The future of stablecoin issuance appears to lie in becoming more like a bank

Well to be precise, the future of “payment stablecoins” seems to lie in some form of bank like regulation. That is one of the main conclusions to be drawn from reading the “Report on Stablecoins” published by the President’s Working Group on Financial Markets (PWG).

One of the keys to reading this report is to recognise that its recommendation are focussed solely on “payment stablecoins” which it defines as “… those stablecoins that are designed to maintain a stable value relative to a fiat currency and, therefore, have the potential to be used as a widespread means of payment.”

Some of the critiques I have seen from the crypto community argue that the report’s recommendations fail to appreciate the way in which stablecoin arrangements are designed to be self policing and cite the fact that the arrangements have to date withstood significant episodes of volatility without holders losing faith. Market discipline, they argue, makes regulation redundant and an impediment to experimentation and innovation.

The regulation kills innovation argument is a good one but what I think it misses is that the evidence in support of a market discipline solution is drawn from the existing uses and users of stablecoins which are for the most part confined to engaged and relatively knowledgeable participants. This group of financial pioneers have made a conscious decision to step outside the boundaries of the regulated financial system (with the protections that it offers) and can take the outcomes (positive and negative) without having systemic prudential impacts.

The PWG Report looks past the existing applications to a world in which stablecoins represent a material alternative to the existing bank based payment system. In this future state of the world, world stablecoins are being used by ordinary people and the question then becomes why this type of money is any different to private bank created money once it becomes widely accepted and the financial system starts to depend on it to facilitate economic activity.

The guiding principle is (not surprisingly) that similar types of economic activity should be subject to equivalent forms of regulation. Regulatory arbitrage rarely (if ever) ends up well. This is a sound basis for approaching the stablecoin question but it is not obvious to me that bank regulation is the right answer. To understand why, I recommend you read this briefing note published by Davis Polk (a US law firm), in particular the section titled “A puzzling omission” which explores the question why the Report appears to prohibit stablecoin issuers from structuring themselves as 100% reserve banks (aka “narrow banks”).

4. A puzzling omission.

By recommending that Congress require all stablecoin issuers to be IDIs, the Report would effectively require all stablecoin issuers to engage in fractional reserve banking and effectively prohibit them from being structured as 100% reserve banks (i.e., narrow banks9) that limit their activities to the issuance of stablecoins fully backed by a 100% reserve of cash or cash equivalents.10

The reason is that IDIs are subject to minimum leverage capital ratios that were calibrated for banks that engage in fractional reserve banking and invest the vast portion of the funds they raise through deposit-taking in commercial loans or other illiquid assets that are riskier but generate higher returns than cash or cash equivalents. Minimum leverage ratios treat cash and cash equivalents as if they had the same risk and return profile as commercial loans, commercial paper and long-term corporate debt, even though they do not. Unless Congress recalibrated the minimum leverage capital ratios to reflect the lower risk and return profile of IDIs that limit their assets to cash and cash equivalents, the minimum leverage capital ratios would make the 100% reserve model for stablecoin issuance uneconomic and therefore effectively prohibited.11 It is puzzling why the PWG, FDIC and OCC would recommend a regulatory framework that would effectively require stablecoin issuers to invest in riskier assets and rely on FDIC insurance rather than permitting stablecoins backed by a 100% cash and cash equivalent reserve.

This omission is puzzling for another reason. There has long been a debate whether deposit insurance schemes or a regime that required demand deposits to be 100% backed by cash or cash equivalents would be more effective in preventing runs or contagion. Indeed, the Roosevelt Administration, Senator Carter Glass, a number of economists and most well-capitalized banks were initially opposed to the proposal to create a federal deposit insurance scheme in 1933.12 Among the arguments against deposit insurance are that the benefits of deposit insurance in the form of reduced run and contagion risk are outweighed by the adverse effects in the form of reduced market discipline resulting from the reduced incentive of depositors to monitor the financial health of their banks. This reduced monitoring gives weaker banks more room to engage in risky activities the costs of which are borne by the stronger and more responsible banks in the form of excessive deposit insurance premiums or by taxpayers in the form of government bailouts.

In a competing proposal that has come to be known as the Chicago Plan, a group of economists led by economists at the University of Chicago argued in favor of a legal regime that required all demand deposits to be 100% backed by a reserve of cash or cash equivalents.13 Proponents of the Chicago Plan argued that it would be more effective in stemming runs and contagion than the proposed federal deposit insurance scheme, without undermining market discipline or creating moral hazard. The Chicago Plan would have been analogous to the original National Bank Act that required all paper currency issued by national banks to be fully backed 100% by U.S. Treasury securities. The Chicago Plan was ultimately rejected in favor of the federal deposit insurance scheme that was enacted in 1933 not because it would have been less effective than deposit insurance in stemming runs and contagion, but because it was viewed as too radical. Policymakers feared that by prohibiting banks from using deposits to fund commercial loans and invest in other debt instruments, the Chicago Plan would have resulted in a further contraction in the already severely contracted supply of credit that was fueling the great contraction in economic output that later became known as the Great Depression.

It is understandable why the Report does not recommend prohibiting IDIs from issuing, transferring or buying and selling stablecoins that represent insured deposit liabilities. What is puzzling in light of this history, however, is why the Report would effectively prohibit stablecoin issuers from structuring themselves as 100% reserve (i.e., narrow) banks that limit their activities to the issuance, transfer and buying and selling stablecoins fully backed by a 100% reserve of cash or cash equivalents.

“U.S. regulators speak on stableman and crypto regulation” Davis Polk Client Update, 12 November 2021

I am open to the possibility that the conventional bank regulation solution was unintended and that a narrow bank option might still be on the table. In that regard, I note that Circle has been pursuing the 100% reserve bank option for some time already so it would have been reasonable to expect that the PWG Report to discuss why this was not an option if they were ruling it out. The value of the Davis Polk note is that it neatly explains why being required to operate under bank regulation (the Leverage Ratio in particular) will be problematic for the stablecoin business model. This will be especially useful for those in the stablecoin community who may believe that fractional reserve banking is a free option to increase the riskiness of the assets that back the stablecoin liabilities.

But, as always, I may be missing something…

Tony – From the Outside

M-Pesa and the African Fintech Revolution – by Marc Rubinstein – Net Interest

You, like me, might be vaguely aware of the M-Pesa story of fintech innovation in Africa. Marc Rubinstein offers one of the best accounts I have encountered of how this came about and where it might be headed. Especially interesting is his analysis of why it took off in Kenya and the challenges it has faced in other markets.

You can find Marc’s post here –

Tony – From the Outside

Taming wildcat stablecoins …

… is the title of an interesting paper by Gary Gorton and Jeffrey Zhang which argues that:

  • Cryptocurrency, or stablecoins to be more precise, can be viewed as the latest variation in a long history of privately produced money
  • The experience of the United States during the Free Banking Era of the 19th century suggests that ” … privately produced monies are not an effective medium of exchange because they are not always accepted at par and are subject to bank runs”
  • Stablecoins are not as yet a systemic issue but could be, so policymakers need to adjust the regulatory framework now to be ready as these new forms of private money grow and and potentially evolve into something that can’t be ignored
  • Policy responses include regulating stablecoin issuers as banks and issuing a central bank digital currency
So what?

I am not convinced that a central bank digital currency is the solution. I can see a case for greater regulation of stablecoins but you need to be clear about exactly what type of stablecoin requires a policy response. Gorton and Zhang distinguish three categories …

The first includes cryptocurrencies that are not backed by anything, like Bitcoin. We call these “fiat cryptocurrencies.” Their defining feature is that they have no intrinsic value. Second, there are specialized “utility coins,” like the JPMorgan coin that is limited to internal use with large clients. Finally, there are “stablecoins,” which aspire to be used as a form of private money and so are allegedly backed one-for-one with government fiat currency (e.g., U.S. dollars)

I am yet to see a completely satisfactory taxonomy of stablecoins but at a minimum I would break the third category down further to distinguish the ways in which the peg is maintained. The (relatively few?) stablecoins that actually hold high quality USD assets on a 1:1 basis are different from those which hold material amounts of commercial paper in their reserve asset pool and different again from those which employ algorithmic protocols to maintain the peg.

However, you do not necessarily have to agree with their taxonomy, assessments or policy suggestions to get value from the paper – three things I found useful and interesting:

  1. The “no-questions-asked ” principle for anything that functions or aims to function as money
  2. Some technical insights into the economic and legal properties of stablecoins and stablecoin issuers
  3. Lessons to be learned from history, in particular the Free Banking Era of the 19th century
The “no-questions-asked” principle.

Money is conventionally defined in terms of three properties; a store of value, a unit of account and a medium of exchange. Gorton and Zhang argue that “The property that’s most obvious, yet not explicitly presented, is that money also must satisfy the no-questions-asked (“NQA”) principle, which requires the money be accepted in a transaction without due diligence on its value“. They freely admit that they have borrowed this idea from Bengt Holmstrom though I think he actually uses the term “information insensitive” as opposed to the more colloquial NQA principle.

Previous posts on this blog have looked at both Holmstrom’s paper and other work that Gorton has co-authored on the optimal level of information that different types of bank stakeholders require. If I understood Holmstrom correctly, he seemed to extend his thesis on the value of being able to trade on an “information insensitive” basis to argue that “opacity” in the debt market is something to be embraced rather than eliminated. I struggle with embracing opacity in this way but that in no way diminishes the validity of the distinction he draws between the relative value of information in debt and equity markets and its impact on liquidity.

Gorton and Zhang emphasise the importance of deposit insurance in underwriting confidence in and the liquidity of bank deposits as the primary form of private money. I think that is true in the sense that most bank deposit holders do not understand the mechanics of the preferred claim they have on the assets of the bank they have lent to but it seems to me that over-collateralisation is equally as important in underwriting the economics of bank deposits.

If I have not lost you at this point, you can explore this question further via this link to a post I did titled “Bank deposits – turning unsecured loans to highly leveraged companies into (mostly) risk free assets – an Australian perspective“. From my perspective, the idea that any form of money has to be designed to be “information insensitive” or NQA rings very true.

Insights drawn from a technical analysis of stablecoins and stablecoin issuers.

The paper delves in a reasonable amount of detail into the technicalities of whether stablecoins are economically or legally equivalent to demand deposits and the related question of whether stablecoin issuers might be considered to be banks. The distinction between the economic and the legal status is I think especially useful for understanding how banking regulators might engage with the stablecoin challenge.

The over arching point is that stablecoins that look and function like bank demand deposits should face equivalent levels of regulation. That does not necessarily mean exactly the same set of rules but something functionally equivalent.

One practical outcome of this analysis that I had not considered previously is that they deem Tether to be based on an “equity contract” relationship with its users whereas the other stablecoins they analyse are “debt contracts” (see below). The link between Tether and a money market fund and the risk of “breaking the buck” has been widely canvassed but I had not previously seen the issue framed in these legal terms.

This technical analysis is summarised in two tables (Table 2: Stablecoins and their Contracts as of June 30, 2021 and Table 3: Stablecoins, Redemptions, and Fiat Money as of June 30. 2021) that offer a useful reference point for understanding the mechanics and details of some of the major stablecoins issued to date. In addition, the appendix to the paper offers links to the sources used in the tables.

Lessons to be learned from history

It may have been repeated to the point of cliche but the idea that “those who cannot remember the past are condemned to repeat it” (George Santayana generally gets the credit for this but variations are attributed to Edmund Burke and Sir Winston Churchill) resonates strongly with me. The general argument proposed by Gorton and Zhang is that lots of the ideas being tried out in stablecoin design and DeFi are variations on general principles that were similarly employed in the lightly regulated Free Banking Era but found wanting.

Even if you disagree with the conclusions they draw, the general principle of using economic history to explore what can be learned and what mistakes to avoid remains a useful discipline for any practitioner of the dark arts of banking and money creation.

Summing up in the authors’ own words

The paper is long (41 pages excluding the Appendix) but I will wrap up this post with an extract that gives you the essence of their argument in their own words.

Tony – From the Outside


The more things change, the more they stay the same. It is still the case that regulation is being outpaced by innovation—thereby creating an uneven playing field—as it is easier and cheaper for more technologically advanced firms to offer similar products and services. 

In this case, it is also true that the problems associated with privately produced money are the same as they were one hundred and fifty years ago. We stress three points from our review of history. First, the use of private bank notes was a failure because they did not satisfy the NQA principle. Second, the U.S. government took control of the monetary system under the National Bank Act and subsequent legislation in order to eliminate the private bank note system in favor of a uniform currency—namely, national bank notes. Third, runs on demand deposits only ended with deposit insurance in 1934. 

Currently, it does not appear that stablecoins are used as money. But, as stablecoins evolve further, the stablecoin world will look increasingly like an unregulated version of the Free Banking Era—a world of wildcat banking. During the Free Banking Era, private bank monies circulated at time-varying discounts based on geography and the perceived risk of the issuing bank. Stablecoin prices are independent of geography but not independent of the perceived risk of their backing assets. If they succeed in differentiating themselves from fiat cryptocurrencies and become used as money, then they will likely trade at time-varying discounts as well. Policymakers have a couple of ways to address this development, and they better get going. 

Stablecoin backing

… is a hot topic full of claims, counter claims and clarifications. Tether’s USDT token has been getting the bulk of the attention to date but questions are now being asked about Circle’s USDC token (a cryptographic stored value token or stablecoin that allows users to trade crypto assets).

My understanding is that USDC is one of the better (in relative terms) stable coins regarding backing and disclosure but this analysis from Amy Castor argues that is still not especially good and may be getting worse. The Financial Times makes a similar argument.

The broad problem they outline

  • Stablecoins generally start out with a promise that each coin is backed 1:1 with fiat currency (typically USD) or fully reserved
  • Ideally those fiat currency reserves are held on deposit in a bank on a custodial basis
  • Over time that simple promise becomes more nuanced with qualifications that dilute the fiat currency component and introduce concepts like “approved investments”
  • The location of the deposit may also become ambiguous
  • Not always clear if the backing itself has evolved or the disclosure evolves in response to questioning

USDT has been the most high profile example of asset backing being understood to be USD cash but evolving into something USD based but not always 100% cash or necessarily liquid. The two sources cited above suggest that USDC backing may also be less than 100% USD.

Amy Castor points to the change in USDC disclosure between February and March 2021 as evidence of an apparent change in (or clarification of?) the composition of the reserve backing.

Source: Amy Castor, “What’s backing Circle’s 25B USDC? We may never know”

As always I may be missing something, and maybe this is just my traditional banking bias, but Amy poses what seem to me to be pretty reasonable questions like “what are those approved investments? Who approves them? What percentage of assets are in that category?” that Circle is yet to answer.

Tony – From The Outside

A contest to control crypto

Gillian Tett (Financial Times) makes an interesting contribution to the crypto currency debate (link here) using Niall Ferguson’s metaphor of the “Square” and the “Tower” to examine the contest for who controls crypto.

Worth reading in full but here is a flavour of her observations…

Where does this leave the crypto “square”? In China, I suspect it will gradually be crushed. Beijing seems intent on using CBDCs to centralise power. In Europe, the “square” may be curbed by bureaucracy.

But the really interesting issue is what will happen in the US, a country that venerates free-market ideas and network-driven innovation. “American cultural values — from support for the underdog to adulation of the frontier explorer — seem to be the precipitating source of how crypto is changing our concept of money,” notes anthropologist Sara Ceraldi. Don’t count out the crowd.

Either way, the point is that nobody can explain crypto prices or other meme assets with monetary economics or portfolio theory alone. The power and culture of “squares” and “towers” matter. Rarely has finance been so fascinating or so hard to model with maths.

Gillian Tett, “A contest to control crypto is underway” Financial Times 24 June 2021

Tony – From The Outside

Central bank digital currencies – Game On

FT Alphaville today wrote up some of the highlights they picked up from a report included in the Annual Economic Report published by Bank for International Settlements (BIS).

The highlights I picked up from the Alphaville column included:

  • Central Bank Digital Currencies (CBDCs) now seem a matter of when, not if, primarily because the BIS has concluded that they need to get ahead of Big Tech (i.e. Big Tech are pushing ahead with their own versions of digital currency in a number of jurisdictions so central banks need to respond to these initiatives)
  • The fact that China is committed to a digital currency with the potential to gain a “first-mover advantage” also seems to be a factor
  • The BIS does not however see a CBDC as adding much value if your financial system already has a well functioning, retail fast payments system with all of the safeguards required by know-your-customer regulations
  • In terms of design, the BIS seems to be opting for an account based (as opposed to token based) form of digital money
  • Two of the larger design issues associated with implementing a CBDC are privacy versus security concerns and the potential for crowding out (i.e. how the new form of digital money impacts financial systems where banks are established as the primary suppliers of digital money).

There is a lot to unpack in the BIS paper but it is worth noting one thing I found immediately curious. In responding to the concerns about privacy versus security, Alphaville noted that “The report … says CBDCs could even have a built-in layer of anonymity for very small inconsequential transactions“.

That might work from an Anti Money Laundering (AML) perspective but it is far from clear to me how you would define “very small inconsequential transactions” in a world where a relatively small number of low value payments can finance child pornography. Westpac Banking Corporation paid a high price for failing to comply with reporting requirements in this regard so it is hard to see how a CBDC could define a threshold that was inconsequential.

Alphaville is of course just one perspective. I am yet to read the BIS paper in full but these are the key takeaways that the BIS author has chosen to highlight:

. Central bank digital currencies (CBDCs) offer in digital form the unique advantages of central bank money: settlement finality, liquidity and integrity. They are an advanced representation of money for the digital economy.

• Digital money should be designed with the public interest in mind. Like the latest generation of instant retail payment systems, retail CBDCs could ensure open payment platforms and a competitive level playing field that is conducive to innovation. 

• The ultimate benefits of adopting a new payment technology will depend on the competitive structure of the underlying payment system and data governance arrangements. The same technology that can encourage a virtuous circle of greater access, lower costs and better services might equally induce a vicious circle of data silos, market power and anti-competitive practices. CBDCs and open platforms are the most conducive to a virtuous circle.

• CBDCs built on digital identification could improve cross-border payments, and limit the risks of currency substitution. Multi-CBDC arrangements could surmount the hurdles of sharing digital IDs across borders, but will require international cooperation.

“CBDCs: an opportunity for the monetary system”, BIS Annual Economic Report 2021

Tony – From the Outside

The rise of digital money

Given the central role that money plays in our economy, understanding how the rise of digital money will play out is becoming increasingly important. There is a lot being written on this topic but today’s post is simply intended to flag a paper titled “The Rise of Digital Money” that is one of the more useful pieces of analysis that I have come across. The paper is not overly long (20 pages) but the authors (Tobias Adrian and Tommaso Mancini-Griffoli) have also published a short summary of the paper here on the VOX website maintained by the Centre for Economic Policy Research.

Part of the problem with thinking about the rise of digital money is being clear about how to classify the various forms. The authors offer the following framework that they refer to as a Money Tree.

Adrian, T, and T Mancini-Griffoli (2019), “The rise of digital currency”, IMF Fintech Note 19/01.

This taxonomy identifies four key features that distinguish the various types of money (physical and digital):

  1. Type – is it a “claim” or an “object”?
  2. Value – is it the “unit of account” employed in the financial system, a fixed value in that unit of account, or a variable value?
  3. Backstop – if there is a fixed value redemption, is that value “backstopped” by the government or does it rely solely on private mechanisms to support the fixed exchange rate?
  4. Technology – centralised or decentralised?

Using this framework, the authors discuss the rise of stablecoins

“Adoption of new forms of money will depend on their attractiveness as a store of value and means of payment. Cash fares well on the first count, and bank deposits on both. So why hold stablecoins? Why are stablecoins taking off? Why did USD Coin recently launch in 85 countries,1 Facebook invest heavily in Libra, and centralised variants of the stablecoin business model become so widespread? Consider that 90% of Kenyans over the age of 14 use M-Pesa and the value of Alipay and WeChat Pay transactions in China surpasses that of Visa and Mastercard worldwide combined.

The question is all the more intriguing as stablecoins are not an especially stable store of value. As discussed, they are a claim on a private institution whose viability could prevent it from honouring its pledge to redeem coins at face value. Stablecoin providers must generate trust through the prudent and transparent management of safe and liquid assets, as well as sound legal structures. In a way, this class of stablecoins is akin to constant net asset value funds which can break the buck – i.e. pay out less than their face value – as we found out during the global financial crisis. 

However, the strength of stablecoins is their attractiveness as a means of payment. Low costs, global reach, and speed are all huge potential benefits. Also, stablecoins could allow seamless payments of blockchain-based assets and can be embedded into digital applications by an active developer community given their open architecture, as opposed to the proprietary legacy systems of banks. 

And, in many countries, stablecoins may be issued by firms benefitting from greater public trust than banks. Several of these advantages exist even when compared to cutting-edge payment solutions offered by banks called fast-payments.2 

But the real enticement comes from the networks that promise to make transacting as easy as using social media. Economists beware: payments are not the mere act of extinguishing a debt. They are a fundamentally social experience tying people together. Stablecoins are better integrated into our digital lives and designed by firms that live and breathe user-centric design. 

And they may be issued by large technology firms that already benefit from enormous global user bases over which new payment services could spread like wildfire. Network effects – the gains to a new user growing exponentially with the number of users – can be staggering. Take WhatsApp, for instance, which grew to nearly 2 billion users in ten years without any advertisement, based only on word of mouth!”

“The rise of digital currency”, Tobias Adrian, Tommaso Mancini-Griffoli 09 September 2019 – Vox CEPR Policy Portal

The authors then list the risks associated with the rise of stablecoins:

  1. The potential disintermediation of banks
  2. The rise of new monopolies
  3. The threat to weak currencies
  4. The potential to offer new opportunities for money laundering and terrorist financing
  5. Loss of “seignorage” revenue
  6. Consumer protection and financial stability

These risks are not dealt with in much detail. The potential disintermediation of banks gets the most attention (the 20 page paper explores 3 scenarios for how the disintermediation risk might play out).

The authors conclude with a discussion of what role central banks play in the rise of digital currency. They note that many central banks are exploring the desirability of stepping into the game and developing a Central Bank Digital Currency (CBDC) but do not attempt to address the broader question of whether the overall idea of a CBDC is a good one. They do however explore how central banks could work with stablecoin providers to develop a “synthetic” form of central bank digital currency by requiring the “coins” to be backed with central bank reserves.

This is effectively bringing the disrupters into the fold by turning them into a “narrow bank”. Izabella Kaminska (FT Alphaville) has also written an article on the same issue here that is engagingly titled “Why dealing with fintechs is a bit like dealing with pirates”.

The merits of narrow banking lie outside the scope of this post but it a topic with a very rich history (search on the term “Chicago Plan”) and one that has received renewed support in the wake of the GFC. Mervyn King (who headed the Bank of England during the GFC), for example, is one prominent advocate.

Hopefully you found this useful, if not my summary then at least the links to some articles that have helped me think through some of the issues.