Passage of the recent GENIUS Act (Guiding and Establishing National Innovation for U.S. Stablecoins Act) spotlights these new digital assets that are making central banks nervous. Eswar Prasad, an economist at Cormell University, sees their benefits in making cross-border payments cheaper and more efficient. Others, including Nobel laureate economist Jean Tirole, worry about how weak regulation of these new assets could lead to financial distress and eventual bailouts.
Both economists have good points, so let’s unpack the arguments using the example of U.S.-dollar backed stablecoins, namely those with 100 percent reserve backing from U.S. Treasury assets. The GENIUS Act calls for protecting consumers with better alignment of state and federal oversight frameworks, although the details remain to be firmly established. One provision places stablecoin holders in a prioritized position in case of insolvency. Of course, these holdings are not, for the moment, insured as are normal bank deposits.
It should be noted that in addition to helping U.S.-backed stablecoins compete with other such instruments, the Act explicitly notes that additional demand for U.S. assets will be created, which can help both in funding deficits and in “cementing the role” of the U.S. dollar as the world’s global reserve currency.
All of this has made the European Central Bank nervous as the conduct of its monetary policy may be affected if new channels to buy U.S. government paper are reinforced.
Back to the risks and returns underlying any serious cost-benefit analysis of stablecoins. There are efficiency gains to the payments systems to be realized in the fact that block-chain technology will be used in tokenizing deposits and that using stablecoins will, in and of itself, prompt reforms in cross-border settlements. These are clear benefits. It should also be noted that the BRICS are exploring such systems on their own to help establish the renminbi as a major reserve currency.
Proponents claim that stablecoins will have less volatility than other assets. They point to the case of 1:1 backing, for example. If the price diverges, buyers will purchase the coins to redeem them at par.
But what if the underlying assets lose significant value? A recent case in point is Silicon Valley Bank (SVB), which had most of its assets in long-dated treasuries that lost significant value as interest rates rose. Regulators intervened and closed SVB at a significant cost to taxpayers since all deposits were guaranteed ex post regardless of size.
What if a surge in rates lowered the backing for stablecoins and, in order to redeem them, the issuers had to sell assets at reduced prices? A run on the coins would ensue and regulators would need to step in—a typical case of “moral hazard”—to ensure the integrity of the financial system.
New digital assets beyond those stablecoins backed by U.S. debt obligations entail even higher risks if backed by commodities or gold or other crypto currencies. Like most financial innovations, the risks are often downplayed, and lobbying for government support ignores the potential cost to taxpayers if things go badly.
Consider, for example, other potential downsides of a major surge in stablecoin issuance, such as the “hollowing out” of the traditional banking system. A large shift in consumer demand for new digital assets will deprive banks of their ability to intermediate savings into investment. Moreover, it will
put an increasing proportion of holdings outside of the deposit insurance framework.
Some observers, such as Professor of Economics Hélène Rey at London Business School, correctly note that digital currencies will alter the transmission channels for conducting monetary policy, making macroeconomic management more difficult.
All this highlights the need for effective regulation of these new assets, something for which we have yet to see the details. Innovation in financial markets can be a double-edged sword as we have seen, especially in the 2008 housing market collapse. Therefore, a dose of caution is advisable to ensure that stablecoins will not produce a repeat of previous financial crisis events.