Stablecoins Are Private Money. That’s Why They’re a Risk to the Economy.
Financial innovations often lead to upheaval and instability. Despite new regulations, those risks persist with stablecoins.
By Greg Ip
The Circle stablecoin USDC is pegged to the U.S. dollar. Richard B. Levine/Levine Roberts/ZUMA Press“Private money” sounds like an oxymoron.
Surely the currency on which our economy runs is the epitome of a public good?
In fact, the U.S. has had private money before, in the 1800s.
And private money is now making a comeback, in the form of stablecoins: cryptocurrencies intended to maintain a fixed value against the dollar.
To proponents, stablecoins are crypto’s killer app.
They will make payments faster and more efficient, especially across borders, than the legacy banking system makes possible.
With that promise, though, comes the risk that this could lead to a financial crisis, much like some past experiments with private money.
Both the Genius Act, signed into law last year, and the Clarity Act now making its way through the Senate, aim to make stablecoins safer and more mainstream.
But no legislation can fully remove risk that is intrinsic to the design of stablecoins.
Stablecoin issuers and affiliated platforms are private enterprises driven to increase usage and profit via the assets they hold to back their coins, the “rewards” they pay to users, and the sorts of activity they tolerate.
Of course, profit and risk-taking are core to how all innovation happens, and that’s a good thing.
In finance, though, innovation routinely leads to excesses that can lead to a sudden loss of confidence, runs and contagion that spills over to the broader economy.
What is money?
Money serves several purposes: a store of value, a unit in which to price transactions, and a medium to carry out those transactions.
U.S. dollars meet all these criteria.
Today, the Federal Reserve controls the issuance of dollars.
But nothing bars private actors from trying to create their own versions of money.
Crypto long aspired to be just that.
But the first cryptocurrencies such as bitcoin weren’t backed by anything, and thus their value fluctuated wildly.
Stablecoins back themselves with tangible assets such as Treasury bills that can be sold to redeem coins one for one for dollars.
CoinMarketCap puts stablecoins outstanding at roughly $300 billion, led by Tether ($190 billion) and Circle ($76 billion).
Stablecoins promised the best of both public and private money: as interchangeable and reliable as dollars but, thanks to the blockchain, faster and cheaper than the dollar-based banking system.
But that promise embodies a contradiction.
“Stablecoins attempt to import credibility from public money while operating outside the established settlement system,” Pablo Hernández de Cos, general manager of the Bank for International Settlements, noted in a recent speech.
An essential quality of money is “singleness,” meaning a dollar must always equal a dollar no matter when, where or with whom it is used.
Bank deposits are a form of private money, but because banks can borrow from the Federal Reserve to redeem deposits, and dollars move between banks via the Fed, their dollars exhibit singleness.
By contrast stablecoins move through proprietary, fragmented infrastructures.
They don’t exhibit singleness.
Though coins issued by Tether and Circle are intended to stay fixed to the U.S. dollar, they often deviate from that value, albeit usually by tiny amounts.
Unlike the Fed, stablecoins seek to make a profit.
One way is by expanding usage, such as by paying interest, as bank deposits do.
The Clarity Act would prohibit payment of deposit-like interest, but permit rewards based on usage.
Historically, crypto has pushed the legal envelope, and may design rewards to mimic interest without violating the law.
“I don’t see any reason they’d completely change their tactics and become conservative about interpreting the law when that has not been the pattern thus far,” said Molly White, who writes the Citation Needed newsletter on crypto and technology policy.
Stablecoins also have an incentive to “reach for yield,” that is to back their coins with slightly riskier or less liquid assets with higher returns.
But if those assets’ value declines, stablecoins may not be able to maintain par value.
Holders could rush to sell or redeem, triggering forced sales of the assets and spillover to other markets, even banks.
Last year’s Genius Act requires stablecoins that cater to Americans be backed with safe, liquid assets such as treasury bills and bank deposits.
But Fed governor Michael Barr noted last year the law has loopholes.
The bank deposits may be uninsured.
The law allows stablecoins to receive money, including foreign money, through “repo” loans, and that could include bitcoin, which El Salvador recognizes as money, Barr noted.
And the law doesn’t cover coins that operate outside the U.S. such as Tether’s main coin, dubbed USDT, though Tether has launched a compliant U.S. coin, USAT.
We’ve been here before
During the free banking era from 1837 to 1863, banks could issue their own currency. But the system was inefficient, with currency values that fluctuated against each other.
Illustration of Wall Street bustling with people and a church steeple in the background after the financial panic of 1857.
“All states maintained a range of requirements for banks to collateralize their notes, but many proved ineffective; fraud was widespread, and the system was fragmented—banknotes of one bank were often not accepted by other banks outside the local area; bank failures were widespread,” the Andersen Institute for Finance and Economics writes in a report on stablecoins.
Nonbanks, such as railroad companies, issued their own currency.
Money-market funds are a type of private money, promising to redeem shares at a dollar each, on demand.
But during the global financial crisis, one fund couldn’t honor that value—it “broke the buck”—because it held devalued assets.
A broader panic ensued.
Those cases showed how a loss of confidence can cause the volume of private money to contract, amplifying economic stress. Fabio Natalucci, chief executive of the Andersen Institute, notes that is the opposite of public money, which is “elastic”: The Fed expands its supply at times of stress.
Stablecoins are here to stay
Stablecoins are a natural evolution of payments technology, so it makes sense to find a way to integrate them into the economy.
That’s what the Genius and Clarity acts attempt to do, which stablecoin advocates hope will encourage adoption.
That really hasn’t panned out yet, though. Japan boasts a “carefully designed regulatory framework” for crypto, but yen-based stablecoins’ market cap is less than 0.01% of dollar coins’, Hernández de Cos noted.
The vast majority of stablecoins are linked to the dollar, and those are largely held outside the U.S., often as a means of skirting laws or capital controls.
Stablecoins account for 84% of illicit crypto activity such as sanctions evasion and money laundering, according to Chainalysis.
Trading crypto remains the primary use of stablecoins.
Today, less than 1% of stablecoin usage is for real-economy payments, a Kansas City Fed study concluded.
Meanwhile, banks are beginning to offer an alternative: “tokenized deposits,” which they think offer the “singleness” of dollars with the benefits of the blockchain.
Banks, of course, have caused their share of crises, which is why over time they became so tightly regulated and integrated with the Fed.
Stablecoins may have to follow the same path.
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