The issue of stablecoins has gained prominence as they continue to gain significance in the world of finance. A recent study released by the Bank for International Settlements (BIS) highlighted the lack of crucial mechanisms that guarantee money market stability in fiat, and proposed that an operational model giving regulatory control to a central bank would be superior to private stablecoin models. As these digital assets become increasingly influential in the financial landscape, it is important to understand their weaknesses and areas for improvement.
The study utilized a “money view” of stablecoin and drew an analogy with onshore and offshore USD settlement to probe the weaknesses of stablecoin settlement mechanisms. It emphasized that when eurodollar holders sought to bring their funds onshore during the financial crisis of the late 2000s, the Federal Reserve provided a $600 billion liquidity swap to other central banks to restore par in global dollar settlement. The authors of the study deemed this as a non-trivial institutional apparatus.
The study revealed that stablecoins bridge on-chain and off-chain funds and maintain par with the fiat USD through up to three “superficial” mechanisms: through reserves, overcollateralization, and/or an algorithmic trading protocol. Reserves are critically important, as they are defined as an equivalent value of short-term safe dollar assets. Stablecoins mistakenly assume their solvency — the ability to meet long-term demand — based on their liquidity — the ability to meet short-term demand, whether they depend on reserves or an algorithm. This points to a fundamental flaw in the stability mechanisms of stablecoins.
Additionally, the study pointed out that reserves are unavoidably tied to the fiat money market, which could lead to stability issues in the event of economic stress. Stablecoins lack the mechanisms that central banks have in place to attempt to maintain bank liquidity both onshore and offshore during financial crises. The study cited an example of a banking crisis where central banks were surprised to find that lender of last resort support for a stablecoin was in effect for a bank, demonstrating the lack of robust mechanisms in place for stablecoin stability.
Another challenge outlined in the study is the need for stablecoins to maintain par among themselves, as well as the issue of bridges, which the authors compare to foreign exchange dealers. As stablecoins are highly dependent on credit to absorb imbalances in order flow, they face difficulties in maintaining par, especially in periods of economic stress and higher interest rates.
The study suggested that the Regulated Liability Network provides a model solution to the difficulties faced by stablecoins. In this model, all claims are settled on a single ledger and are inside a regulatory perimeter. The commitment of a fully-fledged banking system that would include the central bank, and thus have the credibility that today’s private crypto stablecoins lack, was also highlighted.
The BIS has been paying increased attention to stablecoins, as the study earlier in November examined examples of stablecoins failing to maintain their pegged value. The legislative attention stablecoins have been receiving in the European Union, United Kingdom, and United States is a testimony to its increasing role in finance.
As the role of stablecoins continues to evolve and expand, it is crucial for regulators and market participants to address the weaknesses and challenges identified in this study. Improved operational models and regulatory structures can help to ensure the stability and credibility of stablecoins as they become an increasingly integral part of the financial ecosystem.