The dangers of stablecoins

Donald Trump said on Thursday that Jay Powell was “one of the dumbest, and most destructive, people in Government”, before doubling down at the weekend when he added that the Federal Reserve chair was “a Total and Complete Moron!” Central bankers have rallied around the Fed. Banque de France governor François Villeroy de Galhau told the FT that Powell “shows admirably what an independent central banker should do: to tell the truth, and to ensure price and financial stability”.

Today, the Bank for International Settlements, the central bankers’ bank, has joined in the pushback against the US president with a detailed and highly critical analysis of stablecoins, Trump’s favourite monetary project. He signed an order in January seeking to promote the development and growth of stablecoins worldwide. And last week, the Senate overwhelmingly passed the Genius Act, which will regulate and legitimise stablecoin creation by private entities in the US. The BIS is unhappy.

Dumb and destructive

From the extremely cautious and conservative BIS, the criticism is fierce. Stablecoins will always perform poorly as a substitute for money, it said in a special chapter of its annual report published today.

Society has a choice, the BIS concluded. It can modernise payments sensibly or go down the stablecoin route. If it chooses the latter, “society can relearn the historical lessons about the limitations of unsound money, with real societal costs, by taking a detour involving private digital currencies that fail the triple test of singleness, elasticity and integrity”.

At the heart of the BIS’s criticism is the issue of “singleness of money”, the concept that one dollar is always worth one dollar no matter whether it is represented by a dollar bill, in a bank account or at the Fed. By issuing US notes and clearing payments between different banks, the Fed ensures we never have to ask whether you’re holding a Silicon Valley Bank dollar or a Bank of America dollar. They are all US dollars.

Stablecoins are cryptoassets, generally pegged to the US dollar and backed by US dollar assets. But, as the BIS highlights, they are not actually dollars, so their value is not guaranteed. Instead of owning dollars, perhaps intermediated by a commercial bank, you own tether or USDC coins, which generally need to be converted to US dollars if you want to spend them.

As the chart shows, they have not been that stable. The data below is annualised and goes back five years, so exaggerates recent volatility, but the BIS’s point on the singleness of money is nevertheless powerful.

Why are stablecoins prospering?

This is not a case of Gresham’s Law, where bad money is driving out good, because stablecoins are not perfect substitutes for US dollars. But their growth is strong.

The chart below shows there are now more than $200bn of stablecoins in issuance — and circulation is rising fast. While they are clearly dwarfed by the $18.7tn of US dollars held in notes, coins and liquid deposits in banks, we should ask why the digital assets are growing so rapidly.

The genesis of stablecoins is that they can serve as gateways to the cryptoasset ecosystem, making it easier to invest in and cash out of various cryptocurrencies, for those who want to do that sort of thing.

But crime is also clearly involved in stablecoins’ growth. Users can be anonymous and trade outside the main exchanges, and the BIS calls stablecoins the “go to choice for illicit use”. There is no guarantee that users follow “know your customer” or anti-money laundering regulations. While cash is also used for crime, this is a growth business for stablecoins, given they are a relatively new game in town.

But it is not only illicit activity making stablecoins attractive. Deficiencies of the existing domestic and cross-border payments systems in the US have provided opportunities for stablecoins to expand. Even though converting between stablecoins and fiat currency can cost money and the systems can be clunky, making legitimate payments is often cheaper via cryptoassets than the US banking system, as Daniel Davies noted. And the digital assets are much cheaper to use in the case of many cross-border money transfers. This poses a serious challenge to operators in the current payments systems and shows the benefits of new technology.

Becoming a provider of stablecoins is also potentially attractive. You pay nothing to stablecoin holders, nor when investing in short-term US assets paying over 4 per cent. Lots of US companies will be eyeing the opportunity to become a private provider of money in future. Why, they might ask, should taxpayers alone enjoy the benefits of seigniorage?

The dangers

Of course, private provision of money is nothing new. In the free-banking era in the US from the 1830s to the 1860s, there were many different forms of US dollar which had varying success but regular crisis. The failed model ushered in the modern system in which central banks sit at the core. Professor Barry Eichengreen of University of California, Berkeley, says that Trump’s Genius Act threatens to take us back to the chaotic era of free banking. Just imagine if short-term interest rates fell to zero again. Private stablecoin providers could easily go bust, with costs exceeding returns, leading to an exodus.

But crime and financial instability arising from the failure of providers are not the only risks, according to the BIS. Without central bank backing, stablecoins could not guarantee to process very large payments, which the Fed facilitates by being willing to lend unlimited dollars to banks intraday against quality collateral.

If there was a rapid move for the exit from stablecoins, they are now large enough to create volatility in major markets, such as in that of short-term US Treasury bills. Providers have been the third-largest purchaser of Treasury bills this year.

The cross-border growth of stablecoins could also undermine the monetary sovereignty of other countries. Large economies with stable inflation are safe, but stablecoins could pose risks to developing countries. While there are advantages in the competition stablecoins provide, for example their undermining of foreign exchange controls and their forcing some countries to promote monetary and financial stability, the wider threat to monetary sovereignty and domestic economic management exists.

If not stablecoins, then what?

Payments systems need to modernise to counter the stablecoin threat. The BIS is advocating a central bank-based system of tokens that preserves the singleness of money with more efficient domestic and cross-border transactions. Its Agora project’s conceptual phase is complete and the bank is moving towards a prototype. It will combine the benefits of a tokenised system with existing concepts of commercial and central bank money.

The main benefits would be speed improvements and ensuring money does not get stuck along a chain of correspondent banks as they perform the essential anti-money laundering and “know your customer” checks. Because this is a wholesale payments architecture and not (officially) a central bank digital currency, the Fed is involved and it is not outlawed by the Trump administration.

We should wish the BIS and central banks well. It is a race against time.

What I’ve been reading and watching

• The Bank of England and the Fed commented in the past week on the increased risks and uncertainty arising from the conflict between Israel and Iran. With US involvement, the risks have risen further. But no one wants to quantify them yet.

• Fed governor Christopher Waller will have done his chances of becoming chair no harm in calling for US interest rates to fall as soon as July. (In early 2024, he said the “worst” thing would be to start cutting rates prematurely and then watch the data change.)

• The Swiss National Bank has cut its interest rate to zero.

• France is lobbying its EU partners to raise the euro’s profile by issuing more jointly-backed debt.

A chart that matters

Remember German hyperinflation in 1923? The standard images that spring to mind are wheelbarrows stuffed with cash, people burning banknotes to keep warm and children flying kites worth billions of marks.

These are not false memories, but a new ECB blog by David Barkhausen highlights that neither are they comprehensive or representative recollections. Interestingly, he reveals that it took some time for German collective memory of Weimar-era hyperinflation to become a cautionary tale explaining the nation’s fear of inflation and desire for fiscal discipline.

Oral histories suggest the hyperinflation redistributed income between savers and debtors, so was not the national collective disaster we now “remember”. More revealingly, speeches in the Bundestag that referenced Weimar-era hyperinflation generally used it to justify public spending until the 1970s, before politicians started using the event as justification for fiscal discipline. It is fascinating.

Central Banks is edited by Harvey Nriapia