Decentralised ledger technology-based cryptocurrency is highly secure and allows for a near-real-time peer-to-peer global settlement. However, its value is notoriously volatile, making it an unappealing medium of exchange. Participants in the real economy and the rapidly growing world of decentralised finance (DeFi) need a digital currency with a more stable value. Central bank digital currencies might be an option, but these may not use a decentralised ledger technology, may not be meant for retail customers, and are slow to materialise in advanced economies. Consequently, stablecoins – cryptocurrencies with a market value pegged to some external reference asset or assets – have taken off.
The supply has burgeoned from $5.89 billion at the start of 202 to $143.68 billion on 20 July 2022.
A problem for this nascent market, however, is that the European Commission’s proposed regulation of stablecoins may have the effect of dooming them in their current form.
Stablecoins come in four main varieties:
- Tokens pegged to a fiat currency where the issuer holds reserves to maintain their value.
- Tokens backed by another cryptocurrency where the issuer holds excess reserves to maintain their value (over-collateralisation).
- Unbacked tokens pegged to an external reference asset where the issuer uses a ‘mint-and-burn’ algorithm to maintain parity.
- Tokens pegged to a commodity, typically gold.
Crypto-backed stablecoins are too risky; algorithmic stablecoins are run-prone; commodity-backed stablecoins have only a niche role (see Chaudhary and Viswanath-Natraj 2022 and Landau 2022). Fiat-currency-backed stablecoins are the only stablecoins that are practical decentralised-ledger-technology money for the real economy and DeFi. It is not surprising that they currently make up over 90% of the total supply. Following the European Commission, we refer to these stablecoins as e-money tokens. Issuers of e-money tokens offer to redeem them one-to-one with a matching fiat currency and claim that their reserves fully back them. They do not pay interest – positive or negative. They are typically supported on multiple public blockchains, are usable in blockchain applications, and can have a near-real-time, low-cost, peer-to-peer global settlement.
E-money token issuers are not custodial broker-dealers, making their revenue from transaction fees. While they charge fees, their business model is similar to the potentially far more profitable one of traditional fractional reserve banks. They make money by selling tokens and lending and investing the proceeds, keeping only a portion in cash. For example, on 31 March 2022, Tether reported that, while their tokens were 100% backed, only about 86% of their reserves were in cash, cash equivalents, US Treasury Bills, other short-term deposits, and commercial paper. Only about 6% were in cash and bank deposits.
With near-zero risk-free nominal interest rates, e-money tokens have not paid interest. The opportunity cost of holding e-tokens is insignificant, and customers have enjoyed their liquidity services. The issuers of e-money tokens have made money by investing a portion of their customer funds in risky assets. However, when interest rates become significantly positive, issuers will want to pay interest on their e-money tokens. Otherwise, their customer base will dwindle, likely more than offset the potential increase in return on reserve assets. If interest rates were to become significantly negative, issuers would want to charge negative rates. Otherwise, to have a chance of remaining profitable, they would have to invest customer funds in riskier, higher yield-bearing assets, and the representation that safe liquid assets back their tokens is fiction. If e-money tokens become widely adopted, they may become systemically important, and this would create financial stability risks.
The problem for issuers, at least in the EU, is the European Commission’s proposed Markets in Crypto-assets (MiCA) regulation for EU crypto-assets and service providers, expected to come into force in 2024.
It proscribes the paying of interest on e-money tokens. The apparent intent is to ensure they are used as a medium of exchange rather than a store of value. The assumption is that holders of a medium of exchange ignore its opportunity costs. The US experience with Regulation Q in the 1970s ought to be convincing evidence to the contrary (Gilbert 1986).
Of course, the issuers of e-money tokens – unambiguously redeemable on demand at par – should be regulated; they should not escape oversight because of the nature of their digital technology.
However, a ban on paying interest makes their business model unsustainable whenever interest rates are materially positive or negative. We see no sensible reason for a regulation that appears inefficient and restricts the contractual freedom of issuers to pay or charge interest. We do not understand why European legislators and regulators have failed to identify and correct this flaw.
Just as Regulation Q spurred the development of money market funds in the US, MiCA might spur analogous regulatory arbitrage in Europe. An alternative form of on-chain money might be created with a regulated retail money market fund that issues shares in the fund as security tokens on a public blockchain under the applicable securities legislation. The tokenised shares in the fund would be like e-money tokens in that they would be pegged to a unit of fiat currency. However, they would pay (or charge) interest. Like money market funds, they would be at risk of runs, and like money market funds, they should have access to central bank lender-of-last-resort facilities. Because such a fund would fall outside the MiCA regime, paying interest is allowed. It is telling, however, that one needs to circumvent the MiCA regime to design a stablecoin that is stable.
Another possibility for regulatory arbitrage is for commercial banks to offer tokenised deposits on the decentralised ledger of a public blockchain. They would record and administer deposits in the ledger rather than in their own database. This would enable peer-to-peer settlement and make depository institutions’ money programmable and usable in smart contracts and other blockchain applications. Despite the novel technology, in legal and economic terms, an on-chain tokenised bank deposit would be identical to a traditional off-chain deposit. As bank deposits do not fall under the purview of MiCA, banks can pay or charge interest.
The central bank would still have a role to play in ensuring the interoperability between on-chain deposits held with different banks, just as it provides the interoperability of off-chain deposits held with different banks today. The alternative database technology that records the deposit should not make a difference. Private sector solutions might facilitate interoperability between banks using netting constructs in the interim.
Tokenising commercial bank deposits has advantages over e-money tokens or tokenised shares in a money market fund:
- On-chain deposits, being economically and legally equivalent to off-chain deposits, can be expected to fall under and benefit from existing deposit insurance schemes.
- On-chain deposits may qualify as legal tender in some jurisdictions and are likely to function as such in practice.
- Banks have access to the central bank as lender-of-last-resort, widening the scope of assets in which token holders’ funds can be invested while maintaining liquidity requirements.
We believe that the market will likely move away from e-money tokens toward tokenised commercial bank deposits as the preferred form of on-chain money. E-money token issuers will likely apply for banking licenses to benefit from the regulatory advantages. Existing banks, to compete, will likely introduce tokenised deposits. E-money token issuers, as intermediaries, will prove only a temporary phenomenon. What will remain is commercial bank money with enhanced technical functionality.
Adrian, T and T Mancini-Griffoli (2019), “The Rise of Digital Currency”, VoxEU.org, 9 September.
Chaudhary, A and G Viswanath-Natraj (2022), “Algorithmic Stablecoins and Devaluation Risk”, VoxEU.org, 13 May.
Gilbert, R A (1986), “Requiem for Regulation Q: What It Did and Why it Passed Away.” Federal Reserve Bank of St. Louis, February 22–37.
Landau, J-P (2022), “Crypto Currencies and Digital Money: Taking Stock”, VoxEu.org, 27 June.
McLaughlin, T (n.d.), “The Regulated Internet of Value.” Citi: Treasury and Trade Solutions, Citibank.com
Xu, C and H Yang (2022), “Historical Lessons on the Real Effects of Unstable Stablecoins”, VoxEU.org, 3 May.