Yesterday the U.S. Federal Reserve published a paper exploring the impact on banks of various stablecoin designs. Some are concerned that stablecoins might reduce the ability of banks to make loans with a negative knock-on effect on the economy, so this was the area studied.
The research focused on the types of assets used to back the stablecoins: central bank deposits (narrow banking), commercial bank deposits, and securities. Other parties also consider security-backed stablecoins as narrow banking.
Summarising the impact on commercial lending, the conclusion was:
- commercial deposit backed stablecoins: neutral to positive
- security backed stablecoins: neutral to possibly negative
- narrow bank stablecoins: negative.
Controversial assumptions re security backed stablecoins
In our opinion, the security backed scenario made some controversial assumptions. Changing those assumptions would fundamentally impact the conclusions.
The Federal Reserve found that security backed tokens will have a neutral to possibly negative impact on bank lending, although it acknowledged this is the most unpredictable scenario.
In this case, people switch from bank deposits into stablecoins. With fewer deposits, a bank has two choices. It can either reduce lending or replace the bank deposits by issuing its own securities. Most banks will likely mix the two. As a result, the central bank concluded there may be a fall in bank lending but pegged the degree as modest. Why?
We’d note a couple of critical assumptions. Firstly, the Fed assumes that for asset backing, stablecoin companies invest in securities issued by banks, not other firms. In other words, the stabecoin companies buy up all those extra bank-issued securities. With this increased demand for securities, the cost to the banks of issuing securities shouldn’t go up because supply and demand remain neatly matched.
While the Fed’s description of security backed stablecoins supports asset backing in Treasury bills, the logic is based on bank commercial paper. We wonder whether requiring stablecoins to be backed by bank securities is under consideration as a rule?
Lower quality stablecoins such as Tether have more commercial paper backing, but higher quality ones such as USDC and Paxos are backed only by cash and short term Treasuries.
If Treasuries are used for asset backing, then there’s no increase in demand for bank securities. So if banks start issuing a lot more securities to replace lost deposits, the cost goes up. Hence, Treasury-backed stablecoins mean banks will have to pay a higher price when issuing more securities. This means they won’t fully replace the lost deposits with securities and/or they will charge more to bank borrowers.
Secondly, there’s a considerable difference between good times and bad times. People might strongly prefer stablecoins backed by Treasury bills rather than commercial bank deposits in bad times. This switching is seriously bad for banks, potentially causing runs. And it also dramatically increases demand in the Treasury market in a very short time period.
As a result, in the absence of legislation requiring stablecoins to be backed by commercial bank securities, we don’t follow the Fed’s conclusion. Perhaps there’s something we’re missing here. Please let us know if you disagree.
There’s little question that there’s huge upside potential for stablecoins in terms of functionality. But risks need to be understood.
Commercial and central bank backed stablecoins
Looking at the other scenarios, if stablecoins are backed by conventional bank deposits, there would be a small positive impact on lending from some physical cash converted to stablecoins. If the money put into stablecoins instead comes from bank deposits, there’s no impact because these tokens simply represent a bank deposit.
At the other extreme – referred to by the central bank as the narrow bank alternative – if stablecoins have to be backed by central bank reserves, a switch from bank deposits to stablecoins will impact the ability of banks to grant loans.
The central bank was keen to point out it was not looking at the quality of the backing. Nor was it exploring other known risks such as the stability of stablecoin pegs, consumer protection, compliance, and the scalability of blockchains as payment systems.
