Stablecoins, a fast-growing subset of cryptocurrencies, may not be as stable as their issuers advertise. By pegging their value to some other asset, like a fiat currency or exchange-traded commodity, stablecoins are designed to minimize the large fluctuations experienced by popular cryptocurrencies like Bitcoin and Ether. However, this rising class of digital money, which includes Facebook Inc.’s (FB) Libra, lacks access to short-term liquidity facilities common in traditional banking and other payment systems, according to a recent story in Bloomberg.
“Stablecoins, and Libra in particular, have the potential to grow substantially and ultimately shoulder a significant fraction of global transactional activity,” analysts at JPMorgan Chase & Co. wrote in a note to clients. “However, as currently designed and proposed, they do not take into account the microstructure of operating such a payment system. The risk of payment system gridlock, particularly during periods of stress, could have serious macroeconomic consequences.”
The risks are not lost on regulators as authorities across the globe have sounded alarm bells over Libra and other cryptocurrencies. On Monday, Libra Association members met with officials from 26 central banks, according to a Financial Times report. EU Commission vice president Valdis Dombrovski recently expressed concerns over financial stability that Libra poses while the Trump administration has raised concerns of national security. Yesterday, ECB board member Benoit Coeure said, “They give rise to a number of serious risks related to public policy priorities. The bar for regulatory approval will be high,” according to Reuters. French Finance Minister Bruno Le Maire recently stated, “I’m deeply convinced that we should refuse the development of Libra within the EU.”
David Marcus, Libra's co-creator, took to Twitter to allay worries. "Recently there's been a lot of talk about how Libra could threaten the sovereignty of nations when it comes to money. I wanted to take the opportunity to debunk that notion," he wrote. "As such there's no new money creation, which will strictly remain the province of sovereign nations."
- Stablecoins may not be so stable in times of stress.
- Regulators concerned about financial stability and national security.
- Stablecoins are private money not unlike bank deposits.
- Issuers could suffer from low liquidity in times of stress.
- Income from reserve collateral difficult in negative-interest environment.
What It Means for Investors
Barring the glitz and glam that comes with being a high-tech cryptocurrency, stablecoins are not unlike what traditional banks do when they issue demand deposits to their customers. Demand deposits are a form of private money that banks promise to redeem on demand and at par with the nation’s fiat currency. Issuers of stablecoins offer the same kind of promise by pegging the value of their coin to that of a fiat currency or other specified asset. The announced peg is their promise to redeem their coins for the amount of the other asset specified by the peg.
Whether or not issuers of stablecoins can keep that promise is another question. Traditional banks don’t back their deposits one-to-one with fiat currency. At a minimum, it’s more like ten-to-one, as stipulated by regulatory reserve requirements.The other 90% of deposits are backed by assets like treasury securities and other types of debt securities, which generally pay interest at a higher rate than that paid by banks on their deposits. Interest income is one of the sources of a bank’s profits.
Tether, one of the more popular stablecoins that accounts for about 94% of total stablecoin transaction volume, used to claim that every tether coin was always backed one-to-one by traditional currency held in reserve. However, an update to Tether's website earlier this year indicated that was no longer the case. Tether now claims that, while its digital coins are always backed 100% by reserves, those reserves may include assets other than traditional currency and cash equivalents. No big deal, Tether is just acting more like a traditional bank now.
But while chartered banks don’t usually have problems meeting their customers’ demand for deposit redemption in normal times, in times of heightened stress they often need to rely on a lender of last resort—the nation’s central bank. Tether does not have a bank charter and it’s unclear if it has some private backer willing to act as its lender of last resort in times of trouble. Neither does Facebook’s Libra, the white paper of which indicates that it will be backed by “A basket of bank deposits and short-term government securities.” The social-media giant now also wants to be a bank.
While bank deposits and short-term government securities are relatively safe and liquid assets that Facebook may still be able to exchange for cash without relying on a lender of last resort, the company could face a different sort of problem in a world of ultra-low and even negative interest rates. Facebook expects to use the income from its reserve assets to pay for maintaining the network and reward association members. But it’s hard to do that when yields on many of the safest government securities are negative.
“Any system that relies on reserve-asset income to fund operational and other ongoing costs becomes unstable in a negative yield world,” said JPMorgan’s analysts. “With more than half of high-quality short-term sovereign debt already negative, the vast majority of the remainder made up of U.S. government securities, and trends pointing towards global monetary easing, a fully negative yielding Libra reserve has become a plausible (some would argue likely) risk.”
For all the hype surrounding cryptocurrencies in recent years, it’s unclear that the technological innovations associated with them have really solved the problems associated with traditional banking and monetary systems. It’s not even clear whether the innovators behind cryptocurrencies really understand what those problems are, but of course, the financial crisis revealed that a lot of traditional bankers didn’t either.