Stablecoins are private money. That is why they pose a risk to the economy

"Private money" sounds like an oxymoron. Isn't the currency on which our economy operates the very epitome of a public good? In fact, the United States did have private money in the past, back in the 19th century. And private money is making a comeback now, in the form of stablecoins: cryptocurrencies designed to maintain a fixed value against the dollar.

For their advocates, stablecoins are the flagship application of cryptocurrencies. They will make payments faster and more efficient--especially across borders--than the traditional banking system allows. However, that promise carries the risk that this could trigger a financial crisis, just as some past experiments with private money did. Both the Genius Act, enacted last year, and the Clarity Act, currently pending in the U.S. Senate, aim to make stablecoins safer and more widely adopted. However, no legislation can completely eliminate the risk inherent in the design of stablecoins.

Stablecoin issuers and affiliated platforms are private companies seeking to increase usage and profits through the assets they hold to back their coins, the "rewards" they pay to users, and the types of activities they tolerate. Of course, profit and risk-taking are fundamental to all innovation, and that is a positive thing. But in finance, innovation often leads to excesses that can trigger a sudden loss of confidence, panic, and a contagion effect that spreads to the broader economy.

What is money?

Money serves several functions: it is a store of value, a unit for pricing transactions, and a medium for carrying them out. The U.S. dollar meets all these criteria. Today, the Federal Reserve controls the issuance of dollars. But nothing prevents private actors from attempting to create their own versions of money. Cryptocurrencies long aspired to be precisely that. However, early cryptocurrencies, such as Bitcoin, were not backed by anything, so their value fluctuated wildly. Stablecoins are backed by tangible assets, such as Treasury bills, which can be sold to redeem the coins for dollars at a one-to-one ratio. CoinMarketCap estimates the value of stablecoins in circulation at around $300 billion, led by Tether ($190 billion) and Circle ($76 billion).

Stablecoins promised the best of both public and private money: as exchangeable and reliable as dollars but, thanks to blockchain, faster and cheaper than the dollar-based banking system. But that promise contains a contradiction. "Stablecoins attempt to import the credibility of public money while operating outside the established settlement system," noted Pablo Hernández de Cos, general manager of the Bank for International Settlements, in a recent speech. An essential quality of money is "uniqueness," meaning that a dollar must always be worth a dollar, regardless of when, where, or with whom it is used. Bank deposits are a form of private money, but since banks can borrow from the Federal Reserve to repay deposits, and dollars move between banks through the Fed, their dollars possess uniqueness.

"Stablecoins attempt to import the credibility of public money while operating outside the established settlement system"

In contrast, stablecoins circulate through proprietary and fragmented infrastructures. They lack uniqueness. Although the coins issued by Tether and Circle aim to remain pegged to the U.S. dollar, they often deviate from that value, albeit usually by minimal amounts. Unlike the Fed, stablecoins seek to generate profits. One way to do this is by expanding their use, for example, by paying interest, as bank deposits do. The Clarity Act would prohibit the payment of interest similar to that on deposits, but would allow usage-based rewards. Historically, cryptocurrencies have pushed legal boundaries and could design rewards that mimic interest without breaking the law. "I don't see any reason why they would completely change their tactics and become conservative in interpreting the law, when that hasn't been the pattern so far," says Molly White, author of the Citation Needed newsletter on cryptocurrency and tech policy.

Stablecoins also have an incentive to "seek yield"--that is, to back their coins with slightly riskier or less liquid assets that offer higher returns. But if the value of those assets declines, stablecoins may be unable to maintain their face value. Holders might rush to sell or redeem, triggering forced sales of the assets and a contagion effect on other markets, including banks. Last year's Genius Act requires stablecoins targeting U.S. consumers to be backed by safe and liquid assets, such as Treasury bills and bank deposits. However, Federal Reserve Governor Michael Barr noted last year that the law has loopholes, as bank deposits may not be insured. The law allows stablecoins to receive funds, including foreign currency, through "repo" loans, and that could include bitcoin, which El Salvador recognizes as money, Barr points out.

Furthermore, the law does not cover currencies operating outside the U.S., such as Tether's main currency, known as USDT, although Tether has launched a U.S. currency that complies with the regulations, the USAT. We've been through this before. During the era of free banking, from 1837 to 1863, banks could issue their own currency. However, the system was ineffective, with currency values fluctuating against one another. "All states maintained a series of requirements for banks to back their notes, but many proved ineffective; fraud was widespread and the system was fragmented--notes from one bank were often not accepted by other banks outside the local area--and bank failures were frequent," writes the Andersen Institute for Finance and Economics in a report on stablecoins. Non-bank entities, such as railroad companies, issued their own currency.

Money market funds are a type of private money that promises to redeem shares at one dollar each on demand. But during the global financial crisis, one of the funds was unable to meet that value--it "broke the dollar"--because it held devalued assets. This triggered widespread panic. These cases demonstrated how a loss of confidence can trigger a contraction in the volume of private money, which amplifies economic stress. Fabio Natalucci, executive director of the Andersen Institute, notes that this is the opposite of public money, which is "elastic": the Federal Reserve expands its supply during times of stress.

Stablecoins are here to stay

Stablecoins are a natural evolution of payment technology, so it makes sense to find a way to integrate them into the economy. That is what the Genius and Clarity bills aim to do, and stablecoin advocates hope this will encourage their adoption. However, it hasn't borne fruit yet. Japan boasts a "carefully designed regulatory framework" for cryptocurrencies, but the market capitalization of yen-based stablecoins is less than 0.01% of that of dollar-based coins, notes Hernández de Cos.

The vast majority of stablecoins are pegged to the dollar, and these are largely held outside the U.S., often as a means to circumvent laws or capital controls. Stablecoins account for 84% of illicit cryptocurrency activity, such as sanctions evasion and money laundering, according to Chainalysis. Cryptocurrency trading remains the primary use of stablecoins. Today, less than 1% of stablecoin usage is for payments in the real economy, according to a study by the Kansas City Fed. Meanwhile, banks are beginning to offer an alternative: "tokenized deposits," which, in their view, offer the "uniqueness" of the dollar with the advantages of blockchain. Banks, as we all know, have caused their fair share of crises, which is why, over time, they have ended up being so strictly regulated and integrated with the Federal Reserve. Stablecoins may have to follow the same path.

*Content licensed from The Wall Street Journal. Translated by Federico Caraballo

"Private money" sounds like an oxymoron. Isn't the currency on which our economy operates the epitome of a public good? In fact, the United States already had private money in the past, in the 19th century. And private money is making a comeback now, in the form of stablecoins: cryptocurrencies designed to maintain a fixed value against the dollar.