Stabilising the unstable stablecoins
Stablecoins are in vogue, for good and bad reason. On the bright side, by being backed one-for one with hard currencies or near-money safe assets, at least allegedly, stablecoins hold the promise of functioning as privately produced money that could facilitate digital trade on distributed ledger technology (DLT) platform in the future.
To see this, one must recognise an important property that defines the acceptance of a money: no-questions-asked (NQA) principle.
Coined by Bengt Holmström, the 2016 Nobel Economics Prize winner, NQA means no due diligence is needed on the value of money used in a transaction. All parties to a transaction accept the money at par – a one-hundred-ringgit note means RM100, not a cent less.
The implication is enormous: banks will not put your transaction on hold to verify the value of your money when you wave your card to pay for a meal. Neither will the cashier waste time for physical verification if currency notes were presented. Just imagine how messily inefficient the payment system will be if otherwise occurred.
NQA also means no delay when it comes to redemption and convertibility. All banks shall do in the face of deposit withdrawals, for instance, is to let it be. Likewise, no parties to a transaction would question an exchange of a RM100 note for two RM50 notes or ten RM10 notes upon request.
For fiat currency, the trust is grounded upon central bank’s monopoly in currency notes issuance. For bank money, the trust is sealed by deposit insurance and access to central bank reserves.
Which brings me back to the viability of stablecoins as privately issued money. By what the trust on stablecoins can be underpinned? So far not much, other than the collateral in the form of cash and cash equivalents proportional to the stablecoins minted.
Tether, for instance, describes that “Every Tether token is always 100% backed by reserves, which include traditional currency and cash equivalents. Every Tether token is also 1-to-1 pegged to the dollar, so 1 USDT is always valued by Tether at 1 USD.”
Leaving aside the fact that Tether has been sued and fined $18.5 million for lying about its backing assets – less than 7% of its tokens were backed by cash and cash equivalents, the inner logic of a collateralised token is deeply flawed.
Now suppose the token is genuinely 100 percent tied up in perfectly safe and liquid assets. That simply means stablecoins are equivalent to but no better than cash. If so, what it is for to privately create a digital token, while the job can be carried out equally well by riskless central bank money?
But if the token is not fully backed by near-money safe assets, tokens become non-fungible, as the same tokens embody different intrinsic values when the collateralised assets are varying. Then the token users would need to consider whether to accept the token at face value in each transaction. After all, your $1 stablecoin is not worthy of my $1 stablecoin.
In this context, NQA principle is violated. Stablecoins are always vulnerable to runs, and therefore hard to use in transactions.
There is a family resemblance between the Free Banking Era of the 19th century in the United States and stablecoins. By passing the Free Banking Law first in Michigan in 1837 and last in Pennsylvania in 1860, more than a dozen of states changed the way banks were operated – anyone could just open a bank, but with a rule – banks had to back their note issuance one-for-one with state bonds.
Guess what? Bank notes were not economically efficient then as there was constant argument over the value of notes in transactions. NQA principle was broken. And there won’t be a functioning money when there is no NQA.
Later in 1863 the National Bank Act was passed. National banks that could issue national bank notes were established. Privately issued bank notes were penalised out of existence, giving way to national bank notes that ended of the free banking era.
If history is any guide, the parallelity is clear: stablecoins are likely to be replaced by the coming central bank digital currencies that can also circulate on a DLT platform. No privately produced monies, however collateralised, can be as good as a properly run central bank monies.
Unless central bank digital currencies are designed for use only among financial intermediaries. Then other private digital monies like stablecoins can co-exist to serve the wider economy on retail front. But to transform stablecoins into the equivalent public money, the one-to-one peg to national central bank digital coins must be backed by central bank reserves. Stablecoins cannot become a stable money until this occurs.
By leveraging the prevailing well-functioning banking and payment system, another option is to tokenise the bank deposits. These tokens would represent a claim on the bank, just as a debit card holder drawing on her saving deposits does. Tokens are then backed by deposits, which, in turn, are backed fractionally by central bank reserves and deposit insurance. As such, fungibility is restored, and NQA principle is naturally effectuated.
While stablecoins in its current form are inherently unstable, we certainly don’t want to throw baby out with bathwater by putting more nails in stablecoins’ coffin. But rather, if we believe that digital exchanges enabled by DLT platform are here to stay and proliferate in the future, sorting out a viable form for privately produced money that can be used to grease the wheel of digital exchanges is a more productive way out.