Stablecoin Paradox

Original author: Eswar Prasad, Professor of Economics, Cornell University

Original translation by Eric, Foresight News

Early revolutionaries of cryptocurrencies aimed to break the monopoly of central banks and large commercial lending institutions over financial intermediation. The ambitious goal of the original crypto asset, Bitcoin, and the blockchain technology behind it was to bypass intermediaries and directly connect the two parties in a transaction.

This technology aims to democratize finance, making broad banking and financial services easily accessible to everyone, regardless of wealth. Emerging financial institutions will leverage this technology to offer competitive financial services—including customized savings, credit, and risk management products—without establishing expensive physical branches. All of this is intended to weed out old financial institutions that lost public trust during the global financial crisis and establish a new financial order. In this decentralized new world of finance, competition and innovation will flourish. Consumers and businesses alike will benefit.

But this revolution was quickly overturned. Decentralized crypto assets like Bitcoin, essentially created and managed by computer algorithms, proved unworkable as a medium of exchange. Their volatile value and inability to handle large volumes of transactions at low cost made them unsuitable for everyday use and prevented them from achieving their intended goals. Instead, Bitcoin and other crypto assets ultimately became what they shouldn't have been—speculative financial assets.

The emergence of stablecoins has filled this gap, becoming a more reliable medium of exchange. They use the same blockchain technology as Bitcoin, but maintain their value stability by being pegged one-to-one to central bank monetary reserves or government bonds.

Stablecoins have facilitated the development of decentralized finance (DeFi), but they themselves contradict decentralization. They do not rely on decentralized trust mediated by computer code, but rather on trust in the issuing institution. Their governance is also not decentralized; users do not determine the rules through public consensus. Instead, the stablecoin's issuing institution decides who can use it and how to use it. Like Bitcoin, stablecoin transactions are recorded in a digital ledger maintained on a decentralized network of computer nodes. However, unlike Bitcoin, these transactions are verified by the stablecoin's issuing institution, not by a computer algorithm.

Payment channels

Perhaps a grander goal is more important. Stablecoins can still serve as a channel for people of all income levels to access digital payments and DeFi, weakening the long-held privileges of traditional commercial banks and, in some ways, narrowing the gap between rich and poor countries. Even small countries can benefit from easier access to the global financial system and reduced friction with payment systems.

Stablecoins have indeed reduced payment costs and friction, especially in cross-border payments. Economic migrants can send money home more easily and cost-effectively than ever before. Importers and exporters can complete transactions with foreign countries instantly, without waiting for days.

However, beyond payments, DeFi has become a stage for financial engineering, spawning many complex products whose value is questionable beyond mere speculation. DeFi activities have done little to improve the lives of impoverished families and may even harm the interests of inexperienced retail investors who are lured by high returns and ignore the risks.

Regulatory shift

Will the recent US legislation allowing various companies to issue their own stablecoins promote competition and curb some poorly credible issuers? In 2019, Meta attempted to issue its own stablecoin, Libra (later renamed Diem). However, the project was ultimately halted due to strong opposition from financial regulators. Regulators worried that such stablecoins could undermine the effectiveness of central bank monetary policy.

With the changing regulatory environment in Washington and the rise of a new, more cryptocurrency-friendly government, the door has opened for private stablecoin issuers. Stablecoins issued by large U.S. companies like Amazon and Meta, with their strong balance sheets, are likely to sweep aside other issuers. Issuing stablecoins will strengthen these companies, leading to increased market concentration rather than increased competition.

Large commercial banks are also adopting new technologies to improve operational efficiency and expand their business scope. For example, converting bank deposits into digital tokens allows for transactions on the blockchain. It is foreseeable that large banks may one day issue their own stablecoins. All of this will weaken the advantages of smaller banks (such as regional and community lending institutions) and consolidate the power of large banks.

international dominance

Stablecoins may also strengthen the existing international monetary system. Stablecoins backed by the US dollar have the highest demand and are the most widely used globally. They could ultimately indirectly enhance the dollar's dominance in the global payments system and weaken potential competitors. For example, Circle, the issuer of USDC, the second most popular stablecoin, has seen very low demand for its other stablecoins (pegged to major currencies such as the euro and yen).

Even major central banks are uneasy. Concerns that dollar-backed stablecoins could be used for cross-border payments have prompted the European Central Bank to issue a digital euro. The eurozone's payment system remains fragmented. While it's possible to transfer money from a Greek bank account to a German bank account, making payments in another eurozone country using money held in a bank account in another eurozone country remains inconvenient.

Stablecoins pose an existential threat to the currencies of smaller economies. In some developing countries, people may place greater trust in stablecoins issued by well-known companies like Amazon and Meta than in local currencies plagued by high inflation and exchange rate volatility. Even in well-managed economies with reliable central banks, the allure of stablecoins can be irresistible, as they are convenient for both domestic and international payments and are pegged to major global currencies.

The inefficiency of traditional payment systems

Why have stablecoins gained such rapid attention? One reason is that high costs, slow processing speeds, complex procedures, and other inefficiencies continue to plague the international and even domestic payment systems of many countries. Some countries are considering issuing their own stablecoins to prevent their currencies from being marginalized by dollar-backed stablecoins. However, this approach is unlikely to succeed. They would be better off first addressing the problems in their domestic payment systems and collaborating with other countries to eliminate friction in international payments.

Stablecoins may appear safe, but they actually harbor numerous risks. Firstly, they could facilitate illicit financial activities, making it more difficult to combat money laundering and terrorist financing. Secondly, they could establish independent payment systems managed by private companies, thereby threatening the integrity of the overall payment system.

Solution

The solution seems obvious: effective regulation can reduce risk, create space for financial innovation, and ensure fair competition by curbing the excessive concentration of economic power in the hands of a few companies. However, the internet knows no borders, so regulating stablecoins at the national level is far less effective than a collaborative model involving multiple countries.

Unfortunately, given the current lack of international cooperation and the fact that countries are actively protecting and advancing their own interests, such an outcome is unlikely. Even major economies like the United States and the Eurozone are acting independently on cryptocurrency regulation. Even with a more coordinated approach, smaller economies will find it difficult to participate in decision-making. These countries have weak financial systems, limited regulatory capacity, and high hopes for robust regulatory frameworks; they may be forced to accept rules imposed by major powers that largely disregard their own interests.

Stablecoins serve to expose the pervasive inefficiencies in the existing financial system and demonstrate how innovative technologies can address these issues. However, stablecoins could also lead to greater centralization of power. This could give rise to a new financial order—not the innovative and competitive system with a more equitable distribution of financial power envisioned by cryptocurrency pioneers, but one that brings greater instability.