Stablecoins: what they mean for the future of money
Stablecoins - which aim to mimic traditional currencies but which are backed by blockchain technology - could offer cheaper transactions, greater security, wider financial inclusion and many more benefits. But regulation is needed first.
Most people have heard of cryptocurrencies, particularly the most well-known one – bitcoin. Its inexorable rise and subsequent roller-coaster volatility has made millionaires of some, but left many investors nursing often heavy losses, especially in recent months.
The original idea for bitcoin was laid out by Satoshi Nakamoto – presumed to be a pseudonym for a person or a group of people – in a white paper in 2008. In it, bitcoin was described as “a purely peer‐to‐peer version of electronic cash [which] would allow online payments to be sent directly from one party to another without going through a financial institution”.
The original idea behind bitcoin works, up to a point. Where it fails is as a form of payment or reserve currency, because it is not stable. In fact it is highly volatile. In the financial world, volatility represents how an asset's price swings around its average. Equities, for instance, have a volatility of 21% (measured by the S&P 500), while US investment grade bonds are 5%. Bitcoin currently has a volatility of 85.15%.
The original narrative was that as bitcoin matures its volatility would decrease. But this hasn’t happened.
What are stablecoins?
Stablecoins were meant to provide a solution to the problem of volatility. Their aim is to mimic traditional currencies, but with the added benefits of blockchain technology.
Blockchain is essentially a digital ledger of transactions, bringing benefits such as transparency, security, immutability, digital wallets, fast transactions, low fees, programmability and privacy, without losing the guarantees of trust and stability that come with using traditional currency.
Of course, digital money has existed for decades within the banking system, in the form of reserves. What makes stablecoins different is that they can be held by individuals rather thank a bank. It is digital pocket change held in your digital wallet, rather than a bank account.
While many see bitcoin as digital gold, stablecoins and digital currencies are different. Bitcoin derives its value partly from the costs involved in creating or “mining” new coins, but also from demand in the market. This has similarities with gold, where the value goes beyond its mining recycling and storage cost. A stablecoin derives its value from being pegged against a currency such as the dollar.
What does the stablecoin market look like?
US dollar stablecoins have become popular over the last few years and now have a market capitalisation of $155 billion. This is substantial, as they didn’t exist a few years ago. We believe this trend will continue. One method of reference is the Eurodollar market, which increased from $1.7 trillion in 1985 to $13.8 trillion in 2016 (JP Morgan).
Stablecoins: stable in name only
We believe that the terminology should be changed and that this should be regulation-driven. There are many different stablecoins, which can be grouped into three categories each with different risk profiles.
|Each digital "coin" is reserved for on a 1-for-1 basis
|Digital dollar: money market fund; commercial paper, credit
|Reserved by holding crypto currencies. Usually over-collateralised
|Asset-backed security: MBS, RMBS, leveraged loan
|The peg is managed using financial engineering, algorithms and market incentives
|Structured product: CDO
The design of each type is a trade-off between the following three aspects: scalability, stability and decentralisation.
The recent collapse of UST (an algorithmic stablecoin) in May 2022 led to the loss of over $40 billion. Given this, we believe that these types of stablecoins which are in fact structured products are unlikely to be accepted by regulators.
Recent market events have not all been negative. Fiat-backed stablecoins have maintained their peg and are seen as a safe haven, which is a testament to how they are designed.
Fully dollar-collateralised stablecoins operate in a similar way to money market funds, where the peg is backed by a reserve of US Treasuries, certificates of deposit, commercial paper, corporate and municipal bonds. They are currently issued by commercial entities such as Circle, Gemini and Paxos, some of which have been approved by the NY State Department of Financial Services.
Recently, long-established banks such as ANZ in Australia have created their own stablecoins.
Clearly, a stablecoin without stability is – or at least should be – an oxymoron. Yet the reserves of some projects have recently been called into question.
In 2021 a study compared the reserves of two US-dollar stablecoins: tether and USDC.
Although the usability is the same, the reserving is very different. Tether’s stablecoins were found to have unwanted credit risk as a result of being 50% backed by commercial paper, as the pie charts below show.
Regulators are in the process of developing prudential rules for how reserves should be managed in order to reduce counterparty risk. US regulators recently suggested that stablecoins will be regulated in the same manner as banks, with deposits backed by banks that are insured by the Federal Deposit Insurance Corporation (FDIC).
A stringent regulatory framework would also increase barriers to entry, which is risk-reducing.
This makes sense. We think regulators should take advantage of the transparent nature of distributed ledger technology in order to monitor reserve requirements, as these could be observed in real time. In terms of design, the stability (water-tight reserves) aspect will be dictated by regulation.
Regulation and central bank digital currencies will dramatically change the stablecoin landscape
Most stablecoins are currently minted by private companies, but this will change as central banks are introducing their own, known as CBDCs (central bank digital currencies).
President Biden issued an executive order in March 2022, putting in place a framework which regulators can use to build a Federal Reserve (Fed) CBDC. The results are to be expected later this year.
The eurozone is slightly further ahead, but remains at the exploratory stage. The European Central Bank has indicated that smart contracts will most likely be embedded into a digital euro.
The Bank of England has been researching a sterling CBDC together with HM Treasury since 2020. Currently a consultation process is underway which will evaluate the main issues. It is predicted that the earliest we will see a sterling CBDC would be in the middle of this decade.
Many countries are currently at the research stage. In an ideal world we would like to see interoperability between various CBDCs. The Bank of International Settlements is currently trialling this with four central banks on a shared platform.
There has been a constant debate between the merits of a public vs. commercially-issued digital dollar.
On one hand giving consumers and commercial entities a direct banking relationship with the Fed would undermine the commercial banking system, by reducing the level of bank deposits and the lending capacity of the banks. On the other hand, a Fed-issued currency mitigates systematic risk of private providers.
It is worth noting that an offshore commercially-issued USD stablecoin can exist regardless of what US regulators decide, in a similar way to how the Eurodollar banking system works. Eurodollar deposits are dollar-denominated and not subject to US regulation.
We believe that both sides are missing the point. The decision isn’t binary and from an innovation perspective, the ultimate question is design. Innovation can be achieved via both a CBDC and a commercial stablecoin. Once the reserving is regulated, which we believe is a key requirement for adoption, the most important question is design.
What does this mean? It is essentially a debate about privacy. Should a digital dollar have the same characteristics of a dollar coin? Should a government be able to monitor the spending patterns of every transaction? What about only transactions above a certain threshold? Should a government have the ability to financially de-platform individuals, or entities? How does this work in non-democracies?
All of the above are design questions which we are closely watching.
The future of money - digital wallets
The March 2022 White House Executive Order covered a lot of ground regarding illicit activities, "know your client" (KYC), and money laundering, all of which are a good thing.
However, the more interesting aspects concerned leadership in financial innovation revolving around upgrading the payment system and cross-border remittance:
"We must reinforce United States' leadership in the global financial system and in technological and economic competitiveness, including through the responsible development of payment innovations and digital assets."
The UK has also recently acknowledged the importance of developing digial asset technologies. Rishi Sunak stated in April 2022 that:
“It’s my ambition to make the UK a global hub for crypto-asset technology, and the measures we’ve outlined today will help to ensure firms can invest, innovate and scale up in this country.”
“Stablecoins to be brought within regulation paving their way for the use in the UK as a recognised form of payment”
Trading digital assets
The initial use case for stablecoins began in 2014 in the crypto currency world with tether. Previously, it was very difficult and expensive to trade back and forth from the "fiat" (traditional currency) to the crypto world. One would have to transfer money from your bank onto an exchange then buy crypto. Compliance rules, and transaction time, made the market inefficient, especially since digital assets trade 24/7.
Stablecoins resolved this. In terms of market cap and daily transitions, crypto trading continues to remain by far the most important use case. We think this will change as real world adoption takes hold.
Anybody with a smart phone and internet access would be able have an interest-bearing USD current account without having to go through the banking system, as these new currencies will be held in digital wallets on the phone.
Users will not only be able to make payments but send their currency globally in an instant and essentially free of charge. This has implications for card issuing banks, networks, and other money transfer platforms.
The use case has already been tested as a growing percentage of remittance payments are now made via this method. Cross-border payment companies will no longer be able to charge 3 to 6% for a cross-border retail payment when a stablecoin transaction costs less than 0.1%.
Retail payments are not the only sector to become disrupted, as large aspects of the correspondence banking system are also at risk. For instance, a payment from an Indian SME to a Indonesian SME can require up to six banks with a total fee of 3%, and take a week to settle.
Or they can transact in a dollar stablecoin for a fraction of the cost with instant settlement. We see this a beneficial to local payment-focused fintechs.
Stablecoins have the potential to disrupt the SWIFT network. Recently the SWIFT messaging system has been in the spotlight regarding Russian sanctions as the US government removed key Russian banks from the network. SWIFT being a messaging system for cross border inter-bank transactions, it becomes challenging for parties to transact internationally where they are banned from the network.
Stablecoins do not require SWIFT as anyone with a wallet can send to another wallet anywhere. Therefore, we see some sort of control being embedded into most developed market CBDCs and stablecoins, such as identity being linked to wallets.
Domestic payment networks can also be expected to become more efficient. Currently credit card fees, usually paid by the merchant, have increased at a compound annual rate of 8% over the previous decade and are currently estimated to be around 2.2% of a transaction.
Credit card companies are starting to work with stablecoin issuers. PAXO, a stablecoin issuer, piloted a project with Mastercard. Visa has also settled transactions using stablecoin payment infrastructure.
We see many traditional firms as key participants in the eco system, whether providing traditional financial services to stablecoin companies or facilitating on and off-ramp payments to and from the digital world.
The video game industry is currently undergoing significant change. Objects and characters within a game are usually owned by the manufacturer. Distributed ledger technology is enabling ownership (for example of a virtual tennis racquet or a legendary sword) to be transitioned to the player. It is cheaper, easier and faster to facilitate these transactions using a stablecoin rather than fiat money.
Stablecoins can also be "programmable", with smart contracts embedded inside a CBDC. This will enable targeted monetary and fiscal policies.
- 1. Targeted fiscal expenditure – If for example a government wanted to subsidise farming equipment, it could target farmers with a stablecoin which could only be spent on farming equipment controlled by the embedded smart contract.
- 2. Holdings-based interest rates – Low interest rates over the past decade have punished savers from the lowest income bands, as they have less financial product access. One benefit from a programable CBCD is a tiered interest rate system where holdings below a threshold of say $10,000 have a higher rate than those above.
- 3. Direct payments to households – Covid has demonstrated a need for widespread government transfer payments – or “helicopter money”. 17% of the world’s population received a cash payment, according to the World Bank. This is currently facilitated by a number of middle-men, leading to leakage. A CBCD could make this more efficient.
Dollarisation of EM economies
Widespread uptake of stablecoins would have large implications for deposit-taking banks and financial penetration as stablecoins in a wallet would be a de facto current account.
This could lead to further dollarisation for emerging countries, for example, as local currency deposits are swapped into a stablecoin tied to the US dollar. Nervousness about this potential outcome partially explains the tough stance of countries like China and Turkey on bitcoin
Successful stablecoins have to address this issue, amongst others, yet could still lead to a large degree of bank disintermediation.
There is a geopolitical dimension as a CBDC comes with its own payment infrastructure. The absence of a digital euro may be feared as something which could weaken the strategic autonomy of the European Union, for instance.
This will also impact FX trading, as markets can easily be made between non traditional currency pairs. The need to trade via a major institution will no longer exist. Again, this supports emerging markets.
Enabling financial inclusion
Digital wallets will allow financial products to become open-sourced and programmable. The last official data from the World Bank (2017) shows that just under one-third of the world’s adults (or 1.7 billion people) remained “unbanked” or outside the formal financial system.
With stablecoins and digital wallets, anybody with a smartphone and internet access will be able to hold, send and spend fiat currency.
We see this becoming embedded globally, in alignment with UN Sustainable Development Goal 9. We believe that the real opportunity lies in the "underbanked" – a group defined as having limited financial product access. A 2019 Fed report stated that 22% of American adults are underbanked. This number is significantly higher in emerging markets.
Stablecoins offer a cheaper and faster alternative to payments processing and international remittances, giving rise to a first real-world use case for digital assets.
The positive economic impact of this alone justifies the complexity required to correctly regulate them. The group of people who could benefit the most from this are the less fortunate. In terms of innovation we see this as a 18-month story as stablecoin payment infrastructure becomes embedded across continents, with many governments already working towards some form of regulation.
In the long run we see digital wallets having a larger impact as this expands the reach of financial products to the underbanked. We’ll be watching closely as this develops.