An evaluation of stablecoins is a balancing act between polarizing stakeholder priorities. End-users will seek a form of money and payment system that maximizes private benefits and reduces associated costs and risks. End-users emphasize the means of payment and store of value functions of money, which are characterized by criteria like liquidity, scalability, additional services, ease of use, efficiency, and anonymity, amongst others. Commercial banks will seek a form of money and payment system that amplifies society’s reliance on them as intermediaries in the hopes of increasing profits. From a public policy perspective, there are three primary objectives for a money and payment system; that they support financial integrity, financial stability and monetary policy effectiveness. Currently, the central bank is responsible for upholding these public policy objectives. As mentioned in earlier parts of this series, stablecoins shift this responsibility away from central banks. However, the public policy objectives that central banks uphold are likely to remain relevant in the context of alternate money and payment systems, including stablecoin systems, and lend a degree of objectivity to the often-polarized spectrum of stakeholder priorities – as described above. Accordingly, the following evaluates stablecoins within the context of: Financial integrity, financial stability, and monetary policy.
Promoting financial integrity involves fostering good governance and establishing protections for end-users. Central banks and regulators protect end-users by establishing rules for anti-money laundering (AML), know your client (KYC), combatting the financing of terrorism (CTF), and other measures aimed at fighting corruption and promoting customer due-diligence. Within the context of cross-border economic relations, establishing such safeguards is difficult because regulations vary by jurisdiction, as do the governance regimes that support the currency and payment infrastructure. Distinct regulations, coupled by correspondent banking relationships, can lead to a lack of AML, KYC and CTF transparency that can deter a bank from processing a cross-border transaction.
Both CBDC and stablecoins payment infrastructure (blockchains) could strengthen the integrity of cross-border payments by streamlining KYC information sharing, and enabling more efficient settlements; rather than exposing end-users to potentially weak correspondent banking relationships. Whether the CBDC or stablecoin system strengthens integrity will depend on the nature of either systems design, and the trustworthiness of the administrator. The following sections expand on this variability with respect to stablecoins.
Stablecoins are unique in that their designs, regardless of whether they are “off-chain”, “on-chain”, or “algorithmic” are standardized and international by design. This means that end-users all over the world have the capacity to transact with stablecoins in the same way. Theoretically, this use of a single template could promote the standardization of KYC information for regulators because all network participants would have to agree to the same terms to access the stablecoin. Moreover, the blockchain base of stablecoin transactions could increase the speed of due diligence by granting regulators access to a shared ledger of information. This could improve the accuracy and consistency of data amongst network participants. However, the success of an international stablecoin system with respect to financial integrity relies on several key assumptions.
First, regulators across jurisdictions must be able to agree on the same KYC/AML/CTF rules to inform the terms and conditions of the stablecoin network. This would be an exceptionally difficult task because of the international collaboration that would be required and because of varying standards across jurisdictions.
Secondly, network participants would have to be able to trust that the administrators of the stablecoin system – i.e., the miners, nodes and external regulatory agencies – will have the capacity to enforce actions against bad actors. Even if regulators had access to immense quantities of information on customer profiles within the stablecoin network, their ability to enforce violations against bad actors would also be contingent on their ability to supervise stablecoin exchanges with other cryptocurrencies. Cryptocurrency wallets and exchanges are designed to empower the individual user to hold their funds independently from financial institutions and transact pseudonymously. Accordingly, for regulators to effectively enforce actions against bad actors who exchange stablecoins with other cryptocurrencies for money laundering or terrorist financing purposes, they would need supervisory powers over all end-points in the cryptocurrency market (i.e., user wallets and exchanges). This could be possible in circumstances where all countries adopt the same regulatory standards; however, an elimination of regulatory arbitrage in areas of AML and CTF is unlikely.
Trust in good governance demands a third assumption; that the organizations who govern the stablecoin network will embrace a social responsibility mandate and be qualified to uphold that mandate in the long term. Contemporary stablecoins are either privately administered, or governed by a community of users. Accordingly, for stablecoins backed by off-chain collateral, users would have to rely on organizations like Tether Limited and Libra Association, to establish all of the appropriate customer protections and due diligence mechanisms. Such users would have to trust these private, profit-seeking organizations, to protect their individual interests and uphold public policy objectives. Alternatively, for stablecoins backed by on-chain collateral, users would have to trust in a decision making process that involves a changing number of unknown parties to establish the appropriate safeguards for ensuring the financial integrity of the stablecoin and their transactions. In the Maker Dai ecosystem, these parties are the MKR token holders, the identities of whom are unknown to network participants.
Ultimately, the implementation of a compliant cross-border stablecoin currency and payment system would require a substantial degree of regulatory collaboration and likely regulatory concessions amongst some states involved. This is distinguishable from CBDC, which is issued by a state authority and may be tailored to the regulations of a particular jurisdiction accordingly.
While there are numerous definitions of financial stability, most of them are common insofar that financial stability is about the absence of system-wide episodes during which the financial system fails to function. A stable financial system is capable of efficiently allocating resources, assessing and managing financial risks and eliminating price volatility.
Stablecoins were first designed to bring financial stability to the crypto market; however, the price stability of a stablecoin is wholly dependent on the volatility of collateral against which the stablecoin is issued. If the collateral backing the stablecoins collapses, users would have to trust the good will of the managers of the money for redemption (or simply accept that they may lose their money) . Regardless of the security of collateral, users need to trust in these managers for all elements related to stablecoin issuance. Managers can be centralized private parties like Tether Limited, an organized group of entities like the Libra Association, or a decentralized network of unidentifiable entities like those who compose the Maker Dai ecosystem. As a precursor to any discussion on financial stability, it is important to highlight this crucial distinction between stablecoin currencies and central bank backed currencies, which comes with the full faith and credit of governments.
With respect to the price stability of off-chain collateralized stablecoins, if we trust in management’s handling of collateral, stablecoins may prove to be as stable as traditional fiat currencies, but more advantageous than such currencies for cross-border payments. Libra, for example, is backed by a collection of low-volatility assets backed by stable and reputable central banks. Furthermore, a network of investment grade credit rating custodians work together to secure a decentralized system for holding these assets. As a result, the Libra stablecoin may offer cryptocurrency related advantages like programmability and efficiency, with the added benefit of traditional institutional arrangements that establish fungibility, high liquidity and low volatility.
Stablecoins backed by on-chain collateral attempt to establish price stability by offering economic incentives that are designed to encourage self-interested user behavior that would be instrumental in sustaining the currency’s peg. One crucial risk for any stablecoin backed by on-chain collateral, is that the underlying collateral is composed of crypto-assets that are highly volatile and not the liability of any institution. Therefore, users must trust that economic incentives remain sufficient to counteract periods of especially high volatility in the underlying crypto-assets. This risk is compounded by the fact that in circumstances where economic incentives are not enough, there is no single identifiable entity to hold accountable for the redemption of lost funds. The difference between stablecoins backed by on-chain collateral and algorithmic stablecoins is that management of token issuance in on-chain systems is through network participants, as opposed to smart contracts responsible for algorithmically expanding or contracting the supply of the stablecoin. Both systems lack an accountable entity. Both rely on economic incentives and highly volatile crypto-asset collateral.
Broadly speaking, monetary policy is the term used to describe the way in which a monetary authority (ex. a central bank, currency board, etc.) governs the supply of money in an economy in order to influence macroeconomic objectives, such as controlling inflation, consumption, growth and liquidity . Monetary authorities achieve these objectives by modifying interest rates, buying or selling bonds, regulating foreign exchange rates, and changing the amount of money banks are required to maintain as reserves.
Stablecoins pose two challenges to setting effective monetary policy. First, as mentioned in the previous section on financial integrity, the managers of the currency are private entities and unidentifiable networks of users, all of which are arguably less suited to set effective monetary policy. Second, stablecoins are global in nature; supply cannot be controlled to meet state-specific needs.
With respect to management, private issuers, like Tether Limited, are profit seeking, and inherently less inclined to behave in a socially responsible manner in times of crisis. Such entities are less likely to internalize the social cost of systemic disruptions from cyberattacks or negligence, and thus may not adequately invest in security. Moreover, payment systems tend to become natural monopolies; accordingly, some have noted that private monopolistic providers are more likely to offer inadequate and expensive services, and could take unfair advantage of end-user data. Unidentifiable networks of stablecoin managers may lack the sophistication needed to implement effective monetary policy objectives. Moreover, the entities that compose the community of managers (ex. the MKR holders in the Maker Dai system) may have different goals for the future of the technology, which may result in network “forks” that establish competing versions of the same currency. It is important to note that the value of stablecoins as money (i.e., a medium of exchange, store of value and unit of account) is contingent on societies’ trust in their efficacy. Such efficacy is challenged by the community governance model, where differences in opinion amongst managers could result in the sudden demise of the stablecoin, or at the very least, a substantial split in the networks community of users. A split in the community of users also challenges efficacy because less end-users will be willing to trust one of the versions of the stablecoin after a fork.
With respect to the global nature of stablecoins, their rise may result in smaller economies losing control of their economy. A liquid, stable, cryptocurrency could be so attractive to end-users in developing economies that they would trade out of their local currencies. Under such circumstances, some have argued that governments in these developing countries would effectively lose their ability to control monetary supply, the local means of exchange, and their ability to impose capital controls. A weakened ability to set effective monetary policy by jurisdiction could destabilize the very foundation of government in emerging economies.
It is important to note that this review explores stablecoins as a replacement for traditional currency and payment systems or prospective government issued alternatives like CBDC. Moreover, the efficacy of stablecoins will depend largely on the technological and governance architecture of the stablecoin system. Important advances in privacy centric technology, interoperability, and regulation, including standardization, are all variables, amongst others, that may alter this review. Accordingly, the transmute nature of this space, and the fragmented regulatory regime in which it operates can impact organizations in a variety of ways. If you are currently operating in this space it is important that you consult a technologically sophisticated legal team that is positioned to take a coordinated global approach to helping you navigate these issues.
For more information, please contact Tracy Molino and Noah Walters.
- Tommaso Mancini-Griffoli et al, “Casting Light on Central Bank Digital Currency” (2018) IMF Staff Discussion Note.↩
- Ibid at 10.↩
- Ibid at 11.↩
- The World Bank, “Financial Stability”, Global Financial Development Report.↩
- Ibid. ↩
- More on this in the following section on monetary policy.↩
- Marco Del-Erba, “Stablecoins in Cryptoeconomics. From Initial Coin Offerings (ICOs) to Central Bank Digital Currencies (CBDCs)” (2019) New York University Journal of Legislation and Public Policy. ↩
- Kirill Bryanov, “Breaking the Peg: Every Stablecoin has its Points of Failure” (2018). ↩
- Jim Chappelow, “Monetary Policy” (2019)↩
- Casting Light on Central Bank Digital Currency supra note 53 at 19.↩
- Matthew De Silva, "What could possibly go wrong with Facebook’s Libra?" (2019)↩