Original title: "Stablecoins: Growth Potential and Impact on Banking"

Original Compilation: Rhythm BlockBeats

Original Compilation: Rhythm BlockBeats

On March 9, U.S. Treasury Secretary Janet Yellen issued a statement on Joseph Biden's directive on digital assets. This statement did not have a negative view on cryptocurrencies, so many people think that this statement drove market sentiment. The statement appeared to have been accidentally leaked on the official website of the Ministry of Finance and has since been deleted. However, from the remaining traces, we can still see some key points.

In a statement full of official words, Janet Yellen specifically mentioned "stable currency". She said that the Ministry of Finance will cooperate with multiple departments to study stable currency and make recommendations. There is a view that the United States seems to be launching its own CBDC, but Rhythm does not think so. Last year, in the "Full Text of the Federal Reserve's Speech on CBDC: A Comprehensive Macroscopic Understanding of Stablecoins, Bitcoin, and CBDC", the Federal Reserve was not excited about CBDC , and for stablecoins, they are obviously more interested.

In February of this year, the Federal Reserve released the latest stablecoin report, arguing that stablecoins have the potential for next-generation innovation, and focused on discussing the potential impact of stablecoins on the banking system and credit intermediaries.

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TL;DR

A stablecoin is a digital currency that pegs its value to an external reference, usually the United States dollar (USD). Stablecoins play a key role in digital markets, and their growth could spur innovation in the wider economy. The past year has seen an explosion of USD stablecoins circulating on public chains, with a total circulating supply of nearly $130 billion as of September 2021, an increase of more than 500% from a year ago.

As stablecoins gain traction, a host of questions have been raised, including the stability of their pegs, consumer protection, KYC and compliance, and the scalability and efficiency of settlements. We will focus on the potential impact of stablecoins on the banking system and credit intermediation. While a range of issues related to stablecoins can be resolved with appropriate institutional safeguards, regulations, and technological advancements, the continued growth of stablecoins in circulation will ultimately impact the traditional banking system in significant ways.

In this note, we first discuss the basics of stablecoins, their current use cases, and their growth potential. Second, we examine the historical behavior of stablecoins during past cryptocurrencies and broader financial market distress. We find that USD-pegged stablecoins exhibit safe asset quality, as their secondary market prices temporarily rise above the peg price during times of extreme market distress, thereby incentivizing more stablecoin issuance. We also highlight the “run” risk of certain stablecoins backed by non-cash equivalent risk assets.

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Stablecoin Basics

Stablecoins are digital currencies recorded on a distributed ledger technology (DLT), usually a blockchain, pegged to a reference value. Most stablecoins in circulation are pegged to the U.S. dollar, but stablecoins can also be pegged to other fiat currencies, baskets of currencies, other cryptocurrencies, or commodities such as gold. Stablecoins serve as a store of value and medium of exchange on DLT, enabling stablecoins to be exchanged or integrated with other digital assets.

Stablecoins differ from traditional digital currency records, such as bank deposit accounts, in two main ways. First, stablecoins are cryptographically secured. This allows users to settle transactions almost instantly without the need for double spending or intermediaries facilitating settlement. On the public chain, this also allows 24 X 7x365 transactions per day. Second, stablecoins are often built on top of programmable DLT standards and allow for composability of services. "Composability" in this context means that stablecoins can act as independent building blocks that interoperate with smart contracts (self-executing programmable contracts) to create payments and other financial services. These two key features underpin current stablecoin use cases and support innovation in financial and non-financial sectors.

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Current Stablecoin Types

Stablecoins are a nascent, broadly defined technology that may take many forms. This technique is currently implemented in a specific form, which we describe below and summarize in Table 1. However, be aware that stablecoin technology is in its infancy and has a high potential for innovation. The current implementation of stablecoins discussed below, and their current status in the regulatory environment, do not reflect all potential deployments of stablecoin technology.

Circulating supply of top 10 USD-pegged public stablecoins by market capitalization. Data from January 2019 to September 2021. Other categories include Fei, TerraUSD, TrueUSD, Paxos Dollar, Neutrino USD, and HUSD.

Stablecoins backed by public reserves

Most existing stablecoins circulate on public chains such as Ethereum, Binance Smart Chain or Polygon. Of these public stablecoins, most are backed by cash-equivalent reserves such as bank deposits, treasury bills, and commercial paper. These reserve-backed stablecoins are also known as custodial stablecoins because they are issued by intermediaries that act as custodians of cash-equivalent assets and provide a 1-to-1 redemption of stablecoin liabilities against U.S. dollars or other fiat currencies.

The adequacy and soundness of some public reserve-backed stablecoins has been called into question. In particular, Tether, the stablecoin with the largest circulating supply, agreed to pay $41 million to settle a dispute with the U.S. Commodity Futures Trading Commission, which accused Tether of misrepresenting the adequacy of its dollar reserves. Other widely used reserve-backed USD-pegged public stablecoins with varying levels of financial auditing include USD Coin, Binance USD, TrueUSD, and Paxos Dollar.

Public Algorithm Stablecoin

Some stablecoins use other mechanisms to stabilize their prices than rely on the soundness of the underlying reserves. These stablecoins are often referred to as algorithmic stablecoins. While reserve-backed stablecoins are issued as liabilities on the balance sheets of legally registered companies, algorithmic stablecoins are maintained by a system of smart contracts that run exclusively on public chains. The ability to control these smart contracts is usually conferred by owning a governance token, a specialized token that is used exclusively to vote on changes to the protocol or governance parameters. These governance tokens can also serve as direct or indirect claims on future cash flows using the stablecoin protocol.

The field of public algorithmic stablecoins is highly innovative and difficult to classify. However, one can generally think of the design of these stablecoins as being based on two mechanisms: (1) a staking mechanism and (2) an algorithmic peg mechanism. Collateralized public stablecoins like Dai are minted when users deposit volatile cryptocurrencies like Ethereum into Dai's smart contract protocol. The user then receives a Dai (USD-pegged) loan with over 100% collateralization. If the value of the Ethereum deposit falls below a certain threshold, the loan is automatically liquidated.

In contrast, algorithmic peg mechanisms use automated smart contracts to secure the peg by buying and selling stablecoins and associated governance tokens. However, these pegs may experience instability or design flaws that lead to “instability,” as exemplified by the algorithmic stablecoin Fei’s brief break from the peg after its launch in April 2021.

Institutional or Private Stablecoins

In addition to reserve-backed stablecoins circulating on public blockchains, traditional financial institutions have also developed reserve-backed stablecoins, also known as “tokenized deposits.” These institutional stablecoins are implemented on permissioned (private) DLTs, and they are used by financial institutions and their clients for efficient wholesale transactions. The most famous institutional stablecoin is JPM Coin. JPMorgan and its clients can use JPM Coin to conduct transactions such as intraday repo settlement and manage internal liquidity.

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Stablecoin use cases and growth potential

Strong use cases are driving the current growth of stablecoins in their various forms. We summarize these use cases. The most important current use case for stablecoins is their role in cryptocurrency transactions on public blockchains. Investors often prefer public stablecoins to trade cryptocurrencies, as this allows for near-instant 24/7/365 transactions without relying on non-DLT payment systems or escrow holding of fiat currency balances.

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future growth potential

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More inclusive payments and financial systems

Stablecoins have the potential to spur growth and innovation in payment systems, enabling faster and cheaper payments. Since stablecoins can be used to transfer funds almost instantly peer-to-peer between digital wallets with potentially low fees, stablecoins may lower payment barriers and put pressure on existing payment systems to provide better services. This is especially important for cross-border transfers, which can take days to clear and incur high fees. These costs and delays are a burden for low- and middle-income countries.

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Tokenized Financial Markets

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next generation innovation

Finally, stablecoins have the potential to support the next generation of innovation. An example of this innovation is Web 3, which may move from centralized web platforms and data centers to a decentralized web. Under this paradigm, revenues for internet services and social media platforms will shift from advertising to microtransactions, benefiting from the emergence of efficient, integrated online payment systems. For example, imagine a search engine or a video streaming platform powered by near-instant micropayments in stablecoins, rather than advertising revenue and sales of user data. If this shift in web services comes to fruition, it could fuel further growth for stablecoins.

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hook stability

The stability of a stablecoin pegged to its reference value is a central concern. This is not the focus of our paper, but we briefly discuss this important issue here. In this section, we first outline the current sources of peg instability for public reserve-backed stablecoins and discuss how to address them. We then review how stablecoins serve as potential safe assets in digital markets and provide evidence that current public reserve-backed stablecoins may already be serving this role in cryptocurrency markets.

Currently, peg instability for public reserve-backed stablecoins comes in two forms: the issuer’s investor redemption risk and secondary market price misalignment. The former is related to the safety and soundness of stablecoin reserves. If stablecoin holders lose confidence in the robustness of the stablecoin backing, panic could ensue. A run on stablecoins creates the risk of spillover to other asset classes as stablecoin reserves are dumped or unloaded to meet redemption demand. Additionally, runs on stablecoins could cause further headaches by disrupting smart contracts for markets and services that rely on stablecoins through interoperability. We believe this type of instability can be addressed with appropriate institutional and/or regulatory guardrails, such as transparent financial audits and adequate requirements for the liquidity and quality of stablecoin reserves. Concerns around redemption risk and the extent to which they can be addressed were recently mentioned in Quarles (2021).

A second form of peg instability for public reserve-backed stablecoins stems from supply-demand imbalances in secondary markets. Because these stablecoins are traded on both centralized and decentralized exchanges, they are vulnerable to demand shocks, which could temporarily dislocate their pegs until stablecoin issuers adjust supply. In particular, due to public stablecoins serving as a store of value in public blockchain-based markets, these stablecoins have experienced high demand during crypto market distress, as investors rushed to liquidate their speculative positions into stablecoins. During these events, the price of a stablecoin backed by a major public reserve tends to temporarily appreciate in value until the issuer adjusts the supply. As an example, the graph shows the cryptocurrency market crashes on March 12, 2020 and May 19, 2021. The first event occurred during a period of general market volatility surrounding concerns about the spread of Covid-19. The second event occurred during a crypto market downturn associated with massive deleveraging. During both periods, the prices of major public reserve-backed stablecoins surged as the prices of speculative cryptocurrencies bitcoin and ether plummeted by 30% to 50%.

For these events of extreme crypto market distress, stablecoins appreciate as a digital security asset, while more speculative cryptoassets are temporarily in freefall until stablecoin issuers are able to increase their supply and purchase reserves and/or stablecoins experience The decline comes from price pressure from arbitrageurs. The behavior of these public stablecoins is unique and different from that of premium money market funds, which experienced massive outflows during the height of the 2008 global financial crisis and 2020's COVID-19 pandemic.

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The Potential Impact of Stablecoins on Credit Intermediation

If stablecoins gain widespread adoption across the financial system, they could have a significant impact on the balance sheets of financial institutions. Regulators, market participants, and academics are particularly concerned about the potential of stablecoins to disrupt bank-led credit intermediation. In this section, we analyze several possible scenarios for widespread adoption of reserve-backed stablecoins in the financial system. We focus on reserve-backed stablecoins, rather than algorithmic stablecoins, because reserve-backed stablecoins are currently the largest and most closely connected to the existing banking system. Using these scenarios, we highlight how the impact of stablecoin adoption on credit provision critically depends on two factors: the source of stablecoin inflows and the composition of stablecoin reserves.

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source of inflow

If stablecoins are widely adopted, major inflows could come from three sources: physical currency (paper money), commercial bank deposits, and cash-equivalent securities (or money market funds). First, as a form of digital currency, stablecoins will replace some of the paper money in circulation, especially as the economy becomes more digital. In some of our scenarios, we have seen credit supply increase as users switch from physical cash to reserve-backed stablecoins. This is because paper money, which is a direct liability of the central bank, is replaced by a reserve-backed stablecoin, which, depending on the reserve framework, can create credit through loans or securities purchases.

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Reserve Composition

The impact on credit provision of widespread adoption of a reserve-backed stablecoin also depends on the composition of the stablecoin reserve. We propose three plausible frameworks for stablecoin reserves: narrow banking, two-tier intermediaries, and securities holdings. As shown above.

In a narrow banking framework, stablecoins need to be backed by commercial bank deposits, which are fully backed by central bank reserves. Equivalently, it is possible for commercial banks to issue fully stablecoins (or tokenized deposits) backed by central bank reserves. The narrow banking approach is roughly equivalent to a retail central bank digital currency, where the digital currency is a liability of the central bank but accessible to households and firms through intermediaries such as commercial banks or fintech firms. The People's Bank of China has adopted this framework in its state-backed digital currency (known as digital currency and electronic payment), digital yuan, or e-renminbi. The possibility of requiring stablecoins to maintain reserves at central banks is also mentioned in the proposed STABLE Act in the United States.

While a narrow banking framework can guarantee the anchor stability of a stablecoin because it is effectively a pass-through central bank digital currency (CBDC), this reserve framework poses the greatest risk of credit disintermediation. Periods of financial stress or panic could lead to massive transfers of conventional commercial bank deposits into narrowly defined bank stablecoins, which could disrupt credit supply. While this credit disruption effect could be mitigated by limiting stablecoin holdings and differential reserve rates, the overall structure of banks' narrow approach to stablecoin reserves could be destabilizing for the banking system. Additionally, a narrow approach to banking could lead to an expansion of central bank balance sheets to accommodate the need for reserve balances by stablecoin issuers.

These concerns about narrow banking stablecoins mirror concerns about narrow banking more generally, which the Fed has taken note of. In a recently proposed regulation that would affect narrow banks (officially known as pass-through investment entities, or PTIEs), the Fed expressed “concern that [narrow banks] may disrupt financial intermediation in unpredictable ways and may also have consequences for financial stability. negative impact” (Regulation D: Reserve Requirements of Depository Institutions, 2019). In addition, the Fed outlined serious concerns about the demand for reserve balances, stating that “[narrowly defined bank] demand for reserve balances may become very large. To maintain the desired monetary policy stance, the Fed may need to and reserve supply to meet this demand."

Under a two-level intermediation framework, stablecoins would be backed by commercial bank deposits used for fractional-reserve banking, as opposed to a narrow banking framework. Likewise, it is possible for commercial banks to issue stablecoins or offer tokenized deposits for fractional reserve banking. To be clear, this does not mean that stablecoins are not fully supported. Instead, stablecoin issuers rely on commercial bank deposits as assets, and commercial banks practice fractional reserve banking with stablecoins and/or stablecoin deposits, meaning that stablecoins are ultimately backed by a combination of loans, assets, and central bank reserves. It affects effectively re-flagging some of the regular deposits as stablecoin deposits. Importantly, for banking intermediation to remain the same, stablecoin deposits must be treated the same as non-stablecoin deposits in terms of required reserve ratios, liquidity coverage ratios, and other regulatory and self-imposed risk limits.

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scene construction

In our scenario, we consider the impact of one or more fiat reserve-backed stablecoins gaining widespread adoption in a stylized version of the banking system. The baseline balance sheet for the banking system is shown in the figure. Specifically, we consider households and businesses substituting $10 for paper money, commercial bank deposits, or securities, and then we perform accounting to determine how stablecoin adoption affects central banks, commercial banks, and household and business balance sheets. We analyze how this effect varies according to the stablecoin's reserve framework and its source of inflows.

It's important to note that in building these scenarios, we made several key assumptions. The first is that we do not know the exact form of the stablecoin being adopted. Our scenario does not intend to analyze, for example, the specific impact of widespread adoption of an existing stablecoin such as Tether. We do not differentiate whether the adopted stablecoins are institutional tokenized deposits, stablecoins circulating on public blockchains, or otherwise. Second, we only show illustrative advantage cases. In effect, stablecoins can see inflows from multiple sources and hold multiple assets as reserves. Third, these scenarios do not capture secondary knock-on effects or feedback loops, nor do they address heterogeneous effects within industries. Finally, we assume that commercial banks have a 10% statutory reserve ratio on traditional deposits.

To illustrate the complex flows between various parts of the banking system that underpin our edge-case scenarios, we visualize in a graph a subset of the stablecoin inflows and reserve allocations we discussed. Specifically, we use a diagram to show the inflow of commercial bank deposits (inflow A) and banknotes (inflow B) into stablecoins, and the allocation of these funds in the form of commercial bank deposits to reserves (reserve flow A) and securities (reserve flow B).

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scene analysis

narrow banking framework

As noted earlier, narrow banking frameworks pose the greatest risk to credit provisioning, depending on the source of inflows. In our narrow banking scenario, as shown in the table, we find that physical cash flows into narrow bank stablecoins will have a neutral effect on credit supply, while commercial bank deposits disrupt credit supply.

In Panel A (cash inflow scenario), we see stablecoins displacing cash on household and corporate balance sheets. The inflow of cash leads to an indirect increase in commercial bank balance sheets and commercial bank reserves. The central bank's balance sheet is restructured, with reserve liabilities replacing cash liabilities. The net effect is an expansion of commercial bank balance sheets, but no change in credit provisions. This scenario assumes that banks are not constrained by the size of their balance sheets. That is to say, narrowly defined bank deposits and related reserve holdings are exempt from leverage ratio calculations. This leverage exemption for central bank reserve holdings has been adopted by regulators in various jurisdictions.

Panel B shows the narrow banking scenario of deposits migrating to stablecoins. As stablecoin deposits remain entirely on the balance sheets of commercial banks, banks must reduce their asset holdings to accommodate the decline in funding for non-stablecoin deposits. The central bank's balance sheet then expands to accommodate the increased demand for reserve balances without offsetting the decline in cash liabilities. In this case, we assume that the central bank will meet increased reserve requirements by purchasing securities. This assumption of central bank easing is driven by the Fed's previous ruling on narrow banking, as discussed above, in relation to Regulation D: Reserve Requirements for Depository Institutions (2019). However, if the central bank determines the size of its balance sheet, we propose two alternatives in Table A1 of the Appendix. In the first alternative, commercial banks shrink their balance sheets substantially to make up for the shortfall in deposit funding. In the second case, commercial banks make up lost deposit funds by issuing debt securities. The result was a further reduction in bank-led credit creation.

We are not imagining a scenario where narrow bank stablecoins flow in from securities holdings. In this case, the impact on credit provisioning is likely to be neutral. Under the same assumptions as above, the net effect on the supply of credit should be minimal for the central bank to meet increased reserve requirements through purchases of securities (from households). Rather than holding securities directly, the migration to stablecoins would see households own stablecoins backed by central bank reserves, which in turn are backed by securities. This scenario also assumes that increases in narrow bank reserves are not affected by leverage, as noted earlier.

two-tier mediation framework

For the two-level intermediation framework shown in the table below, we find that large stablecoin inflows will have a neutral to positive impact on credit supply. Panel A shows the conversion of cash into stablecoins. As commercial banks engage in fractional-reserve banking through stablecoin deposits, their balance sheets expand with credit and securities holdings, which account for most of the expansion. The central bank has shrunk on its net balance sheet, with a slight increase in reserves and a significant reduction in cash liabilities. Households accumulate more assets to finance expansion in bank loans. The impact on credit provisioning is positive. Panel B shows the two-level mediation scenario with deposit substitution. Overall balance sheets and asset holdings of commercial banks and the central bank were unchanged. The only change is the composition of commercial bank liabilities, as term deposits are converted to stablecoin deposits. As noted, this scenario assumes that stablecoin deposits are treated in the same way as non-stablecoin deposits with respect to required reserve ratios, liquidity coverage ratios, and other regulatory and self-imposed risk limits.

Securities Holding Framework

As the table below shows, the impact of widespread adoption of security-backed stablecoins is the least predictable. Many situations are possible. In Panel A, we present a scenario where a security-backed stablecoin sees an inflow of commercial bank deposits. We assume that stablecoin issuers source securities from commercial banks rather than the household and corporate sectors. In this case, as households exchange their deposits for stablecoins, commercial banks make up for lost deposit funds by issuing their own securities. In addition, commercial banks can reduce their securities portfolio to cover the loss of deposit funds. If a bank adjusts the asset portion of its balance sheet primarily by changing its securities holdings, the size of the bank's loan portfolio may remain constant. In this case, the central bank's balance sheet also shrinks slightly due to the loss of bank reserves.

Panel B shows a scenario where households exchange their holdings of cash-equivalent securities for stablecoins. This would lead to the effective tokenization of cash-like securities without directly affecting the supply of credit in the banking system. We also consider an alternative scenario (not shown) in which a stablecoin backed by securities experiences deposit inflows from the household and corporate sectors while simultaneously selling securities to commercial banks. The securities sellers are the household and corporate sectors, not commercial banks as described in Table 7, Panel A. The net effect on the provision of credit is neutral, as commercial bank deposit balances held by households and firms that purchase stablecoins are eventually recycled back to the bank by transferring them to other households and firms that sell securities to the stablecoin issuer system. This restructuring of security holdings is illustrated in Figure 3 by inflow A and reserve flow B. The end result is a change in the balance sheet, the same as for Panel B.

Summarize

Summarize

Stablecoins have grown significantly over the past year as digital assets gain wider adoption and use cases for programmable digital currencies are clarified. The rapid ascent has raised concerns about possible negative impacts on banking activity and the traditional financial system. In this report, we discuss the current use cases and potential growth of stablecoins, analyze historical events of peg instability, and illustrate different scenarios for the impact of stablecoins on the banking system. As noted in the introduction, this paper does not consider all potential implications of stablecoins for financial stability, monetary policy, consumer protection, and other important unexplored issues. We focus on balance sheet effects and credit intermediation under a range of plausible assumptions.

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