The Fed vs. Stablecoins

The most obvious risk of stablecoins is that they won’t be stable. Stablecoins are crypto tokens that are pegged to the dollar (or to some other fiat currency or non-crypto thing). All of the popular ways to create stablecoins involve some risk that the peg will fail and the stablecoin won’t be worth a dollar. The simplest approach — issue one stablecoin for one dollar, invest the dollar in safe-ish cash-like assets, and promise to redeem the stablecoins for dollars — runs the risk that the issuer will invest its dollars in not-quite-safe assets that lose value, or will just steal the dollars, and when stablecoin holders ask for their money back it won’t be there. This also creates risks of runs (people will ask for their dollars back preemptively) and contagion (when they ask for their dollars back, the stablecoin issuer will have to sell its assets rapidly, driving down the price of those assets and causing losses in the regular financial system). Other approaches to stablecoins — overcollateralizing them with volatile crypto assets, using some algorithmic stabilization mechanism — can also break if, basically, the prices of other crypto tokens go down. These risks are quite salient — algorithmic stablecoins break all the time, and some of the dollar-backed stablecoins, uh, look a little sketchy — and people talk about them a lot.

A less obvious risk of stablecoins is that they might be too stable. A stablecoin is, among other things, a substitute for putting money in a bank. Banks are generally very safe places to put money, but they are not perfectly safe. There can be runs on banks; banks can fail. For most U.S. retail bank accounts this is not a very salient problem, since they are backed by government deposit insurance, but many large institutional pools of money (corporate cash accounts, money-market funds, etc.) park their money in short-term bank instruments and are sensitive to risk. If a bank gets riskier, it will lose deposits. And if a stablecoin is so stable that it is safer than a bank, then banks generally will lose deposits.

Why is this a risk? Well, banks do useful stuff. Classically, they take people’s deposits and lend them out to other people to start businesses and buy homes. The provision of credit by banks helps the economy grow. More to the point, the withdrawal of credit by banks hurts the economy, and the risk here is wrong-way. If people get nervous about banks and pull out all their money to put it in safer stablecoins, then (1) that will probably happen at a time when the economy is shaky and (2) that will definitely make the economy shakier. The bulk of the response to the 2008 financial crisis involved preventing runs on banks, because those would have made all of the problems of the crisis much worse.

I suspect that this worry — that stablecoins might be too safe — is not at the top of most people’s minds. This is not the main problem with actually existing stablecoins! It sounds a bit silly, as I type it. But it does seem to be top of mind for U.S. banking regulators, particularly for the Federal Reserve. This is probably because in some sense the Fed’s introduction to stablecoins came from people pushing the Fed to launch its own stablecoin. A Fed-issued stablecoin — the usual term is CBDC, “central bank digital currency” — would indeed be perfectly safe, a pure dollar on the blockchain, safer than any bank account. And the Fed has not been interested, in part for these sorts of crowding-out reasons. But the Fed has also rejected a proposal to allow a “narrow bank,” meaning a bank that issues super-safe deposits backed solely by reserves at the Fed, for similar reasons. And when U.S. financial regulators put out proposals on stablecoin regulation, they were ostensibly focused on safety, but the proposals also very quietly called for banning ultra-safe Fed-backed stablecoins and requiring stablecoins to be issued through regular banks.

Here is a new Federal Reserve Board discussion paper by Gordon Liao and John Caramichael about “Stablecoins: Growth Potential and Impact on Banking,” which explicitly argues that stablecoins should not be too safe:

Our research suggests the broad adoption of asset-backed stablecoins can potentially be supported within a two-tiered, fractional reserve banking system without a negative impact on credit intermediation. In such a framework, stablecoin reserves are held as commercial bank deposits, and commercial banks engage in fractional reserve lending and maturity transformation as they normally would with traditional bank deposits. We also find that the replacement of physical cash (banknotes) with stablecoins could result in more credit intermediation. In contrast, a narrow banking framework, in which stablecoin issuers are required to back their stablecoins with central bank reserves, minimizes the risk of ”runs” on stablecoins but can potentially reduce credit intermediation. …

While a narrow bank framework would guarantee the stability of a stablecoin’s peg as it is effectively a pass-through central bank digital currency (CBDC), this reserve framework poses the largest risk of credit disintermediation. Periods of financial stress or panic could lead to large migrations of regular commercial bank deposits into narrow bank stablecoins, which could disrupt credit provision. Though this credit disruption effect could be mitigated by limits on stablecoin holdings and differential reserve interest rates, the overall structure of the narrow bank approach to stablecoin reserves is potentially destabilizing for the banking system. Additionally, the narrow bank approach could lead to an expansion of the central bank’s balance sheet in order to accommodate the demand for reserve balances from stablecoin issuers.

I should say here that my sympathies are with the Fed researchers: I think that fractional reserve banking and credit intermediation are good, and accidentally getting rid of them would be bad. But I am also aware that lots of crypto people disagree; they got into crypto specifically because they are suspicious of the existing financial system and of fractional reserve banking. And while “U.S. regulators want to crack down on crypto  to protect banks” sounds a bit like a conspiracy theory, it has some truth to it.