Stablecoins are in vogue, for good and bad reasons. On the bright side, by being allegedly backed one-for-one with hard currencies or near-money safe assets, unstable stablecoins hold the promise of functioning as privately produced money that could facilitate digital trade on distributed ledger technology (DLT) platforms in the future.
To see this, one must recognise an important property that defines the acceptance of a currency: the no-questions-asked (NQA) principle. Coined by Bengt Holmström, the 2016 Nobel Economics Prize winner, NQA means no due diligence is needed on the value of currency used in a transaction. All parties in a transaction accept the money at face value – a one-hundred-ringgit note means RM100, not a cent less.
The implication is enormous: banks will not put your transaction on hold to verify the value of your money when you wave your card to pay for a meal. Neither will the cashier waste time on physical verification if currency notes were presented. Just imagine how messily inefficient the payment system will be if otherwise occurred.
NQA also means no delay when it comes to redemption and convertibility. All banks shall do in the face of deposit withdrawals, for instance, is to let it be. Likewise, no parties in a transaction would question an exchange of a RM100 note for two RM50 notes or ten RM10 notes upon request.
For fiat currency, the trust is grounded upon central bank’s monopoly in currency notes issuance. For bank money, the trust is sealed by deposit insurance and access to central bank reserves.
Which brings us back to the viability of stablecoins as privately issued money. By what the trust on stablecoins can be underpinned? So far not much, other than the collateral in the form of cash and cash equivalents proportional to the stablecoins minted.
Tether, for instance, describes that “Every Tether token is always 100% backed by reserves, which include traditional currency and cash equivalents. Every Tether token is also one-to-one pegged to the dollar, so USDT1 is always valued by Tether at USD1.”
Leaving aside the fact that Tether has been sued and fined USD18.5 million for lying about its backing assets – less than 7% of its tokens were backed by cash and cash equivalents– the inner logic of a collateralised token is deeply flawed.
Now suppose the token is genuinely 100% tied up in perfectly safe and liquid assets. That simply means stablecoins are equivalent to but no better than cash. If so, what is the point to privately create a digital token, while the job can be carried out equally well by riskless central bank money?
But if the token is not fully backed by near-money safe assets, tokens become non-fungible, as the same tokens embody different intrinsic values when the collateralised assets are varying. Then the token users would need to consider whether to accept the token at face value in each transaction. After all, your USD1 stablecoin is not worthy of my USD1 stablecoin. This is a great example of unstable stablecoins.
NQA Concept With The Unstable Stablecoins
In this context, NQA principle is violated. Stablecoins are always vulnerable to runs, and therefore hard to use in transactions. There is a familial resemblance between the Free Banking Era of the 19th century in the United States and stablecoins. By passing the Free Banking Law first in Michigan, in 1837 and last in Pennsylvania in 1860, more than a dozen of states changed the way banks were operated. Anyone could just open a bank, but with one rule: banks had to back their note issuance one-for-one with state bonds.
Guess what? Bank notes were not economically efficient then as there was constant argument over the value of notes in transactions. NQA principle was broken, and there can’t be a functioning currency when there is no NQA.
Later in 1863, the National Bank Act was passed. Banks that could issue national bank notes were established. Privately issued bank notes were penalised out of existence, giving way to national bank notes that ended the free banking era.
If history is any guide, the parallel is clear: stablecoins are likely to be replaced by the coming central bank digital currencies that can also circulate on a DLT platform. No privately produced monies, however collateralised, can be as good as a properly run central bank monies.
Unless central bank digital currencies are designed for use only among financial intermediaries, then other private digital monies like stablecoins can co-exist to serve the wider economy on retail front.
But to transform stablecoins into the equivalent public money, the one-to-one peg to national central bank digitalcoins must be backed by central bank reserves. Stablecoins cannot become a stable currency until this occurs.
By leveraging the prevailing well-functioning banking and payment system, another option is to tokenise the bank deposits. These tokens would represent a claim on the bank, just as a debit card holder drawing on her savings deposits does. Tokens are then backed by deposits, which, in turn, are backed fractionally by central bank reserves and deposit insurance.
As such, fungibility is restored, and NQA principle is naturally effectuated. While stablecoins in its current form are inherently unstable, we certainly don’t want to throw the baby out with the bathwater by putting more nails in stablecoins’ coffin.
But rather, if we believe that digital exchanges enabled by DLT platforms are here to stay and proliferate in the future, sorting out a viable form for privately produced currency that can be used to grease the wheel of digital exchanges is a more productive way out.
We might not be far away from stabilising the unstable stablecoins.
About the Author
Wong Chin Yoong is a professor of economics in Universiti Tunku Abdul Rahman, and an external consultant to Max Wealth Group.