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Barry Eichengreen: The Stablecoin Illusion

BERKELEY – An obscure corner of the digital sphere that was poorly understood two years ago is now subject to increasingly intense scrutiny by central bankers, regulators, and investors. Unfortunately, more intense scrutiny has not necessarily meant better understanding.

The debate over stablecoins has come a long way since Facebook announced the creation of Libra (now rebranded Diem) almost exactly two years ago. An obscure corner of the digital sphere that was poorly understood then is now subject to increasingly intense scrutiny by central bankers, regulators, and investors. The stakes, including for financial stability, are high. Market capitalization, or circulating supply, of the four leading US dollar stablecoins alone exceeds $100 billion.

But more intense scrutiny does not mean better understanding. Start with the belief that stablecoins are intrinsically stable because they are "fully collateralized." The question, of course, is: collateralized by what?

Naive investors in dollar-linked coins assume that the collateral takes the form of dollars held in federally insured US banks or their close equivalent. But that is only partly correct. After being criticized for its opacity, the leading stablecoin issuer, Tether Limited, recently revealed that it held barely a quarter of its reserves in cash, bank accounts, and government securities, while holding nearly half in commercial paper and another tenth in corporate bonds. The second leading stablecoin by capitalization, USD Coin, says only that it holds its reserves in insured US depository institutions and other "approved investments." Whatever that means.

Such murkiness creates risks for stablecoins themselves, for their investors and, critically, for the stability of financial markets. Lack of transparency about what quality of commercial paper, what kind of corporate bonds, and what other "approved investments" are held as collateral is a source of fragility. This kind of information asymmetry, where investors don't know exactly what has been done with their money, has given rise to bank runs and banking crises through the ages. In this setting, a fall in the value of commercial paper or in the corporate bond market could easily spark a stablecoin run. And the fact of falling bond prices would mean that the stablecoin issuer lacked the wherewithal to pay off its holders.

In addition, there is the danger of contagion: a run on one stablecoin could spread to others. What are the chances that a run on Tether would leave confidence in USD Coin intact? The European Central Bank, which knows a thing or two about financial contagion, has warned against just this scenario.

To limit such problems in the banking system, governments insure retail deposits, and central banks act as lenders of last resort to depository institutions. Some commentators, such as former Bank of England Governor Mark Carney, have suggested that central banks should provide similar support to stablecoin issuers.

The authorities would agree to this, of course, only if those issuers were subject to stringent supervision designed to limit the incidence of problems. Stablecoin purveyors would have to apply for the equivalent of bank charters and be subject to the relevant regulation. A stablecoin would then be nothing but a so-called narrow bank, authorized to invest only in Treasury bills and deposits at the central bank, with a Paypal-like payments mechanism built on top.

Alternatively, stablecoins could be regarded as the digital equivalent of prime money market funds, which similarly invest in commercial paper. The problem with this model, as we learned during the 2007-08 global financial crisis, is that normally liquid commercial paper can abruptly become illiquid. When this happened in 2008, the US government sought to quell the ensuing panic by temporarily guaranteeing all money market funds. To prevent that from happening again, the Securities and Exchange Commission then issued rules requiring that funds, rather than maintaining a $1 share price, post floating net asset values as a reminder to investors that money market funds are not without risk. It allowed money funds to institute redemption gates, under which they can limit withdrawals and charge temporary fees of up to 2%.

Revealingly, Diem's latest whitepaper similarly foresees redemption gates and conversion limits to protect the stablecoin against runs. But a stablecoin that is redeemable only for a fee or that can't be redeemed for dollars in unlimited amounts won't be an attractive alternative to Federal Reserve money, just as shares in money market mutual funds are an imperfect substitute for cash.

The more worrisome financial stability problem is that the market capitalization of the four largest US dollar stablecoins already approaches that of the largest institutional mutual fund, JPMorgan Prime Money Market Fund. A panic that forced these coins to liquidate a significant share of their commercial paper and corporate bond holdings would jeopardize the liquidity of those markets. And dislocations to short-term money markets can seriously disrupt the operation of the real economy, as we also learned at considerable cost in 2008.

The upshot is that the stability of stablecoins is an illusion. They are unlikely to replace Federal Reserve money, unlikely to revolutionize finance, and unlikely to realize the dreams of their libertarian enthusiasts.

Barry Eichengreen is Professor of Economics at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund. He is the author of many books, including the forthcoming In Defense of Public Debt

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Posted: July 13, 2021 Tuesday 11:12 AM