Sound Money

Stablecoins are an important and revealing innovation. With deep liquidity, lightning-fast settlement, and dramatic user growth these crypto USDs pose important questions for regulators and traditional financial markets. TLDR: Stablecoins present both challenges and opportunities to regulators, the financial system, and investors. The unfolding regulation of these instruments provides insights for the clash between centralized traditional finance and the new decentralized financial infrastructure of the bitcoin era. I expect centralised stablecoins will be regulated, legitimized and drive adoption into the more powerful decentralized monetary technologies like bitcoin. Eventually they could pose systemic risks for traditional centralized finance.

Conclusions

• Stablecoin supply has grown from $20bn to almost $120bn in the past year
• Instant stablecoin settlement enhances capital efficiency
• Collateralised stablecoins are a stark contrast vs. leveraged traditional finance
• Central banks could be lured by stablecoin velocity
• Stablecoins face towards decentralized bitcoin, but they are centralized
• Centralised stablecoins enhance govt KYC and AML efforts
• Collateral risks could emerge if stablecoin growth continues unabated
• Stablecoin settlement, yields and familiarity open pandora’s box into decentralised technologies like bitcoin

What are they? Digital USDs outside of the banking sector

A stablecoin is a digital token that is pegged to or backed by a fiat currency, most commonly USDs. Unlike traditional digital USDs which are run and maintained by the banking sector, stablecoins sit outside of the banking sector. Reserve backed stablecoins like Tether and USDC are privately issued where pegged stablecoins like DAI are run by protocols like Maker, which work to maintain the peg vs. USDs.

Why do they exist? Instant settlement enhances capital efficiency

Traditional bank transfers take days to clear, which is troublesome for traders who want timely access to capital. For example, a trader may require capital for a pressing margin call. Maybe an investor wants to arbitrage a price discrepancy between exchanges, but they need instant settlement to ensure profitability. In traditional finance banks extend credit lines to cover the transaction and ensure access to capital while the transaction settles behind the scenes.

Credit lines grease the wheels of the economy and financial markets, otherwise participants would have to wait a few days for transactions to clear before executing the next transaction. Imagine the hand-brake on financial and economic activity

Traditional banks with their large balance sheets, extensive credit lines and central bank back-stop, in case they overextend, are not active in crypto markets. So, crypto intermediaries require an innovation to grease the wheels in their ecosystem. Instant and cheap settlement through stablecoins is that innovation, and it works.

Stablecoin velocity to drive central bank adoption?

Stablecoin users spend their capital far more frequently than users of traditional money. Monetary velocity in USDC, GUSD and USDT is 15%, 13% and 12% respectively vs. less than 2% in traditional USDs.

Jerome Powell and Christine Lagarde would love to achieve this level of spending velocity in the traditional economy. Central bankers are constantly trying to force consumers, households and businesses to spend more.

Could stablecoin success embolden central banks to leverage off it?

Analysts constantly speculate over the prospect of central bank digital currencies, but what if they merely capitalize off the success of stablecoins? US Federal Reserve appeal must be particularly strong because stablecoins are largely a USD phenomenon. Stablecoin adoption further entrenches USD hegemony. China would, understandably, be less supportive of USD-based stablecoins and more enamoured with a fully centralized central bank digital currency so I expect to see fragmented policy choices globally. But stablecoins could extend USD soft power across the globe, dollarizing certain emerging markets that were not previously dollarized.

Centralized stablecoin issuers provide regulators with an easy avenue for KYC and AML policies, allowing monitoring and surveillance techniques on crypto markets. Surveillance may increase tax compliance and enhance government control, which is another factor in favour of government support. Lack of control is governments’ biggest fear with bitcoin. And while there isn’t much they can do about bitcoin, stablecoins could be viewed as an opportunity for control.

Why should you care?

Stablecoins offer extremely attractive yields

Apart from eye-watering growth and velocity, stablecoins also offer easy access to foreign currency and attractive yields. I have a follow-up article on the way on crypto yields, but glance at the yields available on stablecoin accounts at Blockfi. It’s difficult to dismiss the appeal of parking cash here rather than a 0% yielding bank account.

We wrote more about crypto yields here.

Are they legal?

Like most innovations, stablecoins are perfectly legal until a government beaurocrat makes a negative pronouncement (check the specific regulations in your country). I have already outlined above the reasons regulators might look upon stablecoins favourably. So, what are the prospects that stablecoins are banned? What risks do stablecoins pose to consumers, the banking system, and the goals of the state?

Issuer or Protocol risks

Stablecoin users trust that the issuer is 100% reserve backed or that the protocol will maintain the peg. If the issuer or protocol fails at this goal, users’ assets are at risk because the token is not actually worth what is promised. Remember, these private issuers or protocols are not government backstopped so credibility of the issuing institution or protocol is paramount.

Tether (the largest stablecoin issuer, which runs USDT) came under scrutiny in recent years because confidence over the quality and backing of its reserves was lacking. Regulators pressured an audit, which has now been completed. Question marks still exist over the thoroughness of the audit and the reserve composition but the fact that Tether still exists post scrutiny, investigation and audit creates some confidence that it (and others) will exist in the future.

I expect that industry and or regulatory standards will be imposed on stablecoin reserve policies. Circle Internet Financial, which runs the second biggest stablecoin USDC, is currently working through an IPO process. It will be interesting to see the regulatory hoops Circle is forced through and what credibility emerges as a result. I expect greater regulation to spur stablecoin adoption and greater market share to accrue to Circle vs. Tether (Circle’s market share rose from 8% to 25% in the past year).

Other than false or unclear reserve policies, what would worry regulators?

Centralised leverage vs. decentralized collateral and settlement-based system

Stablecoin issuers tend to purchase short-term t-bills and or treasuries and store these assets in collateral accounts as reserve backing for their digital tokens. T-bills and short-term treasuries are the foundation of the traditional financial system because they are pristine collateral. Financial market participants value the liquidity and low credit risk of these instruments, readily borrowing and lending against them. Given that the traditional financial system relies heavily on credit lines, debt and leverage it is essentially leveraged on top of t-bills and short-term treasuries.

Systemic risk if stablecoin growth continues unabated?

If stablecoins suck in enough collateral into custody accounts this could pose a systemic risk to the traditional financial markets as the foundation on which leverage is pyramided becomes scarce. Caitlin Long argues that this dynamic is the reason global regulators pushed back against Facebook’s efforts to launch Libra. With 2.8bn customers, Facebook’s stablecoin could suddenly have sucked billions of pristine collateral T-bills and Treasuries into custody accounts, away from the financial system. It is unclear whether the financial system with trillions of dollars’ worth of leverage would have been able to handle the removal of this tier 1 collateral supply.

Stablecoin volumes are growing sharply but they still account for less than 1% of US M1 money supply. So this is an important future consideration, not immediate. Nevertheless, the potential pressure placed by stablecoins on traditional finance highlights the conflicting structure of the financial systems. Traditional finance relies on leverage, leading to overuse, but it maintains the dominant position and has a close relationship with regulators. Crypto is innovative, private, more decentralized and nimbler but it is does not yet have regulatory support. Eventually the new and the old will come to a head, but regulators would prefer to postpone dealing with this elephant in the room. The challenge for them is that it may be too late to shut down crypto. Stablecoins are centralized so heavy regulation is still possible, but banning bitcoin is futile.

I expect that the growth in crypto, primarily based on bitcoin’s sound foundation, will place inordinate pressure on traditional finance in the years ahead. The tussle over scarce collateral merely highlights another structural difference between the architectures. I expect governments and centralized finance will leverage off stablecoins because the centralized design aligns with a government-centric worldview, allowing for strict regulation, AML/KYC policies and tax compliance. However elevated velocity highlights that there is something starkly different between traditional finance and crypto. Digital bearer assets with fast settlement are powerful. Bitcoin has a host of additional innovations including scarcity, decentralisation and censorship resistance but stablecoins could serve as pandora’s box, encouraging more participants into a superior financial infrastructure.

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