Fed paper explores stablecoins’ impact on financial system

Researchers say stablecoins could be a ‘digital safe haven’ during volatility, but design choices matter

Draft Fed TLAC rules unclear on structured notes

New research published by the Federal Reserve explores how different structures underpinning stablecoins can impact the financial sector and the wider economy.

Authors Gordon Liao and John Caramichael find a “two-tier” structure, where stablecoins are backed by commercial bank reserves, can both support stablecoin issuance and maintain credit intermediation.

A more radical design, a “narrow-bank” structure, where stablecoins are fully backed by central bank reserves, could be more stable but would likely come at the cost of lower credit intermediation, they say.

Stablecoins are a form of crypto asset whose value is supported by a pool of more traditional reserve assets such as bank deposits and low-risk securities such as Treasuries. Most stablecoins are pegged to the US dollar.

Stablecoins can be used as payment systems, “on-ramps” to decentralised finance markets and for liquidity management, the researchers say.

“We have archaic payment systems in the US that not only contain single points of failure but also enable economic rents,” says Liao, who recently left the Fed to join crypto asset exchange Uniswap. “For instance, a couple of large players have dominated the card payment space and made consumer transaction costs rather high for goods and services.”

“Stablecoins are one way of reducing that cost,” he says. “The more recent developments in stablecoins such as USD Coin deployed on proof-of-stake blockchains have lowered the costs of payments to fractions of a cent.”

In the paper, the authors say stablecoins may also exhibit attractive qualities in times of market distress. They find dollar-pegged stablecoins sell for slightly more than the assets they’re pegged to when either stock or crypto markets are distressed.

They do warn that certain stablecoins backed by “non-cash-equivalent risky assets” are prone to runs. Fed chair Jerome Powell has previously compared such stablecoins to money market funds, which saw large outflows during the Covid crisis.

However, Liao and Caramichael find that many stablecoins performed better than prime money market funds during the most intense period of Covid stress. “Our analysis suggests that counter-cyclical demand for stablecoins in the secondary market can ameliorate risks of redemption runs during times of broader market downturns,” they write.

Narrow-bank controversy

The paper explores how a framework inspired by the idea of a ‘narrow bank’ could create even greater stability in stablecoin systems.

A narrow bank is one where all deposits are backed by central bank reserves, making runs all but impossible. The idea was tested by former Fed official James McAndrews, whose firm The Narrow Bank (TNB) sued the New York Fed in a bid to gain access to a reserve account. The Fed rejected the idea, in part due to TNB’s potential impact on the monetary policy framework.

In the narrow-bank form of stablecoins, households and businesses still access the stablecoin through intermediary firms. But the stablecoin is backed by central bank reserves. “A narrow-bank stablecoin is most similar to a central bank digital currency (CBDC),” Liao notes.

The paper highlights how such a design could see deposits migrate into stablecoins, which would force banks to cut their asset holdings to accommodate the decline in their standard deposit funding. The issue is similar to central bank concerns that CBDC would reduce bank funding, potentially impacting credit flows in the economy.

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