stablecoin paradox

Written by: Eswar Prasad, Professor of Economics at Cornell University

Compiled by: Eric, Foresight News

The early revolutionaries of cryptocurrency aimed to break the monopoly of central banks and large commercial lending institutions on financial intermediaries. The grand goal of the original cryptocurrency, Bitcoin, and the blockchain technology behind it, is to bypass intermediaries and connect both parties in a transaction directly.

This technology aims to achieve financial democratization, allowing everyone, regardless of wealth, to easily access a wide range of banking and financial services. Emerging financial institutions will leverage this technology to offer competitive financial services—including customized savings, credit, and risk management products—without the need to establish costly physical branches. All of this is intended to eliminate the old financial institutions that lost public trust during the global financial crisis and to establish a new financial order. In this new world of decentralized finance, competition and innovation will thrive. Both consumers and businesses will benefit.

But this revolution was soon overturned. Decentralized crypto assets like Bitcoin are essentially created and managed by computer algorithms, and it has proven that they are not feasible as a medium of exchange. Their value fluctuates wildly, and they cannot process a large number of transactions at low cost, making them unsuitable for everyday use and leading to their failure to achieve the intended goals. Instead, Bitcoin and other crypto assets ultimately became what they were never meant to be – speculative financial assets.

The emergence of stablecoins has filled this gap, becoming a more reliable medium of exchange. They use the same blockchain technology as Bitcoin but maintain value stability by being pegged 1:1 to central bank currency reserves or government bonds.

Stablecoins have facilitated the development of decentralized finance, but they are in direct opposition to decentralization themselves. They do not rely on decentralized trust mediated by computer code, but rather on trust in the issuing institution. Their governance is also not decentralized; users do not determine the rules through public consensus. Instead, the issuing institution of the stablecoin decides who can use it and how it can be used. Stablecoin transactions, like Bitcoin, are recorded in a digital ledger maintained by a decentralized network of computer nodes. However, unlike Bitcoin, the verification of these transactions is done by the stablecoin issuing institution, not by computer algorithms.

Payment channel

Perhaps more ambitious goals are more important. Stablecoins can still serve as a channel for people from all income levels to access digital payments and DeFi, weakening the privileges that traditional commercial banks have enjoyed for a long time and narrowing the gap between wealthy and poor countries in some respects. Even small countries can benefit by accessing the global financial system more easily and reducing friction with payment systems.

Stablecoins do indeed reduce payment costs and minimize payment friction, especially in cross-border payments. Economic migrants can remit money to their hometowns more conveniently and economically than ever before. Importers and exporters can complete transactions with foreign entities instantly, without having to wait for days.

However, apart from payments, DeFi has become a stage for financial engineering, giving rise to many complex products whose value is questionable beyond speculation. DeFi activities have hardly improved the lives of impoverished families and may even harm the interests of retail investors who are tempted by high returns and ignore risks due to lack of experience.

Regulatory Transition

The recent legislation in the United States allowing various companies to issue their own stablecoins, can it promote competition and curb some disreputable issuing institutions? In 2019, Meta attempted to issue its own stablecoin Libra (later renamed Diem). However, due to strong opposition from financial regulators, the project was ultimately halted. Regulators are concerned that such stablecoins could undermine the effectiveness of central bank currencies.

With the shift in the regulatory environment in Washington and the new government taking a friendly stance towards cryptocurrencies, the door has been opened for private stablecoin issuers. Stablecoins issued by large U.S. companies like Amazon and Meta, backed by their strong balance sheets, may sweep away other issuers. The issuance of stablecoins will enhance the power of these companies, leading to increased market concentration rather than intensified competition.

Large commercial banks are also adopting some new technologies to improve operational efficiency and expand their business scope. For example, converting bank deposits into digital tokens that can be traded on the blockchain. It is foreseeable that large banks may issue their own stablecoins one day in the future. All of this will undermine the advantages of small banks (such as regional and community lending institutions) and consolidate the power of large banks.

International dominance

Stablecoins may also reinforce the existing structure of the international monetary system. The demand for dollar-backed stablecoins is the highest and they are the most widely used globally. They may ultimately indirectly enhance the dominance of the dollar in the global payment system and weaken potential competitors. For instance, Circle, the issuer of the second most popular stablecoin USDC, has very low demand for other stablecoins it issues that are pegged to major currencies like the euro and yen.

Even major central banks are feeling uneasy. There are concerns that dollar-backed stablecoins may be used for cross-border payments, prompting the European Central Bank to issue a digital euro. The payment systems within the eurozone remain fragmented. While it is possible to transfer money from a bank account in Greece to a bank account in Germany, it is still not convenient enough to make payments in another eurozone country using funds from bank accounts in other eurozone countries.

Stablecoins pose a survival threat to the monetary composition of small economies. In some developing countries, people may trust stablecoins issued by well-known companies like Amazon and Meta more than their local currencies, which suffer from high inflation and exchange rate volatility. Even in economies with reliable central banks and sound management, people may find it hard to resist the allure of stablecoins, as they are convenient for domestic payments and international payments alike, and their value is tied to major global currencies.

Inefficiency of traditional payment systems

Why have stablecoins gained such significant attention so quickly? One reason is that high costs, slow processing speeds, complex processes, and other inefficiencies continue to plague international payment systems as well as domestic payment systems in many countries. Some countries are considering issuing their own stablecoins to prevent their national currencies from being marginalized by dollar-backed stablecoins. However, this approach is unlikely to succeed. It would be better for them to first address issues within their domestic payment systems and collaborate with other countries to eliminate friction in international payments.

Stablecoins seem safe but actually hide many risks. Firstly, they may facilitate illegal financial activities, making it harder to combat money laundering and terrorism financing. Secondly, they create independently managed payment systems by private companies, thus threatening the integrity of payment systems.

Solution

The solution seems obvious: effective regulation can reduce risks, allow room for financial innovation, and ensure fair competition by curbing the excessive concentration of economic power in a few companies. The internet knows no borders, so the effect of regulating stablecoins at the national level is far less effective than a collaborative model involving multiple countries.

Unfortunately, in a context where international cooperation is lacking and countries are actively maintaining and promoting their own interests, such a result is unlikely to be achieved. Even major economies like the United States and the Eurozone are acting independently on the issue of cryptocurrency regulation. Even with a more coordinated approach, smaller economies find it difficult to participate in decision-making. These countries have weak financial systems, limited regulatory capabilities, and high hopes for a sound regulatory framework; they may be forced to accept rules imposed by major powers that hardly take their own interests into account.

The role of stablecoins is to reveal the inefficiencies that are prevalent in the existing financial system and to demonstrate how innovative technologies can address these issues. However, stablecoins may also lead to greater concentration of power. This could give rise to a new financial order—not one that is filled with innovation and competition, and where the distribution of financial power is fairer as envisioned by cryptocurrency pioneers, but rather one that may bring about greater instability.