About Stablecoins, the Fed Figured It Out 3 Years Ago

Original Article Title: "Stablecoins: Growth Potential and Impact on Banking"

Original Article Authors: Gordon Y. Liao and John Caramichael

Original Article Translation: BlockBeats

On June 5, stablecoin giant Circle will be officially listed on the NYSE under the ticker symbol CRCL, marking one of the most anticipated IPOs in the cryptocurrency space since Coinbase's (ticker symbol COIN) Nasdaq listing in 2021.

According to Bloomberg, Circle plans to issue 24 million shares in this IPO, raising $624 million with a target valuation of $6.7 billion. However, based on the latest market data, this target has been revised upwards to $7.2 billion, and the oversubscription is more than 25 times, indicating that the market had underestimated the enthusiasm for stablecoins.

This enthusiasm is not only from retail investors; many institutional investors, such as Cathie Wood from Ark Invest and Larry Fink from BlackRock, have publicly stated that they will make substantial additional purchases, totaling about 30% of this round of financing. In the one to two weeks leading up to the IPO date, Circle was also involved in "acquisition rumors" with Coinbase and Ripple.

Related Reading: "Sprinting Towards IPO While Discussing Sale, What Is Circle Trying to Do?"

In recent years, stablecoins have appeared in institutional investment reports as one of the few concepts that can drive cryptocurrency market growth and blockchain technology adoption, making Circle the first stock representing the stablecoin concept.

At the end of last month, the Hong Kong Legislative Council passed the "Stablecoin Bill" through its third reading. The Hong Kong and A-share markets saw a surge in stablecoin concept stocks and digital currency sectors, with many companies hitting the 20% daily limit. According to Caixin, Everbright Holdings' stock price also soared by 26.6% on June 3, as it had strategically invested in Circle in partnership with IDG Capital in 2016.

Amid the hype, the topic of "What is a stablecoin?" in the traditional financial sector has rapidly gained popularity. In fact, the technology behind stablecoins, especially Central Bank Digital Currencies (CBDCs), has long been a strategic plan of many governments. In the U.S., thanks to the Trump administration's executive order on CBDCs, the development of the "private stablecoin" sector has made significant progress in just a few months, culminating in the passing of the "GENIUS" Stablecoin Act on May 20.

When it comes to stablecoin technology itself, the U.S. government has certainly conducted thorough research. On January 31, 2022, the Federal Reserve released a report titled "Stablecoins: Potential Development and Banking System Implications." In the report, the Federal Reserve specifically discussed the potential impact of stablecoins on the banking system and credit intermediation. For readers who may not be familiar with the concepts and knowledge related to stablecoins, it may be a good "Stablecoin 101 textbook."

Below is a translation of the original content of the Federal Reserve's "Stablecoins: Potential Development and Banking System Implications" report:

TL;DR

A stablecoin is a type of digital currency that is pegged to an external reference, usually the U.S. dollar (USD). Stablecoins play a critical role in the digital market, and their growth could stimulate innovation in the broader economy. Over the past year, there has been explosive growth in U.S. dollar stablecoins circulating on public blockchains, with a total circulation supply approaching $130 billion as of September 2021, representing a growth of over 500% from a year ago.

As stablecoins receive increasing attention, a series of issues have been raised, including their peg stability, consumer protection, KYC and compliance, and the scalability and efficiency of settlement. We will focus on the potential impact of stablecoins on the banking system and credit intermediation. While a range of stablecoin-related issues can be addressed through appropriate institutional safeguards, regulations, and technological advances, the continued growth and circulation of stablecoins will ultimately impact the traditional banking system in significant ways.

In this briefing, we first discuss the basics of stablecoins, their current use cases, and their growth potential. We then examine the historical behavior of stablecoins during past cryptocurrency and broader financial market distress periods. We find that stablecoins pegged to the U.S. dollar exhibit a secure asset quality, as their secondary market prices may temporarily trade above the pegged price in times of extreme market stress, incentivizing further issuance of stablecoins. We also highlight the "bank run" risk of stablecoins backed by non-cash equivalent risky assets.

Finally, we outline potential scenarios for bank reserve requirements, credit intermediation, and central bank balance sheets if stablecoins garner broader attention. Our research suggests that the widespread adoption of asset-backed stablecoins could be accommodated within a two-tier fractional reserve banking system without adverse effects on credit intermediation. Under such a framework, stablecoin reserves would be held as commercial bank deposits, and commercial banks would engage in fractional reserve lending and maturity transformation akin to traditional bank deposits. We also find that replacing physical cash (banknotes) with stablecoins could lead to more credit intermediation. In contrast, a "narrow" banking framework that requires stablecoin issuers to have central bank reserves backing their stablecoins minimizes the risk of stablecoin "bank runs" but may reduce credit intermediation.

The Foundation of Stablecoins

A stablecoin is a digital currency recorded on a distributed ledger technology (DLT), typically a blockchain, that is pegged to a reference value. Most circulating stablecoins are pegged to the U.S. dollar, but stablecoins can also be pegged to other fiat currencies, a basket of currencies, other cryptocurrencies, or commodities such as gold. Serving as a value storage and exchange medium on DLT, stablecoins enable the exchange or integration with other digital assets.

Stablecoins differ from traditional digital currency records, such as bank deposit accounts, in two main ways. First, stablecoins are cryptographically protected. This allows users to settle transactions nearly instantly without the need for double-spending or a facilitating intermediary. On a public chain, this also enables 24 x 7 x 365 trading. Second, stablecoins are typically built on programmable DLT standards, allowing for service composability. In this context, "composability" means that stablecoins can act as standalone building blocks that interoperable with smart contracts (self-executing programmable contracts) to create payment and other financial services. These two key features underpin the current use cases of stablecoins and support innovation in both financial and non-financial domains.

Since 2020, the usage of stablecoins on public chains like Ethereum, Binance Smart Chain, or Polygon has surged. As of September 2021, the circulating supply of the largest USD-pegged public stablecoin approached $130 billion. The chart displays the circulating supply of public stablecoins saw particularly robust growth at the beginning of 2021, with an average month-over-month growth of about 30% in the first five months of this year.

Current Stablecoin Types

Stablecoins are a nascent, broadly defined technology that may take various forms. The technology is currently implemented in specific forms that we will describe below and summarize in Table 1. However, please note that stablecoin technology is in its early stages and has a high degree of innovation potential. The current implementations of stablecoins discussed below, along with their current status in regulatory environments, do not reflect all potential deployments of stablecoin technology.

Top ten USD-pegged public stablecoins by market capitalization circulating supply. Data from January 2019 to September 2021. Other categories include Fei, TerraUSD, TrueUSD, Paxos Dollar, Neutrino USD, and HUSD.

Publicly Backed Reserve Stablecoins

Most existing stablecoins circulate on public chains such as Ethereum, Binance Smart Chain, or Polygon. In these public stablecoins, most are backed by cash equivalent reserves such as bank deposits, treasury bills, and commercial paper. These reserve-backed stablecoins are also known as custodial stablecoins as they are issued by intermediaries acting as custodians of cash-equivalent assets and provide 1:1 stablecoin liability redemption in USD or other fiat currencies.

The full backing and stability of some publicly reserved stablecoins have been called into question. In particular, Tether, the largest circulating supply stablecoin, agreed to pay $41 million to settle a dispute with the U.S. Commodity Futures Trading Commission, which accused Tether of misrepresenting the adequacy of its U.S. dollar reserves. Other widely used reserve-backed public stablecoins pegged to the dollar with varying levels of financial audits include USD Coin, Binance USD, TrueUSD, and Paxos Standard.

Public Algorithmic Stablecoins

Some stablecoins use alternative mechanisms to stabilize their price rather than relying on the robustness of underlying reserves. These stablecoins are often referred to as algorithmic stablecoins. While reserve-backed stablecoins appear as liabilities issued on the balance sheet of a legally registered company, algorithmic stablecoins are maintained by specialized smart contract systems running on public blockchains. The ability to control these smart contracts is typically granted through ownership of governance tokens, which are tokens specifically used to vote on protocol or governance parameter changes. These governance tokens can also serve as a direct or indirect claim on the future cash flows of using the stablecoin protocol.

The public domain of algorithmic stablecoins is highly innovative and hard to classify. However, people generally consider the design of these stablecoins to be based on two mechanisms: (1) Collateralization Mechanism and (2) Algorithmic Peg Mechanism. When users deposit unstable cryptocurrencies (such as Ethereum) into a smart contract protocol like Dai, collateralized public stablecoins like Dai are minted. Subsequently, users receive a loan of Dai (pegged to the dollar) with over 100% collateralization. If the value of the Ethereum deposit falls below a certain threshold, the loan will automatically liquidate.

In contrast, the Algorithmic Peg Mechanism uses automated smart contracts to protect the peg through the buying and selling of stablecoins with associated governance tokens. However, these pegs can be subject to instability or design flaws leading to "de-pegging," such as the case of the algorithmic stablecoin Fei briefly breaking its peg shortly after launch in April 2021.

Institutional or Private Stablecoins

In addition to publicly reserved stablecoins circulating on public blockchains, traditional financial institutions have also developed reserve-backed stablecoins, also known as "tokenized deposits." These institutional stablecoins are implemented on permissioned (private) DLT and are used by financial institutions and their clients for efficient wholesale transactions. The most prominent institutional stablecoin is JPM Coin. JPMorgan and its clients can leverage JPM Coin for same-day intraday repo settlement transactions and internal liquidity management.

These private, reserve-backed stablecoins functionally and economically resemble products offered by some money transmitters. For example, PayPal and Venmo (a subsidiary of PayPal) allow users to conduct near-instant transfers and payments within their networks, and the balances held by these companies are akin to reserve-backed stablecoins. The key difference lies in using centralized databases rather than permissioned DLT.

Use Cases and Growth Potential of Stablecoins

Strong use cases are driving the current growth of various forms of stablecoins. We summarize these use cases. The most significant current use case for stablecoins is their role in cryptocurrency transactions on public blockchains. Investors generally prefer to use public stablecoins to trade cryptocurrencies as this allows for nearly instant 24/7/365 trading without relying on non-DLT payment systems or custody of fiat balances.

In addition to being used for cryptocurrency transactions, both public and institutional stablecoins are currently utilized for nearly instant 24/7 non-intermediated payments, which may have low fees. This is particularly relevant for cross-border transfers, which often take several days and incurr high fees. Companies also utilize institutional stablecoins to transfer cash almost instantly between subsidiaries to manage internal liquidity and facilitate wholesale transactions in existing financial markets, such as intraday repurchase agreements. Finally, as public stablecoins are programmable and composable, they are extensively used in decentralized, public blockchain-based markets and services, known as decentralized finance or DeFi. DeFi protocols systems enable users to directly use stablecoins and transact with counterparties across various cryptocurrency-related markets and services, such as liquidity provision, collateralized lending, derivatives, and asset management, without traditional intermediaries. As of September 2021, around $600 billion worth of digital assets are collateralized (locked) in DeFi protocols.

Future Growth Potential

The defining characteristics of stablecoins, namely their cryptographic security and programmability, underpin the strong use cases currently driving the adoption of existing public and institutional stablecoins. However, these features hold the potential to drive innovation beyond the current use cases, which are primarily confined to the cryptocurrency market, certain peer-to-peer payments, and institutional liquidity management by large banks. Looking forward, stablecoin technology may see diverse implementations and foster innovation in multiple growth areas, such as more inclusive payment and financial systems, tokenized financial markets, and advancements in technologies like Web 3 through microtransactions.

More Inclusive Payment and Financial Systems

Stablecoins have the potential to stimulate growth and innovation in payment systems, enabling faster and cheaper payments. Since stablecoins can be used to transfer funds between digital wallets almost instantly and potentially at low cost, stablecoins may reduce barriers to payments and put pressure on existing payment systems to improve their services. This is particularly crucial for cross-border transfers, which may take several days to settle and incurr high fees. These fees and delays are burdensome for low- and middle-income countries.

Stablecoins may also support a more inclusive financial system through the growth of DeFi, which may require stablecoins as a necessary component. It should be noted that DeFi faces significant challenges, including complex user experiences, lack of consumer protection, frequent hacks, protocol bugs, and market manipulation. Additionally, nearly all DeFi protocols only support transactions or lending with cryptocurrencies or non-fungible tokens (NFTs). If DeFi protocols mature beyond their current state and integrate with the broader financial markets to support real-world economic activities, DeFi can incentivize a more inclusive financial system, allowing investors to participate directly in markets without intermediaries. This growth of DeFi could drive an increase in stablecoin usage.

Tokenization of Financial Markets

Furthermore, stablecoins may play a crucial role in the tokenization of financial markets. This would involve converting securities into digital tokens on DLT and using stablecoins for transactions and services. For Delivery versus Payment (DvP) transactions, such as securities purchases, tokenized markets would enable real-time settlement at very low costs. This can enhance liquidity, transaction speed, and transparency while reducing counterparty risk, transaction costs, and other market participation barriers. By allowing fractional ownership of tokenized assets and more transparent price discovery, this may be particularly beneficial for certain asset classes, such as real estate. For Payment versus Payment (PvP) transactions, such as cross-currency swaps, tokenization would also allow for near-instant execution, as opposed to the market's current traditional T+2 framework, where the payment of the swap occurs days after the two parties settle the exchange. Additionally, for both types of transactions, tokenized financial markets would benefit from the programmability of DLT, which can automate security services and regulatory requirements, such as required holding periods. If financial markets are partially or fully tokenized, this could further drive the growth of stablecoin usage.

Next-Generation Innovations

Finally, stablecoins have the potential to support next-generation innovations. One example of this innovation is Web 3, which may transition from centralized network platforms and data centers to decentralized networks. In this paradigm, revenues of internet services and social media platforms would shift from advertising to microtransactions, enabled by the emergence of efficient, integrated online payment systems. For instance, one can envision a search engine or video streaming platform supported by stablecoin-based nearly instant micropayments, rather than ad revenue and user data sales. If this shift in internet services is realized, it could drive further growth in stablecoin usage.

In conclusion, the current usage of stablecoins is primarily driven by cryptocurrency trading, limited peer-to-peer payments, and DeFi. Looking ahead, stablecoins may experience further growth through fostering more inclusive payments and financial systems, the tokenization of financial markets, and potential next-generation innovations such as Web 3.

Anchor Stability

The stability of a stablecoin's peg to its reference value is a core issue. While this is not the focus of our paper, we briefly discuss this important issue here. In this section, we will first outline the sources of instability in the peg of stablecoins backed by public reserves and discuss how to address these sources. We will then review how stablecoins may act as a potential safe asset in the digital market and provide evidence that stablecoins backed by public reserves may have already played this role in the cryptocurrency market.

Currently, there are two forms of instability in the peg of stablecoins backed by public reserves: issuer's investor redemption risk and secondary market price dislocation. The former is related to the security and robustness of the stablecoin's reserves. If stablecoin holders lose confidence in the robustness of the stablecoin's support, panic may ensue. A run on the stablecoin poses a risk of spillage into other asset classes as the stablecoin's reserves are sold off or unwound to meet redemption demands. Additionally, a run on the stablecoin could disrupt market and service smart contracts that rely on the stablecoin through interoperability, causing further distress. We believe this type of instability can be addressed through appropriate institutional and/or regulatory guardrails, such as transparent financial audits and adequate requirements for the liquidity and quality of stablecoin reserves. Concerns around redemption risk and the extent to which it can be addressed were recently mentioned in Quarles (2021).

The second form of anchoring instability in stablecoins backed by public reserves stems from imbalances in supply and demand in the secondary market. As these stablecoins trade on both centralized and decentralized exchanges, they are susceptible to demand shocks that may temporarily dislocate their peg until the stablecoin issuer adjusts the supply. In particular, as public stablecoins serve as a store of value in markets based on public blockchains, these stablecoins have experienced high demand during times of distress in the crypto markets as investors rush to liquidate their speculative positions into stablecoins.

In such events, the prices of major public reserve-backed stablecoins tend to temporarily appreciate until the issuer adjusts the supply. For example, the graph illustrates the cryptocurrency market crashes on March 12, 2020, and May 19, 2021. The first event occurred during a period of widespread market turmoil surrounding concerns about the spread of Covid-19. The second event occurred during a period of crypto market slump associated with a large-scale deleveraging. In both periods, as the prices of speculative cryptocurrencies Bitcoin and Ethereum plummeted by 30% to 50%, the prices of major public reserve-backed stablecoins surged.

For these extreme events in the encrypted market, stablecoins have appreciated as a digital safe-haven asset, while more speculative encrypted assets are temporarily in free fall until the stablecoin issuer can increase its supply and purchase reserves and/or the stablecoin experiences downward price pressure from arbitrageurs. The behavior of these public stablecoins is unique and distinct from prime money market funds, which experienced significant outflows during the 2008 global financial crisis and the most intense periods of the 2020 COVID-19 pandemic.

These events have demonstrated the potential of stablecoins as a digital safe haven during market turmoil. While discussions of financial stability risks of public-reserve-backed stablecoins have primarily focused on the redemption risk specific to the individual stablecoin reserve form, our analysis suggests that countercyclical secondary market demand for stablecoins can mitigate redemption risks during broad market downturns. With appropriate safeguards and regulations, stablecoins could potentially offer stability comparable to traditional forms of safe value.

Potential Impact of Stablecoins on Credit Intermediation

If stablecoins are widely adopted throughout the financial system, they could have a significant impact on the balance sheets of financial institutions. Regulators, market participants, and scholars are particularly concerned about the potential for stablecoins to disrupt bank-dominated credit intermediation. In this section, we analyze several scenarios of widespread adoption of reserve-backed stablecoins in the financial system. We focus on reserve-backed stablecoins rather than algorithmic stablecoins, as reserve-backed stablecoins are currently the largest and most closely linked to the existing banking system. Through these scenarios, we highlight how the adoption of stablecoins could critically depend on two factors concerning the impact on credit provision: the sources of inflows into stablecoins and the composition of stablecoin reserves.

We summarize our findings. We find that in most of the scenarios we considered, credit provisions are unlikely to be negatively impacted. In fact, replacing physical currency (cash) with stablecoins may allow for more bank-dominated credit supply. An important exception to note that could result in significant credit disintermediation is if stablecoins require full central bank backing, which we refer to as a narrow banking framework. In this framework, while redemption risk is minimized, the trade-off is greater credit disintermediation (debanking).

Sources of Inflows

If stablecoins are widely adopted, the main sources of inflows could come from three sources: physical currency (cash), commercial bank deposits, and cash-equivalent securities (or money market funds). Firstly, as a form of digital currency, stablecoins will replace some physical cash in circulation, especially as the economy becomes more digital. In some of our scenarios, we see an increase in credit supply as users substitute physical cash for reserve-backed stablecoins, as cash is a direct liability of the central bank that is replaced by reserve-backed stablecoins, which, depending on the reserve framework, can create credit through lending or securities purchases.

Next, if households and businesses are more willing to hold stablecoins rather than traditional bank deposits, stablecoins may flow out of commercial bank deposits. Policymakers are very interested in this source of inflows because there is a general concern that a large-scale substitute for deposits could disrupt the credit supply of commercial banks. We demonstrate that the impact of deposit substitution on credit supply can be positive, negative, or neutral, depending on the reserve framework. Finally, stablecoins may see inflows from cash-equivalent securities (or money market funds). This may not have an impact on credit supply as it would need to recycle funds back into the banking system, which we will discuss in a later section.

Reserve Composition

The impact of widely adopted reserve-backed stablecoins on credit provision also depends on the composition of stablecoin reserves. We propose three plausible stablecoin reserve frameworks: narrow bank, two-tier intermediary, and security-token holdings. As shown in the figure above.

Under the narrow bank framework, stablecoins would need to be backed by commercial bank deposits, which are fully supported by central bank reserves. Equivalently, commercial banks could potentially issue full-fledged stablecoins (or tokenized deposits) backed by central bank reserves. The narrow banking approach is roughly equivalent to a form of retail central bank digital currency where the digital currency is a liability of the central bank, but households and firms can transact through intermediary entities like commercial banks or fintech firms. The People's Bank of China has adopted this framework in its state-backed digital currency (referred to as Digital Currency Electronic Payment, digital RMB, or e-CNY). The proposed STABLE Act in the United States also mentions the possibility of requiring stablecoins to maintain reserves at the central bank.

While the narrow bank framework can ensure the anchoring stability of stablecoins as it effectively amounts to a conveyance of central bank digital currency (CBDC), this reserve framework poses the greatest risk of credit disintermediation. Periods of financial stress or panic could lead to a significant flight of conventional bank deposits into narrow bank stablecoins, which could disrupt the credit supply. While this credit disintermediation effect could be mitigated by limiting the amount of stablecoin holdings and differential reserve rates, the overall architecture of a narrow bank approach to stablecoin reserves could undermine the stability of the banking system. Additionally, the narrow banking approach could result in an expansion of the central bank's balance sheet to accommodate the stablecoin issuer's demand for reserve balances.

These concerns about narrow bank stablecoins reflect broader concerns about narrow banks, which the Federal Reserve has already taken note of. In a recently proposed regulation affecting narrow banks (officially referred to as pass-through investment entities or PTIEs), the Federal Reserve expressed concerns that "[narrow banks] could disrupt financial intermediation in ways that are difficult to anticipate, and could also have adverse effects on financial stability" (Regulation D: Reserves of Depository Institutions, 2019). Furthermore, the Federal Reserve outlined serious concerns about the demand for reserve balances, stating that "[narrow banks'] demand for reserve balances could become quite large. To maintain the desired monetary policy stance, the Federal Reserve may need to meet this demand by expanding its balance sheet and reserves supply."

Compared to the narrow banking framework, in a two-tier intermediary framework, a stablecoin would be backed by commercial bank deposits used for fractional reserve banking. Similarly, commercial banks may also issue stablecoins or provide tokenized deposits for fractional reserve banking. It is important to note that this does not mean the stablecoin is not fully backed. Instead, stablecoin issuers rely on commercial bank deposits as assets, with commercial banks using stablecoins and/or stablecoin deposits for fractional reserve banking. This implies that stablecoins are ultimately backed by a combination of loans, assets, and central bank reserves. It will affect the effective rebranding of part of regular deposits as stablecoin deposits. Importantly, to maintain the banking intermediary unchanged, the treatment of stablecoin deposits must be the same as non-stablecoin deposits in terms of statutory reserve requirements, liquidity coverage ratio, and other regulatory and self-imposed risk constraints.

Lastly, stablecoin issuers may hold cash equivalents such as treasury bills and high-quality commercial paper instead of keeping funds in commercial banks. These securities can be purchased directly or indirectly through money market funds. This is the primary framework adopted by stablecoin issuers supported by public reserves, such as Tether. Federal Reserve Chairman Jerome Powell recently noted that it is "sort of like a money market fund."

Scenario Setup

In our scenario, we will consider the impact of one or more fiat reserve-backed stablecoins gaining widespread adoption in a programmable version of the banking system. The baseline balance sheet of this banking system is shown in the diagram. Specifically, we consider the case where households and firms substitute $10 for banknotes, commercial bank deposits, or securities, and then perform accounting work to determine how the adoption of stablecoins would affect the balance sheets of the central bank, commercial banks, and households and firms. We analyze how this impact varies based on the stablecoin's reserve framework and its sources of inflows.

It is important to note that several key assumptions were made in constructing these scenarios. First, we do not know the specific form of the stablecoin adopted. Our scenarios are not intended to analyze, for example, the specific impact of widespread adoption of existing stablecoins (such as Tether). We do not distinguish whether the adopted stablecoin is an institutional tokenized deposit or a stablecoin circulating on a public blockchain, or another form. Second, we only present illustrative best-case scenarios. In reality, stablecoins can see inflows from various sources and hold multiple assets as reserves. Third, these scenarios do not capture second-round effects or feedback loops and do not address heterogeneous impacts within the industry. Finally, we assume a 10% statutory reserve requirement for commercial bank traditional deposits.

To illustrate the complex flows between different parts of the banking system in support of our edge-case scenario, we visualize a subset of stablecoin inflows and reserve allocation discussed in the diagram. Specifically, we use the chart to show the flow of commercial bank deposits (inflow A) and banknotes (inflow B) into stablecoin, as well as the allocation of these funds in the form of commercial bank deposits to reserves (reserve flow A) and securities (reserve flow B).

In the diagram, we see how stablecoin inflows and reserve flows are interconnected. Companies and households substitute deposits (Inflow A) and currency (Inflow B) for stablecoins. The stablecoin issuer deposits a portion of this fund into the commercial banking system as commercial bank deposit reserve (Reserve Flow A) and uses this fund to purchase securities as reserve (Reserve Flow B). These securities purchases also recycle funds back into the banking system as the seller of the securities ultimately receives the proceeds of the securities sale and deposits it back into the banking system. As shown in the diagram, these flows impact the central bank, with the central bank holding cash and central bank reserves as liabilities, and companies and households borrowing from commercial banks. While this diagram does not capture all flows between these entities, it symbolizes how the widespread adoption of stablecoins is reshuffling the complex financial relationships within the banking system.

Scenario Analysis

Narrow Bank Framework:

As previously mentioned, the narrow bank framework poses the greatest risk to credit provisioning, depending on the source of the inflows. In our narrow bank scenario, as shown in the table, we find that the inflow of physical cash into narrow banks through stablecoins will have a neutral impact on credit supply, while commercial bank deposits will disrupt credit supply.

In Panel A (Cash Inflow Scenario), we see stablecoins replacing cash on households' and companies' balance sheets. The inflow of cash leads to an indirect increase in commercial bank assets and commercial bank reserves. The central bank's balance sheet undergoes a restructuring, where reserve liabilities replace cash liabilities. The net effect is an expansion of the commercial bank's balance sheet, but credit provisioning remains unchanged. This situation assumes that banks are not constrained by the size of their balance sheets. In other words, narrow bank deposits and associated reserve holdings are exempt from leverage ratio calculations. This leverage exemption for central bank reserve holdings has been adopted by regulatory authorities in different jurisdictions.

Panel B shows the narrow bank scenario where deposits migrate to stablecoins. Since stablecoin deposits are fully retained on the commercial bank's balance sheet, the bank must reduce its asset holdings to accommodate the decrease in non-stablecoin deposit funds. The central bank's balance sheet will subsequently expand to accommodate the increased demand for reserve balances without offsetting the decrease in cash liabilities. In this scenario, we assume the central bank will meet the increased reserve demand by purchasing securities. This lenient assumption by the central bank aligns with the previous rulings on narrow banks put forth by the Federal Reserve, as mentioned earlier, in relation to Regulation D: Reserve Requirements of Depository Institutions (2019). However, if the central bank determines the size of its balance sheet, we present two alternative scenarios in Appendix Table A1. In the first alternative scenario, commercial banks significantly contract their balance sheets to make up for the shortfall in deposit funds. In the second scenario, commercial banks offset the loss of deposit funds by issuing debt securities. The result is a further reduction in bank-led credit creation.

We do not envision a scenario where a narrow bank stablecoin experiences a significant inflow from the securities holding. In this case, the impact on credit reserves may be neutral. Under the same assumptions as above, the central bank would address the increased reserve demand by purchasing securities (from households), with the net impact on credit supply being minimal. Unlike direct security holdings, the migration to stablecoin would see households holding a stablecoin backed by central bank reserves, which in turn are backed by securities. This scenario also assumes that the increased narrow bank reserves are unaffected by leverage ratios, as described earlier.

Two-Tier Intermediation Framework:

For the two-tier intermediation framework shown in the table below, we find that a significant inflow into stablecoin would have a neutral to positive impact on credit supply. Panel A illustrates the case of cash conversion into stablecoin. As commercial banks engage in fractional reserve banking through stablecoin deposits, their balance sheets expand primarily through the expansion of credit and securities holdings, accounting for the majority of the expansion. The central bank contracts on the net balance sheet, with reserves increasing slightly, and cash liabilities decreasing significantly. Households accumulate more assets, expanding lending in the bank loan. The impact on credit reserves is positive. Panel B shows a two-tier intermediation scenario with deposit substitution. Overall, there is no change in the commercial banks' and central bank's balance sheets and asset holdings. The only change is in the composition of commercial bank liabilities, as term deposits shift to stablecoin deposits. As mentioned earlier, this scenario assumes that the treatment of stablecoin deposits is the same as non-stablecoin deposits in terms of statutory reserve ratios, liquidity coverage ratios, and other regulatory and self-imposed risk constraints.

Securities Holding Framework:

The impact of widely adopted security-backed stablecoins, as shown in the table below, is the most unpredictable. Many scenarios are possible. In Panel A, we present a scenario where a security-backed stablecoin sees an inflow of commercial bank deposits. We assume the stablecoin issuer purchases securities from commercial banks rather than households and corporate sectors. In this case, as households swap deposits for stablecoin, commercial banks make up for the loss of deposit funding by issuing their own securities. Additionally, commercial banks may reduce their securities portfolios to make up for the loss of deposit funding. If banks primarily adjust the asset side of their balance sheet by altering their holdings of securities, the scale of the bank loan portfolio may remain unchanged. In this case, due to the loss of bank reserves, the central bank's balance sheet also contracts slightly.

Panel B illustrates a scenario where households swap cash equivalent securities for stablecoin. This would result in the tokenization of quasi-cash securities without directly impacting the credit supply in the banking system. We also consider another scenario (not shown) where a security-backed stablecoin experiences inflows from households and corporate sectors while selling securities to commercial banks. The securities' sellers are households and corporate sectors, not commercial banks as described in Panel A of Table 7. The net impact on credit provision is neutral, as the commercial bank deposit balances held by households and corporates purchasing stablecoin are eventually recycled back into the banking system by transferring them to other households and corporates selling securities to the stablecoin issuer. This reshuffling of securities holdings is illustrated in Figure 3 through the inflow A and reserve flow B. The ultimate result is a change in the balance sheet, similar to Panel B.

Finally, we did not describe a scenario where a security-supported stablecoin receives inflows of physical cash. However, this could have a neutral or positive impact on credit creation. If the stablecoin issuer uses cash to purchase existing securities, and this cash does not end up in the banking system, it would not affect the credit supply as it would represent a direct exchange of cash for securities. However, if the cash used to purchase existing securities is deposited into the banking system, or if this cash is used to fund the issuance of new securities, this could increase the credit supply through increased lending by commercial banks and securities purchases, or by reducing the equilibrium cost of issuing securities. In summary, the potential impact could be a moderate increase in credit supply.

Summary

As digital assets gain wider adoption and use cases for programmable digital currency become clearer, stablecoins have seen significant growth over the past year. This rapid rise has raised concerns about potential negative impacts on banking activity and the traditional financial system. In this report, we discussed the current use cases and potential growth of stablecoins, analyzed historical events of unstable pegs, and outlined different scenarios for the impact of stablecoins on the banking system. As mentioned in the introduction, this paper did not consider all potential impacts of stablecoins on financial stability, monetary policy, consumer protection, and other important unexplored issues. We focus on balance sheet effects and credit intermediation under a set of reasonable assumptions.

We studied reserve-backed stablecoins and found that the impact of stablecoin adoption on traditional banking and credit provision could vary depending on the sources of inflows and the composition of stablecoin reserves. In various scenarios, the two-tier banking system can both support stablecoin issuance and maintain traditional forms of credit creation. In contrast, a narrow-bank stablecoin framework can provide the highest level of stability but may come with potential costs of disintermediation. Finally, if a stablecoin pegged to the US dollar is believed to have sufficient backing, then during market distress, a USD-pegged stablecoin can serve as a safe haven compared to other cryptocurrencies.

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