The only good stablecoin is a central bank one
Central bank digital currency development must hurry up to contain the risks stablecoins pose
The volatility in the stablecoin market over the last week has highlighted the need for secure digital currency alternatives, with central bank digital currency (CBDC) best placed to fill the gap. But with major CBDCs still only in gestation, central banks must expedite their development if they want to avoid stablecoin instability shocking the wider market.
Stablecoins are a type of cryptocurrency designed to allow investors to switch between coins with ease while never leaving confines of the crypto market. Unlike traditional cryptocurrencies, stablecoins are pegged to another asset, in most cases the dollar.
However, this sort of asset is easily afflicted by the constantly fluctuating cryptocurrency market, with the recent rout in the sector wiping out billions and destabilising these so-called stablecoins.
Despite what crypto fanatics might claim, a stablecoin is no substitute for conventional cash deposits. “There is no guarantee that [stablecoins] can be redeemed at par at any time,” said ECB executive board member Fabio Panetta in a speech on Monday. They “do not benefit from deposit insurance, nor do they have access to central bank standing facilities. They are therefore vulnerable to runs.”
A CBDC is is a stable alternative however — a digital asset issued by a central bank, which sits between stablecoins and hard currency. Although many central banks are researching the topic, only a few have so far made it to the market, with those issued by major central banks unlikely to launch until the latter half of the decade.
The algorithmically backed stablecoin Terra exposed huge cracks in the cryptocurrency market last week as it dipped below $1. Instead of using real world assets, like cash or short-dated debt, Terra is traded against the more conventional Luna coin, with the hope that this would keep Terra close to parity with the dollar.
But when Terra broke the buck on May 9, it triggered a sharp increase in the supply of the corresponding coin, cratering the value of both.
On Tuesday, one Terra stablecoin was worth $0.12, with many exchanges choosing to delist the asset. Luna was down at $0.0002083, having traded above $110 as recently as last month.
Of course, Terra is not alone. Tether, the largest stablecoin by market capitalisation, briefly dropped to $0.9514 on Thursday, before rising back to $1.
Unlike Terra, Tether is backed by real world assets, which it claims help it to maintain its peg to the dollar. However, only a small part of this collateral is cash, just under 5%, according to its December 31 disclosure report.
On Tuesday, Tether’s market cap sat at $75.7bn, suggesting that just over $3.8bn is backed by cash. Most of Tether’s reserves are held in cash-like assets, such as US Treasuries, short term deposits and commercial paper. The size of its cap would make the coin one of the largest investors in short-term money markets.
Since Tether dipped below $1 last week, investors have redeemed more than $7bn of the coins — almost twice its cash on hand. If these outflows were to continue, Tether may need to liquidate some of its short-term debt holdings.
Fitch last year sounded alarm bells over the influence coins like Tether could wield over short-term debt markets, with a run on stablecoins potentially having disastrous consequences for the wider market.
Meanwhile, in the US, Democrat senator Elizabeth Warren described the cryptocurrency market as “the new shadow bank” last September, raising concerns over the lack of regulation in the sector.
Pimco economist Paul McCulley coined the term "shadow bank" in 2007, using it to describe leveraged non-bank financial institutions that fueled the easy money lending in the run up to the 2008 financial crisis by issuing and investing in asset backed paper.
The lack of regulatory oversight for these institutions became "a source of systemic risk" during the crisis, according to a Financial Stability Board paper, which spiraled into something "that threatened the entire financial system."
Central banks combat crypto
Of course, what can central banks do about this? They could ensure that bank-like stablecoin deposits are protected in the event of a default, for instance.
But although this has its crypto market proponents, like Ethereum co-founder Vitalik Buterin, central bank regulators remain aghast at the idea. “Anyone investing in cryptos must be prepared to lose all their investment,” warned Panetta.
Even then the market is a highly fragmented Wild West. Many coins are decentralised and not governed in a single jurisdiction, complicating attempts at regulation. Furthermore, crypto zealots would likely resist any attempts to regulate the market.
Major central banks like the Federal Reserve or the ECB should instead look to expedite their own CBDC programmes and provide a better digital asset without the pitfalls of stablecoins.
To date, only three central banks have launched their own digital currency — the Bahamas, East Caribbean and Nigeria — although over 90 are looking into the technology.
The digital equivalents of the world’s two most widely traded currencies, the dollar and the euro, are still years off. On Monday, Panetta suggested that the digital euro will be ready by 2026. A Federal Reserve issued coin is still in the research stage, with US president Joe Biden only giving the go ahead to explore a possible coin in March.
However, when these CBDCs come to the market, it will already be several years too late. Tether, USD Coin and exchange issued stablecoins already enjoy a large share of the marketplace, and any central bank challenger — even one backed by the might of the Fed — has a mountain to climb.
As these huge stablecoin market caps show, there is demand for a stable digital monetary unit — and central banks are the best placed to offer it in the same way that they and governments are the right institutions to back fiat currency.
A CBDC would eschew the questionable algorithmic backing of Terra or the short term debt of Tether, but rather maintain the same central bank guarantees as cash.
Central banks have near bottomless pockets — the ECB, for instance, was able to spend more than Tether’s entire cap each month last year on debt for its Pandemic Emergency Purchase Programme.
As the fate of a CBDC is entwined with the rest of the monetary base, a central bank is unlikely to let its digital component fail. The only true stablecoin is a central bank issued one.