The Bank for International Settlements (BIS) has issued a new report, warning that stablecoins – a type of cryptocurrency whose value is linked to a pool of assets in order to achieve price stability – could pose risks to the stability of both financial markets and the real economy.
The report opens by acknowledging that the payments space is ripe for change, and that cross-border payments in particular “remain slow, expensive and opaque, especially for retail payments such as remittances”. In addition, it says that there are currently 1.7 billion people globally that are “unbanked or underserved with respect to financial services”.
Cryptocurrencies have in some instances been touted as a solution to both of these problems, but, as the report notes, the fact that these assets have remained highly speculative and subject to large price swings means that they have thus far been ill-suited for making payments. One potential way to rectify this problem is “stablecoins”, which the BIS describes as having many of the features of cryptoassets, but aim to stabilise the price of the “coin” by linking its value to that of a pool of assets. Indeed, Facebook made waves earlier this year when it proposed the creation of a new stablecoin, Libra.
Although the BIS report says that such stabelcoins “could potentially contribute to the development of global payment arrangements that are faster, cheaper and more inclusive than present arrangements” it also argues that this technology is largely untested and that it poses many legal, regulatory and oversight challenges and risks. Some of the concerns highlighted by the report centre around the potential for money laundering, terrorist financing and other forms of illicit finance, tax compliance issues, the protection of data privacy and cybersecurity and operational security of stablecoins.
But where the report really gets interesting is when it starts to consider the potential impact of a global stablecoin (GSC). Not only does it argue that GSCs would amplify the risks already outlined in the report, but that they could also introduce more wide-reaching ones.
From the report’s executive summary: “GSCs could have significant adverse effects, both domestically and internationally, on the transmission of monetary policy, as well as financial stability, in addition to cross-jurisdictional efforts to combat money laundering and terrorist financing. They could also have implications for the international monetary system more generally, including currency substitution, and could therefore pose challenges to monetary sovereignty.”
Digging deeper into the report, perhaps the most thorough portion of it looks at the implications of GSCs for financial stability.
For starters, it warns that GSCs could be vulnerable to runs, akin to standard runs on bank deposits where users might all attempt to redeem their GSCs at the reference value at the same
time. The BIS explains that if the mechanism used to stabilise the value of the GSC doesn’t incorporate the high standards of financial risk management to address market, credit and liquidity risk then it could undermine confidence in the GSC’s value.
In addition, the report argues that GSCs, which rely on market makers to stabilise the price of the GSC in the open market, may be fragile if those market makers are not obliged to stabilise the price in all circumstances and could exit the market when the GSC comes under strong selling pressure.
“Poor governance, such as non-segregated funds in the reserve, ambiguous or misunderstood legal obligations of the issuer, or weak mechanisms to allow stablecoin holders to realise or redeem value from the issuer, may result in the GSC being vulnerable to runs or loss of confidence,” the BIS adds in the report.
Meanwhile, GSCs whose reference assets include bank deposits, may be exposed to the credit risk and liquidity risk of the underlying bank, meaning that a default or liquidity problem at that bank could mean that the GSC would become unable to meet redemption requests. But if the GSC’s set reference assets is more broad, then it may be exposed to the market and liquidity risk of those assets and the credit risk of their issuers. A fall in the value of the reserve assets triggered either by overall market conditions or by an idiosyncratic change in the fundamental value of the asset could therefore significantly reduce the value of the GSC itself.
These inherent fragilities of GSCs could increase vulnerabilities in the broader financial system in a number of ways, according to the report.
Firstly, if people hold GSCs permanently then retail deposits in banks could decline, increasing bank dependence on more costly and volatile sources of funding, including wholesale funding.
Secondly, the easy availability of GSCs could potentially exacerbate bank runs in times when confidence in one or more banks erodes.
Thirdly, if new financial intermediaries in the GSC ecosystem captured a significant fraction of financial intermediation activity, this could further reduce bank profitability, potentially leading banks to take on more risks or to contract lending to the real economy. While the BIS says that it is not up to public authorities to protect banks from competition or technological advances, it also claims that these risks need to be assessed and managed.
Fourthly, depending on the adoption level of GSCs, the BIS says that purchases of safe assets for a stablecoin reserve could cause a shortage of high-quality liquid assets (HQLA) in some markets, potentially affecting financial stability.
Risks to the real economy
Not only could GSCs heighten threats to financial stability, but the BIS report also says that it could introduce risks into the real economy.
“If a GSC became a widely used means of payment, any disruption to payments may ultimately harm real economic activity. If the GSC were used as a means of settlement within financial markets, such delays could create additional financial stability risks. The impact would depend on the extent to which other payment systems (including cash) were sufficient substitutes,” says the report.
It continues: “If a GSC were used as a store of value, and unbanked or underserved populations (in particular) were to use a GSC as a form of savings account, then any shock to the value of that GSC would have a wealth effect on its holders. This could have a wider effect on the economy as people adjust their spending plans accordingly. Moreover, if there was borrowing denominated in a GSC, fluctuations in its value could also exert balance sheet effects on firms.”
Another problem highlighted by the BIS is that banks and other financial institutions might become indirectly exposed to GSC in order to service their customers and therefore could suffer a loss if the value of the GSC decreased.
The report points out that the size of the GSC’s reserve assets might have to become massive in order to back the number of coins in existence, which could have “significant implications for financial markets”. For example, large purchases or sales of other assets, such as bonds, could move prices – and yields – in those markets. The BIS imagines an extreme scenario where the issuer must sell assets quickly in order to meet redemption requests in a run on the GSC, with fire sales resulting that might disrupt the funding of the custodian banks.
“Finally, in times of stress, if a GSC provides a substitute for a fiat currency, it may undermine monetary sovereignty,” says the BIS in the report.
An uncertain future
Thus, the report concludes that while recent GSC initiatives highlight the shortcomings in cross-border payments and access to transaction accounts, “it remains to be seen whether GSCs will indeed be able to overcome the shortcomings of existing payment systems”. In addition, it states that the legal, regulatory, supervisory and operational challenges associated with GSCs – not least of which are the potential risks to financial stability previously outlined – mean that the potential for their mainstream adoption is uncertain.
“Consequently, it is important that the private and public sectors continue to explore innovative ways to make payments better, reduce inefficiencies and be more inclusive,” says the BIS report.
As such, the G7 Working Group on Stablecoins recommends that relevant public stakeholders, in collaboration with relevant international organisations, should develop road maps for supporting and scaling up ongoing efforts to improve the efficiency and inclusiveness of payment and financial services. It also calls on central banks to both individually and collectively assess the relevance of issuing central bank digital currencies (CBDCs) in their jurisdictions.