Technology is driving rapid change in the way we make payments and in the concept of “money.” There is a long history of technological advances challenging the prevailing notions of money, from the trading of coins to the use of paper currency, to the electronic debiting and crediting of funds on the accounts of banks. Today, efforts by global stable coin networks such as Facebook’s Libra to establish the next chapter in the story of money are raising threshold questions about legal and regulatory safeguards, financial stability, and monetary policy. Because of its potential global reach, Facebook’s Libra imparts urgency to the debate over what form money can take, who or what can issue it, and how payments can be recorded and settled.
A battle is raging for your wallet. New entrants want to occupy the space once used by paper bills or your debit card. The adoption of new, digital payment methods could bring significant benefits to customers and society: improved efficiency, greater competition, broader financial inclusion, and more innovation. The coronavirus pandemic and its severe social, political and economic repercussions give digital currencies one more chance to shine. Unlike cash, digital currencies would not be a potential source of virus transmission or require persons to overlook social distancing when making payments. A central-bank digital currency (CBDC) available to the public could, moreover, allow the government to send money directly to the population as part of a stimulus plan without having to mail checks.
Stable coin Adoption:
Adoption of new forms of money will depend on their attractiveness as a store of value and a means of payment. New entrants like Stable coins, however, are significantly different from the popular incumbents: cash or bank deposits. While many Stable coins continue to be claims on the issuing institution or its underlying assets, and many also offer redemption guarantees at face value, government-backing is absent. Trust must be generated privately by backing coin issuance with safe and liquid assets. And the settlement technology is usually decentralized, based on the Block chain model.
Times are changing. USD Coin recently launched in 85 countries, Facebook announced Libra, and centralized variants of the stable coin business model are becoming widespread. The strength of stable coins is their attractiveness as a means of payment. Low costs, global reach, and speed are all huge potential benefits. Moreover, stable coins could allow seamless payments of block chain-based assets, and can be embedded into digital applications thanks to their open architecture, as opposed to the proprietary legacy systems of banks.
But the strongest attraction comes from the networks that promise to make transacting as easy as using social media. Payments are more than the mere act of transferring money. They are a fundamentally social experience linking people. Stable coins offer the potential for better integration into our digital lives and are designed by firms that thrive on user-centric design. Large technology firms with enormous global user bases offer a ready-made network over which new payment services can quickly spread.
Risks of Stable Coins:
Risks abound, however so policymakers must create an environment that maximizes benefits and minimizes risks. Policymakers will need to innovate and collaborate across countries, but also across functions. Here are six observations for them to consider.
First, banks may lose their place as intermediaries if they lose deposits to stable coin providers. Banks will surely try to compete by offering their own innovations. Also, stable coin providers could recycle their funds into the banking system, or decide to engage in lending by extending deposits themselves. In short, banks are unlikely to disappear.
Second, new monopolies could arise. Tech giants could use their networks to shut out competitors and monetize information, using proprietary access to data on customer transactions. New standards are needed for data protection, portability, control, and ownership. And services need to be interoperable to facilitate entry.
Third, weaker currencies could face threats. In countries with high inflation and weak institutions, local currencies might be shunned in favor of stable coins in foreign currency. This would be a new form of “dollarization” and might undermine monetary policy, financial development, and economic growth. As countries are forced to improve their monetary and fiscal policies, they will have to decide whether to restrict foreign-currency stable coins.
Fourth, stable coins could promote illicit activities. Providers must show how they will prevent the use of their networks for activities like money laundering and terrorist financing by enforcing international standards. New technologies offer opportunities to improve monitoring, however supervisors will need to adapt to the more fragmented and geographically diverse value chain of stable coins.
Fifth, stable coins could provoke the loss of “seigniorage,” where central banks capture profits from the difference between a currency’s face value and its manufacturing cost. Issuers could siphon off profits if their stable coins do not carry interest but if the hard currency backing them earns a return. One way to address this issue is to promote competition so issuers of coins would eventually pay interest.
Sixth, policymakers must reinforce consumer protection and financial stability. Customer funds must be safe and protected from bank runs. This calls for legal clarity on what kind of financial instruments stable coins represent. One approach would be to regulate stable coins like money market funds that guarantee fixed nominal returns, requiring providers to maintain sufficient liquidity and capital.
Stable coins thus present as many conundrums as they do potential benefits and policymakers would be wise to envision far-sighted regulatory regimes that will meet the challenge.
The Regulatory imperative:
Stable coin providers must privately generate trust in their liabilities the very coins they issue. Many do so by backing coins one-for-one with assets of the same denomination. So, if a stable coin owner wanted to redeem her 10-euro coin for a 10 euro note, the stable coin provider could sell the assets for cash to be pay out on the spot. Much depends on the safety and liquidity of the underlying assets, and on whether they fully back the coins in circulation. It also depends on whether assets are protected from other creditors if the stable coin provider goes bankrupt.
Regulation must eliminate these risks. One option is to require that stable coin providers hold safe and liquid assets, as well as sufficient equity to protect coin-holders from losses. In essence, the call would be to regulate stable coin providers despite them not being traditional banks; not an easy task we have found out.
Central bank Backing:
Another approach is to require stable coin providers to fully back coins with central bank reserves the safest and most liquid assets available. The solution is not innovative. The People’s Bank of China, for instance, requires giant payment providers Ali Pay and WeChat Pay to do so, and central banks around the world are considering giving fintech companies access to their reserves though only after satisfying a number of requirements related to anti-money laundering, connectivity between different coin platforms, security, and data protection among others.
Clearly, doing so would enhance the attractiveness of stable coins as a store of value. It would essentially transform stable coin providers into narrow banks institutions that do not lend, but only hold central bank reserves. Competition with commercial banks for customer deposits would grow stronger, raising questions about the social price tag.
But there are also clearer-cut advantages. Chief among these is stability, as backing is in perfectly safe and liquid assets. Another is regulatory clarity, as narrow banks would fit neatly into existing regulatory frameworks. Moreover, different stable coins could be seamlessly exchanged thanks to the central bank settling all transactions. This would enhance competition among stable coin providers. Additional benefits include support for domestic payment solutions in the face of foreign-currency stable coins offered by monopolies that are hard to regulate; and better monetary policy transmission if pressure on currency substitution were alleviated, and interest rates were paid on reserves held by stable coin providers however distant the prospect.
A Central bank Digital Currency?
If stable coin providers held client assets at the central bank, clients would indirectly be able to hold, and transact in, central bank liabilities the essence, after all, of a “central bank digital currency.” In practice, the coins would remain the liability of private issuers, and client assets would have to be protected against the bankruptcy of the stable coin provider.
In the CBDCs model, which is a public-private partnership, central banks would focus on their core function: providing trust and efficiency. The private sector, as providers of stable coins, would be left to satisfy the remaining steps under appropriate supervision and oversight, and to do what they do best: innovate and interact with customers.
Whether central banks jump on board at all is another matter. Each central bank would weigh the pros and cons related to payment system stability, financial inclusion, and cost efficiency as discussed in a recent IMF staff paper. To the extent that central banks wish to offer a digital alternative to cash, they should consider CBDC as a potentially attractive option. Will CBDC turn out to be the central-bank money of the future? One thing is sure: the world of fiat money is in flux, and innovation will transform the landscape of banking and money. You can bet your bottom dollar on it.