance (right up there with “no free lunch”).
Tony – From the Outside
In a recent post devoted to a BIS report summarising the results of interviews on what a small group of central banks had been doing with regard to Central Bank Digital Currencies, I posed the question whether central bankers might be better placed using their resources and powers to foster the development of fast payment systems rather than Central Bank Digital Currencies (CBDCs) and offered the following perspective:
the business case for a retail CBDC seems to have the most weight in the emerging market and developing economies with relatively poorly developed financial infrastructure
the business case for a retail CBDC in an advanced economy is less obvious
other initiatives such as central bank sponsorship of fast payment systems might be a better use of central bank resources
not explicitly referenced in the paper, but the recent experience with the roll out of fast payment systems in Brazil and India offer interesting case studies
the central bank focus on CBDCs seems to continue to be heavily weighted toward account based systems
token based CBDCs are mentioned in passing but do not seem to be high on the list of priorities
From the Outside – 15 March 2022 – “Central Bank Digital Currencies: A new tool in the financial inclusion toolkit”
For anyone interested in CBDC’s and fast payment systems, the BIS has published another report exploring the lessons to be learned from Brazil’s adoption of the “Pix” fast payment system. The authors identify three takeaways from Brazil’s experience which I think broadly support the thesis that fast payment systems often have the potential to achieve many if not all of the public policy objectives associated with CBDCs:
Public payment infrastructures build on the central bank’s foundational role in the monetary system by promoting competition and interoperability between payment platforms. They can reduce costs for users and promote financial inclusion.
Brazil’s recent experience with the Pix retail instant payment system illustrates the potential gains. In little over a year since its launch in November 2020, Pix has signed up 67% of adults in Brazil, with free payments between individuals and low charges for merchants.
The two key ingredients in the success of Pix are, first, the mandatory participation of large banks to kick-start network effects for users, and second, the central bank’s dual role as infrastructure provider and rule setter.
It is important to note however that these benefits do not flow automatically from just building the payment system infrastructure, the report highlights the importance of the central bank using its power to:
I may be missing something here but it still feels to me like CBDCs are over-rated and (well constructed) fast payment systems under-rated. There are no doubt some economies where a CBDC has a role to play but I for one am paying more attention to the roll out of their less glamorous sibling.
Tony – From the Outside
CBDCs and stablecoins have been getting most of the attention lately. In contrast the release in late March 2022 of a draft bill titled the ECASH Act seems to have flown under the radar. The bill as I understand it is only a proposal at this stage and not something actively in the process of becoming law. It is however worth noting for a couple of reasons
You can find more detail about the proposal here but for those short of time the argument put up by the Act’s proponents for why someone might want to use E-Cash is summarised as those who:
1. Lack access to traditional banking/payments services;
2. Value privacy and wish to avoid surveillance and/or data-mining;
3. Are concerned about third-party censorship and/or discrimination;
3. Lack reliable internet or digital network connectivity; and
5. Are low-income and/or cannot afford high transaction, withdrawal, and exchange fees.
www://https.ecashact.us/#whyuse
The Act’s proponents emphasise however that “… E-Cash, like physical cash, does not pay interest, and offers less third-party protections than traditional bank accounts or payments app (chargebacks, loss and fraud-prevention, etc).” The basic idea is that this is a complement to the existing forms of money (physical and digital) and it is not envisaged that most people will seek to hold large amounts in the form of E-Cash.
1. Directs the Secretary of the Treasury to develop and introduce a form of retail digital dollar called “e-cash,” which replicates the offline-capable, peer-to-peer, privacy-respecting, zero transaction-fee, and payable-to-bearer features of physical cash, and to coordinate their efforts with other agencies, including the Federal Reserve through an intergovernmental Digital Dollar Council led by the Treasury Secretary;
2. Establishes an Electronic Currency Innovation Program within the U.S. Treasury to test and evaluate different forms of secure hardware-based e-cash devices that do not require internet access, third-party validation, or settlement on or via a common ledger, with a focus on widely available, interoperable architectures such as stored-value cards and cell phones;
3. Establishes an independent Monetary Privacy Board to oversee and monitor the federal government’s efforts to preserve monetary privacy and protect civil liberties in the development of digital dollar technologies and services, and directs the Treasury Secretary to, wherever possible, promote and prioritise open-source licensed software and hardware, and to make all technical information available for public review and comment; and
4. Establishes a special-purpose, ring-fenced Treasury overdraft account at the Federal Reserve Bank of New York to cover any and all government expenses related to the development and piloting of E-Cash, and directs the Board of Governors of the Federal Reserve System to take appropriate liquidity-support measures to ensure that the introduction of e-cash does not reduce the ability of banks, credit unions, or community development financial institutions to extend credit and other financial services to underserved populations, as prescribed under the Community Reinvestment Act of 1977 and related laws.
www:https://ecashact.us/#ecashact
I have been a professed sceptic on the need for a retail CBDC in advanced economies with well functioning fast payment systems (see here and here) but this proposal is intriguing and one that I will watch with interest.
Tony – From the Outside
The BIS recently published a paper summarising what had been learned from a series of interviews with nine central banks exploring how these institutions were thinking about the potential of a CBDC to support the pursuit of “financial inclusion” objectives explicit or implicit in their mandates.
A lot of what the paper documents and discusses will be pretty familiar to anyone who has been following the BIS and individual central banks on this topic but I think the following observations offered by the paper about the best way to pursue financial inclusion is worth noting
It needs to be noted that many of these features [i.e. the benefits of a CBDC] can, in isolation, be offered by other payment innovations, and many gaps could be addressed through regulation and sound oversight arrangements. Combining different payment innovations – such as open application programming interfaces (APIs), fast payment services, contactless chips and QR codes – could achieve many of the same goals. This is particularly true when accompanied by robust regulatory and oversight arrangements that public authorities can use to catalyse private sector players, enforce sound governance arrangements and foster required coordination and collaboration. Adoption of relevant technologies for supervisory and regulatory compliance could also improve the efficiency and effectiveness of regulators and supervisors. What is truly different about CBDC is that it is a direct claim on the central bank. It is an open question for central banks whether CBDCs or other policy interventions are the best fit for their jurisdiction. Yet if a CBDC is to be issued (for financial inclusion or other motives), interviews with central banks clearly point to the importance of inclusive design elements to successfully promote inclusive outcomes. We discuss these elements in the next subsection.
Page 13, paragraph 16
There is a narrative that sees CBDC adoption as inevitable based in part on the fact that so many central banks are looking at the question. In contrast, the BIS paper clearly states that a CBDC is not a “panacea” and that many of the outcomes a CBDC might deliver could equally be delivered by other payment innovations such as “open application programming interfaces (APIs) , fast payment services, contactless chips and QR codes”
It is also worth noting that, of the nine central banks interviewed, eight were emerging market and developing economies and only one (Bank of Canada) an advanced economy. The results should therefore be interpreted with that bias in mind.
Summing up, my take is that
Let me know what I am missing
Tony – From the Outside
Stablecoin regulation is one of my perennial favourite topics. Yes I know – I need to get out more but getting this stuff right does truly matter. I have gone down this particular rabbit hole more than a couple of times already. This has partly been about the question of how much we can rely on existing disclosure regarding reserves (here and here for example ) but the bigger issue (I think) is to determine what is the right regulatory model that ensures a level playing field with existing participants in the provision of payment services while still allowing scope for innovation and competition.
JP Koning has been a reliable source of comment and insight on the questions posed above (see here and here for example). Dan Awrey also wrote an interesting paper on the topic (covered here) which argues that the a state based regulatory model (such as the money transmitter licensing regime) is not the answer. There is another strand of commentary that focuses on the lessons to be learned from the Free Banking Era of the 19th century, most notably Gorton and Zhang’s paper titled “Taming Wildcat Stablecoins” which I covered here.
Although not always stated explicitly, the focus of regulatory interest has largely been confined to “payment stablecoins” and that particular variation is the focus of this post. At the risk of over-simplifying, the trend of stablecoin regulation appears to have been leaning towards some kind of banking regulation model. This was the model favoured in the “Report on Stablecoins” published in November 2021 by the President’s Working Group on Financial Markets (PWG). I flagged at the time (here and here) that the Report did not appear to have a considered the option of allowing stablecoin issuers to structure themselves as 100% reserve banks (aka “narrow banks”).
Against that background, it has been interesting to see that United States Senator Toomey (a member of the Senate Banking Committee) has introduced a discussion draft for a bill to provide a regulatory framework for payment stablecoins that does envisage a 100% reserve model for regulation. Before diving into some of the detail, it has to be said that the bill does pass the first test in that it has a good acronym (Stablecoin TRUST Act where TRUST is short for “Transparency of Reserves and Uniform Safe Transactions”.
There is not a lot of detail that I can find so let me just list some questions:
None of the questions posed above should be construed to suggest that I am anti stablecoins or financial innovation. A business model that may be found to rely on a regulatory arbitrage is however an obvious concern and I can’t find anything that addresses the questions I have posed. I am perfectly happy to stand corrected but it would have been useful to see this bill supported by an analysis that compared the proposed liquidity and capital requirements to the existing requirements applied to:
Let me know what I am missing
Tony – From the Outside
Note – this post was revised on 14 April 2022
One of the arguments for buying Bitcoin is that, in contrast to fiat currencies that are at mercy of the Central Bank money printer, its value is underpinned by the fixed and immutable supply of coins built into the code. Some cryptocurrencies take this a step further by engineering a systematic burning of their coin.
I worry about inflation as much as the next person, perhaps more so since I am old enough to have actually lived in an inflationary time. I think a fixed or shrinking supply is great for an asset class but it is less obvious that it is a desirable feature of a money system.
Crypto true believers have probably stopped reading at this point but to understand why a fixed supply might be problematic I can recommend a short speech by Claudio Borio. The speech dates back to 2018 but I think it continues to offer a useful perspective on the value of an elastic money supply alongside broader comments about the nature of money and its role in the economy.
Borio was at the time the Head of the BIS Monetary and Economic Department but the views expressed were his personal perspective covering points that he believed to be well known and generally accepted, alongside others more speculative and controversial.
I did a post back in March 2019 that offers an overview of the speech but recently encountered a post by J.W. Mason which reminded me how useful and insightful it was.
The specific insight I want to focus on here is the extent to which a well functioning monetary system relies on the capacity of credit extended in the system to expand and contract in response to both short term settlement demands and the longer term demands driven by economic growth.
One of the major challenges with the insight Borio offers is that most of us find the idea that money is really just a highly developed form of debt to be deeply unsatisfying if not outright scary. Borio explicitly highlights “the risk of overestimating the distinction between credit (debt) and money” arguing that “…we can think of money as an especially trustworthy type of debt”
Put differently, we can think of money as an especially trustworthy type of debt. In the case of bank deposits, trust is supported by central bank liquidity, including as lender of last resort, by the regulatory and supervisory framework and varieties of deposit insurance; in that of central bank reserves and cash, by the sovereign’s power to tax; and in both cases, by legal arrangements, way beyond legal tender laws, and enshrined in market practice.
Borio: Page 9
I did a post here that explains in more detail an Australian perspective on the process by which unsecured loans to highly leveraged companies (aka “bank deposits”) are transformed into (mostly) risk free assets that represent the bulk of what we use as money.
Borio outlines how the central banks’ elastic supply of the means of payment is essential to ensure that (i) transactions are settled in the interbank market and (ii) the interest rate is controlled …
“To smooth out interbank settlement, the provision of central bank credit is key. The need for an elastic supply to settle transactions is most visible in the huge amounts of intraday credit central banks supply to support real-time gross settlement systems – a key way of managing risks in those systems (Borio (1995)).”
Borio: Page 5
… but also recognises the problem with too much elasticity
While the elasticity of money creation oils the wheels of the payment system on a day to day basis, it can be problematic over long run scenarios where too much elasticity can lead to financial instability. Some degree of elasticity is important to keep the wheels of the economy turning but too much can be a problem because the marginal credit growth starts to be used for less productive or outright speculative investment.
This is a big topic which means there is a risk that I am missing something. That said, the value of an elastic supply of credit looks to me like a key insight to understanding how a well functioning monetary system should be designed.
The speech covers a lot more ground than this and is well worth reading together with the post by J.W. Mason I referenced above which steps through the insights. Don’t just take my word for it, Mason introduces his assessment with the statement that he was “…not sure when I last saw such a high density of insight-per-word in a discussion of money and finance, let alone in a speech by a central banker”.
Tony – From the Outside
Izabella Kaminska is one of the commentators that I find reliably generates interesting and useful insights. Personally I remain sceptical on crypto but this link takes you to a post where she makes an argument that I find persuasive.
For those short of time here is an extract capturing the key points I took from her post…
My position on crypto has evolved over time to appreciate this factor. Crypto may not be an optimal system. It’s clunky. It’s energy intensive. It’s confusing. But as a back-up system for when the shit really hits the fan, it’s an incredibly worthwhile system to have in place and I increasingly think we should be grateful that some deep-pocketed individuals with concerns for freedom and privacy took the risks they did to make it become a thing.
I have in the past compared crypto to a monetary equivalent of the right to bear arms, whose main purpose, many argue, is to act as a deterrent to rising authoritarianism. Its optimal deployment is as a right that it is never actually exercised.
Crypto should be treated the same way. On a day to day basis, it’s much better for us all to trust in a centralised and properly supervised system. But having crypto there as a challenger or backup system is no bad thing. It should in theory enhance the core system by helping to keep it honest and working in our interests.
“Why Canada is cultivating an M-pesa moment for bitcoin”, The Blind Spot 18 February 2022
Tony – From the Outside
One of the use cases for cryptocurrency and\or stablecoins is that it offers cheaper and faster alternatives to the conventional payment rails. Whether they will succeed remains to be seen but I have long believed cross country payments is one of the areas where the banking system really does need to lift its game.
Against that context, this research study released by the Bank for International Settlements (BIS) suggests that TradFi banking is making some improvements.
The study lists three key takeaways …
“- The speed of cross-border payments on SWIFT global payment innovation (gpi) is generally high with a median processing time of less than two hours. However, payment speeds vary markedly across end-to-end payment routes from a median of less than five minutes on the fastest routes to more than two days on several of the slowest routes.
– Prolonged processing times are largely driven by time spent at the beneficiary bank from when it receives the payment instruction until it credits the end customer’s account. Longer processing times tend to occur in low and lower-middle income countries, which can be partly attributed to capital controls and related compliance processes, weak competition as measured by the number of banks as well as limited operating hours of and the use of batch processing by beneficiary banks.
– Cross-border payments on SWIFT involve, on average, just over one intermediary between the originator and beneficiary banks. Each additional intermediary prolongs payment time to a limited extent, while the size of time zone differences between banks has no discernible effect on speed.”
If I am reading it correctly, the study does not capture any delays the initiating bank may introduce before it processes a payment instruction. With that caveat, it is worth noting that TradFi is not standing still – competition can be a beautiful thing.
Also worth noting the extent to which domestic payment systems are improving though not necessarily in the USA.
Tony – From the Outside
Anyone following the stablecoin debate is probably familiar with a paper by Gary Gorton and Jeffrey Zhang titled (somewhat provocatively) “Taming Wildcat Stablecoins”. I did a post back in July 2021 when it first came out and have some more detailed notes on it here.
In my initial July 2021 post I listed three things I found useful and/or interesting
Having reread the paper and some of the critiques it has attracted, I think these insights mostly remain valid. Of the three, the principle that money must be exchangeable on a NQA basis is (for me at least) the most useful. I must confess however that I find the lessons they draw from the Free Banking Era are muddled by the reference to “Wildcat Banking”. There are lessons for sure but you have to dig deeper into the historical record to really get a clear read on the conditions under which the uninsured liabilities of private entities can and cannot function as a reliable form of money.
This does not in itself fatally undermine the argument that stablecoins need a stronger regulatory framework to function effectively and efficiently as a form of money. It is however worth being clear on what lessons drawn from the history of private money can be usefully employed in figuring out how best to respond to the rise of stablecoins. While this post takes issue with some of analysis in the paper, I must declare that I still rate Gorton as one of my favourite commentators on banking and the NQA principle he espouses has long influenced my own views on banking.
At this point it might be helpful to recap the main elements of the argument Gorton and Zhang lay out in their joint paper:
As a rhetorical device the, Wildcat Free Banking analogy works pretty well as an attack on stablecoins. You don’t really need to delve into the detail, wildcat banking tells you all you need to know. It sounds pretty bad and lawless in Wild West kind of way and so, by association, stablecoins must also be problematic.
The problem is that Gorton and Zhang themselves explicitly state that wildcat banking was not as big a problem as is commonly asserted and the Free Banking system in fact functioned well from the view of efficient market theory .
For many years, the literature asserted that there were wildcat banks during this period. These were banks that either (1) did not deposit the requisite bonds, or (2) in some states, where bonds were valued at par and not market value, defrauded the public by issuing notes that they would never redeem in specie (gold or silver). Counterfeiting was a big problem, but the system was not chaos. Bank failures were not due to wildcat banking as has often been alleged. In fact, it functioned well from the point of view of efficient market theory.
Gorton and Zhang, “Taming Wildcat Stablecoins”, p28
So it appears that, notwithstanding its prominence in the title of their paper, the problem they are highlighting with Free Banking is not wildcat banks per se but rather the extent to which Free Banking in America resulted in bank notes trading at discounts to their par value …
The market was an “efficient market” in the sense of financial economics, but varying discounts made actual transactions (and legal contracting) very difficult. It was not economically efficient. There was constant haggling and arguing over the value of notes in transactions. Private bank notes were hard to use in transactions.
Page 29
The fundamental lesson Gorton and Zhang draw from the Free Banking Era and the subsequent development of a national currency in America is that competition and market forces alone will not by themselves ensure that privately produced forms of money can be relied on to exchange at their face value on a NQA basis under all market conditions.
In order to better understand the other side of this debate I have attempted to dig a bit deeper into the history of Free Banking. As part of the search I came across this podcast in which Nic Carter (Castle Island Ventures) interviews George Selgin (Director of the Center of Monetary Alternatives at the Cato Institute). It is long (1 hour 12 minutes) but appears to offer a good overview of the counter arguments advanced by proponents of cryptocurrencies, stablecoins and Free Banking.
Selgin argues (convincingly I think) that quite a lot of the problems experienced with Free Banking in America were a function (ironically) of poorly designed regulations – i.e. Free Banking in America did still involve regulation though maybe not as much supervision as banks are subject to today. In particular, he calls out the prohibition on branch banking (which restricted the capacity of banks to diversify the risk of their loan books) and the requirement that bank notes be backed by state government bonds (that ultimately proved to be very poor credit risks).
This is another area where the debate gets a bit muddled.
Selgin concedes that some bank notes did trade at discounts to their par value – one of the central claims of Gorton and Zhang’s paper – but argues that these discounts were not a function of risk differences (i.e. concerns about the solvency and or liquidity of the issuing banks) but rather a reflection of the transaction costs incurred to redeem the notes at their issuing banks.
Selgin argues that “local” notes (i.e. those circulating in the local economy of their issuing bank) did in fact exchange at their par value and that the evidence of discounts cited by Gorton and Zhang were for “foreign” notes where they reflected the transaction costs of presenting the notes back to their issuing bank in another town, city or state.
However Selgin also concedes that part of the reason we don’t see evidence of local bank notes trading at discounts is that shopkeepers and other banks simply refused to accept any note where there was real or perceived default risk
In truth, antebellum banknote discounts were for the most part neither a consequence of the lack of regulation nor a reflection of distrust of their issuers. [Default risk was sometimes a factor], to be sure. But when it was, shopkeepers and banks tended to refuse them altogether, leaving it to professional note “brokers” to deal with them, much as they dealt with notes of banks that were known to be “broken,” but which might yet have some liquidation value. Discounts on “bankable” notes, on the other hand, reflected nothing more than the cost of sorting and returning them to their sources for payment in specie, plus that of bringing the specie home. This explains why, whatever the discounts placed on them elsewhere, [most notes traded at par in their home markets].
George Selgin, “The fable of the cats”
I can’t get any sense of the relative size of the instances where shopkeepers and banks simply refused to accept notes issued by suspect banks. The fact that it happened under Free Banking regimes in America does however seem to support Gorton and Zhang’s assessment that “money” requires a support framework to be capable of being exchanged widely and freely on an NQA basis.
Based on my (so far not very deep) exploration of the Free Banking literature, it seems that its proponents also believe money requires a support framework. The key difference seems to be whether the private sector can maintain that support framework on its own or whether you require public sector involvement in the form of regulation, supervision and deposit insurance to achieve that outcome.
To properly explore what lessons we can learn about money and banking from history, we need to look beyond the American experience with Free Banking.
Selgin and Carter point to the experience of Free Banking in a range of countries other than America as evidence that unregulated stablecoins subject to the forces of market discipline not only could work but potentially offer a better model than the highly regulated, deposit insured model that has come to dominate the modern banking status quo.
Scotland and Canada figure prominently in this alternative narrative of what history teaches us. I don’t really know enough about these eras to comment with any authority but it does appear that the notes issued by banks operating under these regimes did in fact hold their value and function effectively as the primary form of money.
Nic Carter wrote a post on the Scottish Free Banking era which listed five features which kept it stable
– Competitive ‘note dueling’
– A private clearinghouse
– Full liability partnership models
– Until 1765, clauses permitting the temporary suspension of convertibility
– Branching and diversification
Nic Carter, “Scotland, Free Banks and Stablecoins” Murmurations 19 Sep 2021
… and summarised its virtues as
There was no regulatory body…. There was simply a legal structure that discouraged excessive lending, market mechanisms through which banks could competitively keep each other in check, and a vibrant information environment the public could benefit from. The Scottish banking system during the period was remarkably stable; financial crises and panics were rare, contrasting favorably with neighboring England. The Scottish experience of lightly regulated banking shows clearly that such a model can work …
Carter proposes two lessons that stablecoin issuers might extract from the Scottish Free Banking era.
Firstly that stablecoin issuers consider cooperating to create a private clearing house
First, as exchanges (oftentimes, it’s exchanges issuing stablecoins) continue mutually accepting each others notes, they might consider a private clearinghouse. That way they can achieve efficiency in settlement – moving from real time gross settlement to a net settlement model, saving on fees and on-chain headaches. If they do this, they will be fully incentivized to surface information regarding the solvency of their counterparties. This would solve the coordination problem inherent in entities like Tether being untransparent; their clients don’t have a sufficient economic motive to diligence them. A clearinghouse might in its charter insist that stablecoin issuers disclose their collateral to the group.
Secondly that stablecoin issuers include in their terms of service the right to temporarily suspend the right to exchange coins for fiat
Second, one tool that Scottish banks developed in 1750, as an alternative to deposit insurance, was an ‘option clause’. This allowed the bank to suspend redeemability of their notes for specie for a given period of time, effectively allowing solvent but illiquid banks to honor client withdrawals (albeit on a slower schedule). For the privilege, they would pay note holders interest on the normally non-interest bearing notes. This massively reduced the risk of a bank run and it was popular until it was outlawed in 1765. Now for stablecoins to eliminate run risk, they could be structured more like Money Market Mutual Funds, in which you can only withdraw a proportional share of the underlying assets, rather than a fixed claim redeemable for $1. So as a depositor you have no incentive to be the first out the door, as you do with a bank. Or they could implement something similar to the option clause, suspending redeemability if they were faced with a liquidity crunch. Larry White has suggested this, and I believe Tether may have a similar option clause in their ToS but I’d have to double check that.
Whether Carter’s Free Banking based suggestions are useful contributions to the debate about what to do about stablecoins is a question for another day and another post. I am sceptical but I need more time to think through exactly what concerns me. The idea of exchanges taking on a supervisory role via a private clearing house seems to lean away from the decentralised ethos that is a strong feature of many in the crypto, stablecoin, DeFi community – but maybe I am missing something.
I also want to take the time to get a better understanding of exactly how the pure forms of Free Banking that Carter and Selgin advocate actually worked. The problems that Gorton and Zhang describe with the experience of runs on MMF’s in 2008 and again in 2020 also look to me like they still have something useful to contribute to the stablecoin regulation debate.
My scepticism is also reinforced by my professional experience working through the various iterations of the Basel capital adequacy accord. In particular Basel II which introduced the idea of 3 mutually supporting Pillars. For the purposes of this discussion, Pillar 3 (Market Discipline) is the one I want to focus on. Basel II was developed at a time when conventional wisdom placed an enormous amount of faith in the power of markets to hold everyone to account.
In practice that did not really work out the way the theory suggested it should. I do not subscribe to the view that risk based capital requirements are a total failure. The enhancements introduced under the aegis of Basel III (in particular bail-in but also higher capital and liquidity requirements) have gone a long way to make the traditional banking system stronger and more resilient but I think it is fair to conclude that market discipline alone is not a reliable basis for ensuring the stability of the banking system.
I am a big fan of using economic history as a guide to avoiding repeating the mistakes of the past but I think the evidence from the American Free Banking Era is not especially useful as a guide to the risks of stablecoins. This does not however mean that we should embrace the unregulated rise of stablecoins as a new form of private money.
As a conceptual framework, the five features underpinning the stability of the Scottish Free Banks is a good place to start when thinking about the extent to which stablecoins might also be, or become, self regulating. The practical challenge however is that stablecoins also have to fit into the financial system we have and that is one based around prudential regulation, supervision, deposit preference and deposit insurance. It is very hard to see bank regulators giving ground on the principle of same activity same regulation. Innovation is valuable for sure but it is equally true that regulatory arbitrage never ends well.
I have disclosed my bias and, as always, it is entirely possible that I am missing something. However, at this stage I am struggling with the idea that stablecoins that aim to expand in size and scope beyond facilitating the settlement of crypto asset trading can function as money without a regulatory framework that underpins the promise of repayment made by the private entities responsible for issuing them. That regulatory framework might not be the same as that applied to depositary institutions but it does need to be consistent with it.
Let me know what I am missing …
Tony – From the Outside
From the outside 