Stablecoins are here to stay and regulators, far from burying their heads in the sand, are taking on the new challenge they present. Rules on how stablecoin issuers conduct their business are a necessary component of a stable financial ecosystem in which these instruments play a role. But what is driving the formation of these rules?
When seeking to protect financial stability from the new threats stablecoins present, there are two scenarios that concern central banks. First, rapid redemptions of stablecoins would require the issuer to quickly dispose of reserve assets, causing a slump in the price of these assets (or the funding liquidity of deposit takers) and risking contagion. The second scenario is the possibility that the increasing popularity of stablecoins will cause banks to lose deposits.
Protecting banks from rapid runs is part of regulators’ responsibilities. Runs on solvent and viable banks are a market failure and, as such, financial stability policy should be calibrated to reduce their likelihood.
But does a structural migration of deposits away from banks into a new product – for example, stablecoins – necessarily represent a risk to financial stability? It should not present per se a crisis for bank funding.
Banks have a variety of sources of financing and can lean on capital markets to ensure that they have the requisite capital to create credit and keep the economy running. Even if funding costs of banks increased, a necessary condition for regulatory intervention is a market failure. It would need to be associated with some positive externalities of banking, which would be lost if deposits migrate to narrow balance-sheet issuers of money, such as Tether or USDC.
Making stablecoins less attractive won’t solve the issue
Most regulators seem to see it as their obligation to ensure that stablecoins are structured to be less attractive than bank deposits. The evidence for this is clear: major stablecoin regimes from many jurisdictions prohibit the paying of interest. Since stablecoins are not remunerated, this prevents them from competing with bank deposits.
Moreover, regulatory measures to protect bank deposits should not be based on the attempt to prevent stablecoins from being safe and trustworthy. Neither should they create new cyclicality and unintended instability of funding liquidity.
Banning remuneration for stablecoin holders leads to the attractiveness of stablecoins versus bank deposits fluctuating with the interest rate. This means that both stablecoins and banks face fluctuating demand, rather than stability. News on the interest rate path becomes big news on the competitiveness and business models of stablecoins – relative to banking. And as the history of liquidity crises tells us, even small news can trigger big, self-fulfilling flows of funds.
There is another explanation for the prevalence of the ban on remunerated stablecoins. In the same way as they did for central bank digital currencies, banks effectively lobbied regulators that remuneration of a new monetary instrument would compromise their business models.
It may be the case that the link between deposits and banking is uniquely valuable. If it is, then central banks should say so and provide evidence, because insisting that stablecoin holders do not receive interest on their holdings does not make stablecoins safer or less likely to be the destination of acute deposit flight in the event of bank distress.
An alternative approach
Contrast this with an approach where stablecoin issuers are able to earn interest on reserves held at the central bank. First, this would mean that stablecoins were backed by the safest possible asset. Second, it would give the central bank a means of controlling the relative attractiveness of stablecoins versus bank deposits and limiting the likelihood of runs. Rapid inflows above a certain size could be negatively remunerated, limiting the amount of value stablecoin issuers are able to pass on to holders and thereby rendering them less attractive.
Remuneration of stablecoins’ deposits with the central bank should however be lower than the one obtained by banks for four reasons. The first is the need for general initial prudence towards this new form of settlement asset. Second is the negative externalities from the use of stablecoins for illicit payments (applying only to stablecoins circulating on pseudonymous public blockchain networks and awaiting the achievement of a regulatory level-playing field with the banking system).
The third reason is to protect the positive externalities of banking for society (which eventually require further proof). And fourth is because a part of the seignorage income generated by stablecoins would come from their safety, resulting from their full backing in central bank money, i.e. the possible perception that they are substitutes for central bank money. A part of the seignorage income that stablecoins generate should thus be owned by central banks.
The spread between the remuneration of banks´ deposits with the central bank and those of stablecoins would summarise the views on these four points. This kind of framework both ensures the maximum safety of stablecoins and gives regulators a tool to address market failures.
The alternative to this would be a laissez-faire approach that only imposes strict capital and liquidity requirements on stablecoin issuers (which should be done in any case). Imposing zero remuneration is counterintuitive and destabilising because of the unintended dependence of its effects on the level of interest rates.
Ulrich Bindseil was Director General, Market Infrastructure and Payment Systems at the European Central Bank. Lewis McLellan is Head of Content, Digital Monetary Institute, OMFIF.
This commentary expands on ideas discussed in a recent paper published by Ulrich Bindseil available here.
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