An article to sort out the financial stability risks of stable coins and the countermeasures from all walks of life

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Stable currency is a basic tool in the world of encrypted assets, but it also brings risks to the financial stability and monetary policy of various countries.

Original title: “Stablecoin: A Beautiful New World? | Chain Catcher
Written by: Anastasia Melachrinos, Christian Pfister
Compilation: Bran

Recently, Anastasia Melachrinos from Kaiko, an encrypted data provider, and Christian Pfister from Banque de France, jointly wrote an analysis of the status, risks, and future of stablecoins. They pointed out that stablecoins will bring risks to the financial stability and monetary policies of various countries, especially In the underdeveloped economies, the response measures of all sectors of society were sorted out at the same time, and the chain catcher translated the article and made deletions that did not affect the original intention.

Classification and representation of stablecoins

A stablecoin can be defined as an encrypted asset that aims to maintain a stable price relative to a benchmark. The benchmark is usually provided by fiat currency, sometimes by a basket of currencies, gold and other commodities or even another encrypted asset. By using stablecoins, crypto-asset investors can stay in the crypto world and gain advantages in terms of flexibility, integration, immutability, and anonymity, while benefiting from the stable environment that is usually borrowed from fiat currencies.

Stablecoins can also achieve arbitrage between encrypted assets, while maintaining contact with investors’ reference currency, and avoiding regulatory restrictions and costs related to the conversion between encrypted assets and fiat currencies (transaction fees, often lack of liquidity, price Large fluctuations, etc.). Therefore, stablecoins are designed to serve as tools in the world of crypto assets.

Stable coins seem to provide a beautiful new world. From this perspective, if it fulfills its promise of stability, stablecoins will be the next natural step in the evolution of digital assets.

Stablecoins can be defined in four complementary ways:

  • According to the price guarantee mechanism: the governance system that implements rules to stabilize the value of stablecoins and the entity responsible for managing the stability mechanism ensure the goal of stablecoins converging to their benchmarks. From this, stable coins can be divided into algorithmic stable coins, off-chain guaranteed stable coins, and on-chain guaranteed stable coins.

  • According to whether stablecoins are potentially systemic: This method is the method adopted by the G7 stablecoin issue working group, and is particularly relevant when assessing macroeconomic stability risks. According to this distinction, although all stablecoins have risks, stablecoins built on a large customer base and/or cross-border basis may rapidly expand in scale and achieve a considerable global footprint.

  • According to the target market, it can be divided into wholesale (large-value transactions, usually between financial institutions or between financial institutions and large companies) or retail (large-scale transactions between individuals or between individuals and businesses) stablecoins. This difference reflects the difference between the two forms of central bank digital currencies, the wholesale CBDC is for financial institutions, and the retail CBDC is for the public.

  • Depending on the base currency, stablecoins may be unique (usually USD) or consist of a basket envisioned by the initiators of the Libra (now Diem) initiative.

Given their price fluctuations, small quantities, limited circulation, and market concentration, the success of stablecoins seems to be uneven. So far, their markets have emerged as a subsidiary of encrypted assets.

Most importantly, the arrival of large participants who issue guaranteed stablecoins off-chain and have the potential to cover a wide range of audiences can provide additional confidence to stablecoin users and provide potential systemic impact for their projects.

Among the wholesale stablecoin projects, the two largest projects stand out: the USC (Utility Settlement Coin) project and JPM Coin.

USC is an initiative led by major banks to create a market infrastructure for cross-border payments to meet the recommendations of various regulatory agencies, which are now often costly, time-consuming, and opaque. Circulated on the permissioned blockchain, the stablecoin will be issued in different reference currencies and will be fully supported by reserves held by the central bank (Canadian dollar, Euro, British pound, Japanese yen, and US dollar) that issued these reference currencies. In principle It is possible to ensure the convertibility of these legal currencies.

The main contribution of the project is to provide users with the possibility of almost instant settlement at the global level at any time of the year-saving each currency represented by liquidity by holding only one liquidity pool at the global level, and Several pools with different correspondent banks are not restricted by time zone.

The JPMorgan Chase project is similar in the technology used (permitted blockchain) and purpose (institutional real-time remittance, 365/24). There are two important differences between it and USC: In the current state of the project, the only reference currency is the U.S. dollar. The most important thing is that the guarantee will be made up of JPMorgan Chase Bank’s deposits instead of central bank reserves. There is liquidity and credit risk.

JPM Coin aims to reduce friction in the US dollar currency market by facilitating the settlement of transactions between different customers. Another situation where JPM Coin can be used is in the repurchase market, which can be extended to maturity within a day, so that collateral can be released by ensuring a faster turnover rate.

Among the retail stablecoin projects, the most famous is Diem, whose issuance and governance are intended to be supervised by the Diem Association and responsible for verifying that the transactions performed are on the permissioned blockchain. Other private participants are also part of the association, such as Vodafone, Coinbase, Spotify, Uber, etc.

In the latest white paper, the association proposed two types of tokens:

  • A multi-currency stable currency presented as a global currency. Diem will be backed by a basket containing only stable currencies, which will ensure its stability by investing the assets raised by the issuance of Diem in a set of low-volatility assets, including bank deposits and government securities denominated in stable currencies. More precisely, the reserves will include at least 80% of short-term government bonds issued by sovereign countries with extremely low credit risk, and the rest will be cash.

  • A stable currency based on a single currency “will enable people and companies to trade in stable currency denominated in their own currency, thereby realizing a series of domestic application scenarios.” Each currency will be supported by the above-mentioned reserve system.

Compared with other encrypted assets, wholesale stablecoins can promote the integration of financial transactions on the blockchain and reduce friction in cross-border payments; similarly, retail stablecoins can reduce remittance costs and promote financial inclusion in emerging countries; in addition, , A basket of stablecoins may reduce the U.S. dollar’s ​​dominance in international transactions and the resulting external adjustment difficulties for emerging economies; finally, in emerging or developing economies, especially those experiencing currency instability or structural In economies affected by high inflation, a basket of stablecoins can be used as a substitute for legal tender, especially as a store of value.

In this regard, it is of course questionable whether economic entities in countries with unstable currency values ​​will benefit from using a basket of currencies as the support of their assets instead of directly purchasing hard currency. However, by purchasing a basket of currencies, these participants will reduce exchange rate risk on the one hand (that is, the volatility of the basket may be less than the volatility of currency pairs), and on the other hand may save diversification costs. Therefore, if the basket is not much different from the holder’s optimal risk/return portfolio, then it is reasonable to buy a basket of currencies.

The risks of stablecoins

Any stablecoin has inherent risks, including:

  • Legal certainty, especially regarding the rights of users;

  • Governance, allowing clear assignment of responsibilities, especially in terms of risk review and control;

  • Financial integrity to prevent stablecoins from funding illegal activities;

  • Regulatory arbitrage, and the regulatory framework is designed to apply to the technology used;

  • Market integrity, as the pricing of the services provided, starts from a stable price, and must be fair and transparent to protect consumers and ensure a level playing field;

  • Data protection, because users need to know how their data is used by participants in the ecosystem surrounding the issuance of blockchains and possible third parties;

  • Consumer/investor protection, because the risks and obligations of all parties must be clearly defined and stipulated;

  • Comply with tax requirements, because stablecoins should not provide fraud tools;

In principle, these risks are only possible in economies with insufficient confidence in fiat currency, limited supply of financial products, problems with the health of financial intermediaries, or payment systems. Therefore, these countries are often underdeveloped economies, and may also be emerging economies.

A particularly serious risk is the use of stablecoins instead of fiat currencies, which may cause stablecoin issuers to make them a self-referential currency. These issuers will then become central banks in the private currency sector: this is the subject of “loss of monetary sovereignty.” For these two types of risks, there is a difference between wholesale and retail stablecoins.

Financial stability risk

For wholesale stablecoins, there will be some risks that may endanger financial stability. Those JPM Coins that are not backed by central bank deposits are subject to credit risk. In addition, the concentration of financial transactions in the blockchain will strengthen the connections between large financial institutions and large companies on a global scale, causing single points of failure and moral hazard problems that are too large to fail in the case of systemic stablecoins.

For retail stablecoins, the feasibility of its business model depends to a large extent on the interest rate level of the assets held. If stablecoins are 100% backed, and reserves are invested in assets denominated in currencies such as the U.S. dollar, euro, or yen, the historically low interest rate levels now greatly limit the return on reserves.

Therefore, in order to maintain profitability, issuers may prefer to invest in securities with higher risks in terms of credit, liquidity, swaps, and even exchange rates, even if the latter strategy does not replicate the composition of the basket. In the case of a basket of stablecoins, it can even change the composition of the basket in principle.

From the perspective of the holder, if the issuer defaults or ceases operations, what will be the financial impact on stablecoin users? As far as investors know, these risks are reflected in the discounts of the issuer related to the benchmark, which may lead to a crisis of confidence and a run.

For on-chain guaranteed stablecoins, if the price of encrypted assets falls sharply, investors’ failure to meet the margin call requirements may also lead to a run, although the issuer can choose to liquidate the positions of defaulting investors.

Monetary policy risk

The influence of stablecoins on monetary policy behavior may be much greater than that of encrypted assets.

In the case of wholesale stablecoins, their issuance may reduce the demand for reference currency reserves. This is especially true if the wholesale stablecoin envisaged by JPM Coin is not backed by central bank deposits as envisioned by USC.

This is because the transactions that were previously closed on the books of the central bank, such as the settlement of cleared balances, can be transferred to the blockchain of wholesale stablecoins. One consequence is that if a liquidity crisis that affects the currency market occurs, the central bank’s insufficient knowledge of institutional cash holdings may make it more difficult to intervene as the lender of last resort.

On the other hand, if wholesale stablecoins are fully or mostly backed by the base currency, the demand for reserves may increase significantly and become more volatile, depending on the liquidity needs of stablecoin users. In this regard, since wholesale stablecoins should always be available, cash pressure may affect wholesale stablecoins backed by the central bank’s currency outside of the central bank’s business hours, exposing holders to liquidity risks. However, this problem can be solved by moving to real-time monetary policy.

For retail stablecoins, their widespread use may cause fiat currencies to be squeezed out, bringing difficulties to the implementation of monetary policy in terms of transmission mechanism and implementation:

1) Delivery mechanism, which can be subdivided into interest rate channels, credit channels and asset price channels . The conversion of bank deposits into stable currency and the final distribution of stable currency-denominated loans will weaken the transmission of changes in legal currency interest rates to the economy. For example, if this interest rate rises, the motivation for saving and the motivation for debt will be weakened, and the impact on economic contraction will be weakened.

On the other hand, credit channels will be affected by ambiguity. Narrow channels may be weakened, because the liquidity of the banking industry will be at least partly in stable currencies, so unless the central bank intervenes in the stable currencies, it will not be directly affected by the central bank. On the contrary, if the fungibility between stable currency and fiat currency financing is lower than that of different forms of fiat currency financing, the increase in financial friction will strengthen a wide range of channels. Finally, as long as the legal currency continues to be used as the unit of accounting, the asset price channel will become more powerful, because the impact of interest rates on exchange rates will affect a larger proportion of assets.

Overall, the impact on the transmission mechanism will be ambiguous, and its characteristic may be more uncertain about the effects of monetary policy, which in turn can justify further gradualism rather than weakening its power .

2) Implementation ability. As long as the fiat currency continues to be used, there will be a demand for the base currency in the market, and it should still be possible to implement monetary policy. However, a model of digital currency competing with non-competitive national currencies will be proposed, which will lead to the complete convergence of interest rates between them. It deprived the central bank of its ability to adjust monetary policy in accordance with its economic conditions.

In the extreme case of global stablecoins squeezing out legal tender, foreign exchange reserves will have to invest in global stablecoins, but the amount of liquidity that central banks can provide is limited, and they are usually not restricted in providing their own currencies. In addition, in the case of full dollarization and in a world without currency, seigniorage will be eliminated, leaving the central bank to rely on budget allocation to cover its operating costs unless it has sufficient capital.

However, in addition to reducing international transfer costs and promoting financial inclusion in emerging markets, stablecoins can also increase currency competition by increasing the choice of trading and investment tools, and by allowing benign currencies to promote currency competition, thereby bringing benefits and eliminating disadvantages. , And restrict monetary policy when appropriate. In turn, the restraining effect of asset diversification and currency competition on monetary policy will encourage local investment and increase financial resources.

Reactions from all walks of life

Private sector response

Stablecoins are deployed in an environment driven by two trends: hypothetical supply capabilities enhanced by basic technology, and changes in target market demand or consumer preferences. This fully applies to stablecoins. However, participants in the payment industry, especially banks, can meet the challenge by improving the quality of the services they provide.

In this regard, one of the most radical changes in recent years has been the commoditization of instant payments. This is particularly evident in China, where two giants, Alipay and WeChat Pay, accounted for 92% of the US$41 trillion mobile payment market in 2018. In China, due in part to competition from Alipay and WeChat, banks’ return on equity fell by 35 basis points in both years (2015 and 2016), causing their return on equity to fall by 6.7%.

Faced with the threat of disruption to their businesses, banks in the United States, Europe, and Australia first responded by digitizing some of their businesses. About 15% to 25% of the annual budgets of these regional banks have been allocated to information technology. 2016. In France, major banks have teamed up to create PayLib entre amis, a system that allows users to identify themselves with their phone numbers through the bank’s online platform and make instant payments with other users.

At the European level, TARGET 2 has been a real-time gross settlement (RTGS) system developed and managed by the Euro system since 2008, and each country manages its national part. In November 2018, in order to promote the full rollout of instant payments in Europe, the Eurosystem introduced a system in TARGET2 for instant payment settlement in central bank currency, the TARGET Instant Payment Settlement (TIPS) service.

This new service runs 24/7/365 and is offered at a price of 0.20 Euro cents per transaction for at least the first two years of operation. The entry and maintenance fees for the TIPS account are set to zero, and the goal is that the Euro system will eventually be completely Pay for this cost. However, more than a year after the implementation of this measure, instant payment has not yet become popular in the Eurozone, mainly because of its cost to users.

At the global level, in the face of the inefficiency of the correspondent banking system, central banks that issue major reserve currencies can interconnect their real-time aggregate settlement systems to facilitate cross-border payments. This initiative will partly compete with and partly complement the wholesale global stablecoin initiative, expanding its actions to the national or currency zone level.

In fact, real-time total settlement systems are designed to provide a secure framework for the final settlement of wholesale transactions, especially through the use of central bank currency; in addition, they compete with privately operated settlement systems to a certain extent, so they must be paid for. cost. By interconnecting real-time general settlement systems, central banks will largely avoid the need for payment service providers to use correspondent banking arrangements, thereby enabling them to save liquidity and provide customers with more reliable, faster, and possibly cheaper Settlement of international transactions.

Regulatory response

“The same business, the same risks, and the same rules” and the consistent regulatory methods between countries constitute the regulatory guidelines proposed by the G7 Global Stablecoin Working Group. Following the latter’s work, the G20 authorized the Financial Stability Board (FSB) in June 2019 to review the regulatory issues raised by the global stablecoin arrangement and make recommendations on multilateral responses. Therefore, the first response of regulators is to coordinate to avoid regulatory arbitrage.

However, since regulation differs depending on the nature of the relevant assets (such as currencies or securities), regulators must also consider the legal classification of stablecoins. In particular, there are many options for the most common off-chain guaranteed stablecoins.

The first is to treat them as money market funds, because in principle they invest in low-risk, short-term assets denominated in the currencies they support, with the goal of maintaining a constant value, because each issued unit can be stable even in a basket In the case of currency, it is also assimilated into money market fund units.

The second option is to treat stablecoins as electronic currencies on the grounds that stablecoins are intended to be used as payment instruments and their issuers promise to redeem them at face value. Compared with the first condition, the second condition has much stricter regulatory restrictions on the issuer. For example, in Europe, the European Electronic Currency Directive of 2009 includes capital requirements and the issuer’s obligation to redeem the holder at face value at any time. .

The current laws and regulations applicable to traditional financial or payment instruments still do not address the various risks posed by stablecoins, so regulatory adjustments are required:

  • The widespread use of global stablecoins may be accompanied by their use for money laundering and terrorist financing purposes, which violates the LCB-FT regulations. In fact, Libra users can conduct transactions anonymously in order to protect their privacy, which is inconsistent with regulatory compliance;

  • Regulators can consider the above financial stability risks, including the risk of liquidity crises, by imposing prudential requirements on stablecoins;

  • Regulators may also consider protecting data from commercial use by the issuer. Many concerns have been raised about Diem’s ​​use of this data;

  • Finally, regulators can ensure that the blockchain used by stablecoins has operational flexibility. In fact, the scalability of the blockchain to the number of transactions recorded is still uncertain. It is within this framework that the Diem project expects to increase tariffs based on Diem demand in order to avoid possible congestion, in order to reduce this demand and avoid congestion.

Faced with this measure, regulators can introduce insurance for customers regarding the maximum time limit for transferring their applications. In addition, in the event of a cyber attack or blockchain hacking, the procedures established by stablecoin holders to limit risks should be clearly explained, and regulations should be formulated to compensate legitimate holders.

On September 24, 2020, the European Commission issued a proposal on the regulation of the crypto asset market. According to the proposal, all issuers of encrypted assets must publish white papers, and members of their governing bodies must meet integrity standards. Compliance with these requirements will be monitored by the competent national authority or the European Banking Authority.

In addition, all encrypted asset service providers must have a physical presence in the European Union and must obtain prior authorization from the national authority. This will enable them to obtain a “European passport” (that is, it is possible to provide their services throughout the European Union), but will eliminate off-chain stablecoins that do not have an identifiable issuer. Finally, crypto asset service providers will also be subject to capital requirements, governance standards, and the obligation to separate customer assets from their own assets.

The response of central banks

Both measures are possible, depending on whether they are defensive (the central bank adjusts its policies and tools to adapt to the new environment brought about by the expansion of global stablecoins) or offensive (the central bank proposes its own solutions to compete with the global Stablecoin competition).

At the defensive level, emerging countries have often implemented foreign exchange controls and can treat stable currencies as foreign currencies. At the international level, this requires the coordination of the central bank and all regulatory agencies, and is the minimum response. G7 does this because stablecoins are global in nature and to avoid regulatory arbitrage;

At the offensive level, the central bank can issue CBDC to counter stablecoins. However, this may cause difficulties for their banking industry, and their resources will be affected by the substitution of CBDC for deposits. In addition, it is uncertain whether this can adequately cope with the risk of the marginalization of the domestic currency due to the inefficiency of the legal tender, the national financial system or the domestic payment operation of the retail stable currency.

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