As the brave new world of digital assets enters its second decade, the rapid growth of this once-nascent industry has put the focus on issues relating to financial stability. Rather than presenting new risks, Matthew Alexander argues that stablecoins have the potential to enhance global financial stability, including the stability of individual and household finances.
Regulatory hurdles are nothing new for digital asset issuers and service providers. Initial coin offerings (ICOs) – the sector’s novel fundraising method – have justifiably drawn the attention of securities regulators and consumer protection advocates alike. Additionally, many early digital asset entrepreneurs have learned – some quite painfully – that their projects qualify as Money Service Businesses (MSBs). This makes them subject to a compulsory, comprehensive, and globally-standardized regulatory regime known as Anti-Money Laundering /Combatting the Financing of Terrorism (AML/CFT). By making inroads into the global financial sector, the emergence of digital assets has caused many once-basic financial policy matters to be re-examined: What are securities? What is money? These are important questions.
As the legal identity of Bitcoin and other digital assets continues to be forged by an interplay of various domestic regulatory agencies’ interpretations, headway is being made. Once labelled “evil” by a Nobel Prize-winning economist, bitcoin has since proven itself critically valuable to law enforcement in the arrest of high-profile hackers. Being only pseudonymous, bitcoin’s publicly digital traceability empowers law enforcement to pursue the criminal element more effectively than under the traditional process of subpoenaing for private bank records. The ‘Wild West’ days of regulatory precariousness appear over, and the private sector now enjoys much more predictable legal compliance. Public authorities have gained a powerful method to track down criminals.
Yet, despite this progress, all is not quiet on the regulatory front. In the past year, three major financial oversight bodies have introduced a brand-new policy concern: threats to financial stability purported to be posed by digital assets.
What is Financial Stability?
While acknowledging the potential of digital assets to enhance the efficiency of financial services, reports from the Bank of International Settlements (BIS), the United States Federal Reserve, and the Financial Stability Board (FSB) each emphasize numerous concerns, all under the banner of “financial stability”. With Facebook’s Libra project having likely catalysed these efforts, the focus is on “global stablecoins”: those with the potential to achieve widespread adoption and substantial volume. No stranger to regulatory scrutiny, this 1.7 billion-user elephant in the room may have spurred these oversight bodies to act. However, their published concerns extend to other digital assets as well. It is only a matter of achieving sufficient scale.
But despite listing an array of risks under this heading, the term “financial stability” is neither defined nor explained anywhere in these reports. The Financial Stability Board – the namesake BIS-funded G20 institution – included a glossary of definitions for key terms in their report, but none was provided for “financial stability”. This is unfortunate. If a problem is not defined, it cannot be solved. Any confusion over a problem’s basic nature will likely impair good-faith attempts to provide legislative solutions.
There is an added layer of opacity: the FSB believes that individual countries may be incapable of adjudicating potential threats to financial stability. They maintain that even absent any single jurisdiction’s detection of systemic risk, digital assets could still pose a threat globally, thus necessitating global oversight. According to their report, a case could be made for global-level monitoring if the digital asset “has a presence across many jurisdictions and therefore has high interlinkage to the global financial system.”[1] Their focus is currently on stablecoins, but bitcoin and other projects may soon fit this bill as the sector continues to grow.
Just as the application of securities and MSB laws to digital assets prompted a re-examination of some basic financial terminology, these newer policy developments beg the question: what is “financial stability”? The maintenance of this fuzzy concept is poised to form the basis of globally-recommended policy standards, marking a new frontier of regulatory challenge. To prevent a misunderstanding – to avoid burdensome-yet-ineffective regulation – digital asset industry leaders should begin to initiate dialogue on this matter, both amongst themselves and with public authorities. With a financial stability-themed regulatory challenge to digital assets looming on the horizon, two distinct threads of financial history are coming full circle.
A Tale of Two Responses
The 2007-2008 Global Financial Crisis (GFC) marked the modern epitome of financial instability. In response, G20 leaders established the FSB in April 2009 to facilitate global monitoring and coordination. Preventing another GFC-like event is presumably the main purpose of this body, whose stated objective is to “address vulnerabilities affecting financial systems in the interest of global financial stability.” This was a top-down response.
By contrast, led by bitcoin in January 2009 and rooted in discontent with the prevailing order, the emergence of digital assets was a truly bottom-up response to the GFC. The specific vision of ‘Satoshi Nakamoto’ is sometimes debated, but bitcoin’s pseudonymous creator left no doubt as to the project’s general motivation. Embedded within bitcoin’s initial code is the message “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”, a reference to the political fallout of the GFC. In an apparent renewal of vows, bitcoin’s latest milestone block included the more recent headline: “NYTimes 09/Apr/2020 With $2.3T Injection, Fed’s Plan Far Exceeds 2008 Rescue”. This sentiment lives on within the digital asset community.
What is financial stability? How is it best promoted and maintained? Deeply opposing views on these questions lie at the heart of the above countervailing responses to the GFC. On one hand is the centralized response: quantitative easing, suppressed volatility, and an outsourcing of financial rulemaking to global bodies. Digital assets represent a decentralized alternative: sound money, disintermediation, and a restoration of financial autonomy to the individual. Though still unfamiliar and cumbersome, digital assets offer a suite of innovative characteristics upon which a more stable global financial system can be built.
Digital Assets as Stabilizing Agents
Owing to its scarcity, and despite its high security and transaction costs, gold has long been relied on to stabilize household finances during periods of currency depreciation. By removing these frictions in the context of a digitally scarce asset, bitcoin is an unprecedented monetary innovation. But deeply-rooted practices are not transformed overnight; emergent alternatives must develop and mature. Thus, despite being heralded as a revolutionary long-term savings technology, bitcoin remains a speculative financial asset with high short-term volatility.
While created to facilitate access to bitcoin, stablecoins have many use cases, not least of which is their use as money. The leading stablecoin’s velocity of money - the rate at which it is exchanged in an economy - is the highest among digital assets, and dwarfs the velocity of traditional currency, which has been in steep decline for two decades. Firms like Celsius Network convert this demand for stablecoins into attractive opportunities for savers. As explained by founder and CEO Alex Mashinksy, in an era in which no bank or central bank plans to pay savers any meaningful interest on their deposits, “stablecoins represent a unique opportunity for investors to use their hard earned cash to earn high yield on their fiat.”
While the below charts represent only a portion of USDt in circulation, research from blockchain analytics firm Chainalysis suggests that the velocity of USDt greatly exceeds that of both M1 and M2 (traditional measures of money supply). As the leading stablecoin, tether is growing increasingly popular for transacting.
Whereas the velocity of M1 has decreased from 10 to 5 in the last decade, tether’s quarterly velocity has been trending higher, even as a growing number of users are holding the stablecoin as a store of value.
By imbuing a highly-mobile digital asset with a stable value, stablecoins enhance liquidity and price discovery within the broader digital asset ecosystem. In the traditional financial sector, central banks “inject” liquidity to stabilize asset prices. But this short-term strategy effectively suspends price discovery in these markets, setting the stage for asset-bubbles and more serious longer-term issues. By contrast, stablecoins promote a market-oriented liquidity that is provided by autonomous digital asset market participants. Some volatility remains, but price discovery is enhanced rather than impaired. Longer-term market stability is promoted rather than jeopardized.
Could the soundness of major stablecoins themselves be a source of concern? Not likely. While their reliance on third-party banking services does pose an outside risk to reserves, the token’s overall liquidity and price discovery is exceedingly robust. The business is simple: primary market participants are verified customers who deposit (or receive) reserve assets upon the issuance (or redemption) of tokens from the issuer, at the pegged rate. Vibrant secondary markets are governed strictly by supply and demand, but the arbitrage activity of incentivized primary market participants keeps prices hovering near the pegged rate. Should prices deviate in either direction, they are quickly stabilized by this activity. There is perhaps no other financial product for which the neoclassical ideal of market equilibrium is more perfectly realized.
When compared to the highly complex and impossible-to-price subprime securities at the root of the GFC, stablecoins exist – by design – on the opposite end of the risk spectrum. The principal threat they pose is to the stability of fee-driven bank profits. Widely misunderstood and underappreciated, stablecoins are a vital component of the digital asset ecosystem. They facilitate price discovery while working to alleviate the sector’s reliance on traditional banking – a critical aid in the face of blanket de-risking by major banks, a practice which heightens any risk to a stablecoin’s reserves.
As global authorities take aim at these projects in the name of “financial stability”, both the broader sector and society at large must consider the implications. Should asset prices be determined by authorities or discovered within markets? This is what is at stake.
[1] https://www.fsb.org/wp-content/uploads/P140420-1.pdf (FSB Report, Pg. 11, para. 2)