Original title: Stablecoins: Growth Potential and Impact on Banking
Author: Gordon Y. Liao and John Caramichael
Compiled by: BlockBeats
On June 5, stablecoin giant Circle will officially be listed on the New York Stock Exchange with the stock code CRCL. This is also the most watched IPO in the cryptocurrency field since Coinbase (stock code COIN) was listed on the Nasdaq 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, according to the latest market data, this target has been raised to $7.2 billion and has been oversubscribed by more than 25 times. The market has clearly underestimated the enthusiasm of funds for the concept of stablecoins.
This enthusiasm does not only come 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 further large subscriptions, which together account for about 30% of this financing. Just a week or two before the IPO date was officially confirmed, Circle was still in a "acquisition rumor" with Coinbase and Ripple.
Related reading: " While rushing for IPO and talking about selling, what does Circle want to do? "
In recent years, stablecoins have appeared in institutional investment reports as one of the few concepts that can bet on the growth of the cryptocurrency market and the popularization of blockchain technology, making Circle the first stock in the stablecoin concept.
At the end of last month, the Hong Kong Legislative Council passed the Stablecoin Bill in its third reading, and many stablecoin concept stocks and digital currency sectors in the Hong Kong and A-share markets also saw a big boom, with many companies hitting their 20% daily limit. According to Caixin, Everbright Holdings' stock price soared 26.6% on June 3 due to its strategic investment in Circle with IDG Capital in 2016.
Amid the hype, the topic of "What is a stablecoin?" in the traditional financial circle has quickly gained popularity. In fact, stablecoin technology, especially CBDC (central bank digital currency), has long been a strategic plan that many governments have been planning for a long time. In the United States, thanks to the Trump administration's administrative ban on CBDC, the development of the "private stablecoin" field has made rapid progress in just a few months, and the "GENIUS" stablecoin bill was passed on May 20.
The US government has done a lot of research on stablecoin technology itself. On January 31, 2022, the Federal Reserve released a report titled "Stablecoins: Development Potential and Impact on the Banking System". In the report, the Federal Reserve focused on the potential impact of stablecoins on the banking system and credit intermediaries. For readers who do not understand the concepts and knowledge related to stablecoins, it may be a good "Stablecoin 101 Textbook".
The following is a compilation of the original content of the Federal Reserve’s “Stablecoin: Development Potential and Impact on the Banking System”:
TL;DR
A stablecoin is a digital currency that pegs its value to an external reference, typically the U.S. dollar (USD). Stablecoins play a key role in digital markets, and their growth could spur innovation in the broader economy. Over the past year, there has been an explosion in the number of USD stablecoins circulating on public chains, with a total circulating supply of nearly $130 billion as of September 2021, up more than 500% from a year ago.
As stablecoins gain more and more attention, a range of issues are raised, including the stability of their pegs, consumer protection, KYC and compliance, and 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 issues related to stablecoins can be addressed through appropriate institutional safeguards, regulations, and technological advances, the continued growth of stablecoins in circulation will eventually affect the traditional banking system in important ways.
In this note, we first discuss the basics of stablecoins, their current use cases, and their potential for growth. Second, we examine the historical behavior of stablecoins during past periods of distress in crypto and broader financial markets. We find that stablecoins pegged to the U.S. dollar exhibit safe asset quality, as their prices on secondary markets temporarily rise above their pegs during times of extreme market distress, incentivizing the issuance of more stablecoins. We also highlight the risk of “runs” for certain stablecoins backed by non-cash equivalent risky assets.
Finally, we outline possible scenarios for bank reserves, credit intermediation, and central bank balance sheets if stablecoins gain wider traction. Our research suggests that widespread adoption of asset-backed stablecoins could be supported within a two-tier fractional reserve banking system without negative impacts on credit intermediation. In such a framework, stablecoin reserves are held as commercial bank deposits, and commercial banks engage in fractional reserve lending and maturity transformation like traditional bank deposits. We also find that replacing physical cash (banknotes) with stablecoins can lead to more credit intermediation. In contrast, a “narrow” banking framework that requires stablecoin issuers to back their stablecoins with central bank reserves minimizes the risk of stablecoin “runs” but may reduce credit intermediation.
The basics of stablecoins
Stablecoins are digital currencies recorded on distributed ledger technology (DLT), usually a blockchain, and pegged to a reference value. Most stablecoins in circulation are pegged to the U.S. dollar, but stablecoins can also be pegged to other fiat currencies, baskets of currencies, other cryptocurrencies, or commodities such as gold. Stablecoins act as a store of value and medium of exchange on DLT, enabling stablecoins to be exchanged or integrated with other digital assets.
Stablecoins differ from traditional digital currency records, such as bank deposit accounts, in two main ways. First, stablecoins are cryptographically secured. This allows users to settle transactions almost instantly, without double spending or intermediaries facilitating settlement. On public chains, this also allows for 24 X 7x365 transactions per day. Second, stablecoins are often built on programmable DLT standards and allow for the composability of services. In this case, "composability" means that stablecoins can serve as independent building blocks that interoperate with smart contracts (self-executing programmable contracts) to create payments and other financial services. These two key features underpin the current use cases for stablecoins and support innovation in both the financial and non-financial sectors.
Since 2020, the use of stablecoins on public chains such as Ethereum, Binance Smart Chain or Polygon has surged. As of September 2021, the circulating supply of the largest public stablecoin pegged to the US dollar was close to $130 billion. The figure shows that the circulating supply of public stablecoins grew particularly strongly in early 2021, with an average month-on-month increase of about 30% in the first five months of this year.
Current stablecoin types
Stablecoins are a nascent, broadly defined technology that may take many forms. The technology is currently implemented in specific forms, which we describe below and summarize in Table 1. However, please note that stablecoin technology is in its infancy and has a high potential for innovation. The current implementations of stablecoins discussed below, as well as their current status in the regulatory environment, do not reflect all potential deployments of stablecoin technology.
Circulating supply of the top 10 USD-pegged public stablecoins by market cap. Data from January 2019 to September 2021. Others in the category include Fei, TerraUSD, TrueUSD, Paxos Dollar, Neutrino USD, and HUSD.
Stablecoins backed by public reserves
Most existing stablecoins are circulated on public blockchains, such as Ethereum, Binance Smart Chain, or Polygon. Among 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 called custodial stablecoins because they are issued by an intermediary that acts as a custodian of cash equivalent assets and provide 1:1 redemption of stablecoin liabilities in USD or other fiat currencies.
The adequacy and robustness of some public reserve-backed stablecoins have been called into question. In particular, Tether, the largest stablecoin by circulating supply, 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 U.S. dollar with varying levels of financial auditing include USD Coin, Binance USD, TrueUSD, and Paxos Dollar.
Public algorithmic stablecoin
A subset of stablecoins uses other mechanisms to stabilize their prices, rather than relying on the robustness of the underlying reserves. These stablecoins are often referred to as algorithmic stablecoins. While reserve-backed stablecoins are issued as liabilities on the balance sheet of a legally registered company, algorithmic stablecoins are maintained by a system of smart contracts that run exclusively on public blockchains. The ability to control these smart contracts is often granted through the possession of governance tokens, which are specialized tokens used to vote on changes to the protocol or governance parameters. These governance tokens can also serve as direct or indirect claims on future cash flows from the use of the stablecoin protocol.
The field of public algorithmic stablecoins is highly innovative and difficult to categorize. However, one can generally think of these stablecoins as being designed based on two mechanisms: (1) collateralization and (2) algorithmic pegs. When a user deposits a volatile cryptocurrency (such as Ethereum) into Dai’s smart contract protocol, a collateralized public stablecoin, such as Dai, is minted. The user then receives a loan of Dai (pegged to the U.S. dollar) with a collateralization ratio of over 100%. If the value of the Ethereum deposit falls below a certain threshold, the loan is automatically liquidated.
In contrast, algorithmic pegs use automated smart contracts to secure the peg by buying and selling stablecoins and associated governance tokens. However, these pegs can experience instability or design flaws that lead to “instability,” as exemplified by the algorithmic stablecoin Fei’s brief depegging after its launch in April 2021.
Institutional or private stablecoins
In addition to reserve-backed 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) DLTs, and they are used by financial institutions and their clients for efficient wholesale transactions. The most famous institutional stablecoin is JPM Coin. JPMorgan Chase and its clients can use JPM Coin for transactions such as intraday repo settlements and to manage internal liquidity.
These private, reserve-backed stablecoins are functionally and economically comparable to products offered by certain money transmitters. For example, Paypal and Venmo (a subsidiary of Paypal) allow users to make near-instant transfers and payments within their networks, and the balances held by these companies are similar to reserve-backed stablecoins. The key difference is the use of a centralized database rather than a permissioned DLT.
Stablecoins’ use cases and growth potential
Strong use cases are driving the growth of various forms of stablecoins today. We summarize these use cases. The most important current use case for stablecoins is their role in cryptocurrency trading on public blockchains. Investors often prefer to use public stablecoins to trade cryptocurrencies because this allows for near-instant 24/7/365 transactions without relying on non-DLT payment systems or custodial holdings of fiat currency balances.
In addition to being used for crypto trading, both public and institutional stablecoins are currently used for near-instant, 24/7, non-intermediary payments with potentially low fees. This is particularly relevant for cross-border transfers, which often take multiple days and require high fees. Companies also use institutional stablecoins to transfer cash between their subsidiaries almost instantly, to manage internal liquidity, and to facilitate wholesale transactions in existing financial markets, such as intraday repo transactions. Finally, because public stablecoins are programmable and composable, they are heavily used in decentralized, public blockchain-based markets and services, known as decentralized finance, or DeFi. The DeFi protocol system allows users to use stablecoins to participate in a variety of cryptocurrency-related markets and services, such as market making, collateralized lending, derivatives, and asset management, directly and with trading parents, without the need for traditional intermediaries. As of September 2021, approximately $60 billion in digital assets are collateralized (locked) in DeFi protocols.
Future growth potential
The defining characteristics of stablecoins, cryptographic security and programmability, support strong use cases that currently drive the use of existing public and institutional stablecoins. However, these features have the potential to drive innovation beyond current use cases, which are largely limited to cryptocurrency markets, certain peer-to-peer payments, and institutional liquidity management for large banks. Looking ahead, stablecoin technology is likely to see diverse implementations and drive innovation in multiple growth areas: more inclusive payments and financial systems, tokenized financial markets, and microtransactions that facilitate technological advances such as Web 3.
A more inclusive payments and financial system
Stablecoins have the potential to spur growth and innovation in payment systems, enabling faster and cheaper payments. Because stablecoins can be used to transfer funds peer-to-peer between digital wallets almost instantly with potentially low fees, they may lower payment barriers and put pressure on existing payment systems to provide better services. This is particularly important for cross-border transfers, which can take days to clear and incur high fees. These fees and delays are a burden on 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 is important to note that DeFi faces severe challenges, including complex user experience, lack of consumer protection, frequent hacking attacks, protocol dysfunction, and market manipulation. In addition, almost all DeFi protocols only support the trading or lending of cryptocurrencies or non-fungible tokens (NFTs). If DeFi protocols mature beyond their current state and integrate with broader financial markets to support real-world economic activities, then DeFi can encourage a more inclusive financial system that allows investors to participate directly in the market without intermediaries. This growth in DeFi may drive growth in stablecoin usage.
Tokenized financial markets
Additionally, stablecoins could play a key role in the tokenization of financial markets. This would entail 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 allow for real-time settlement at very low costs. This could improve liquidity, transaction speed, and transparency while reducing counterparty risk, transaction costs, and other barriers to market participation. This could particularly benefit certain asset classes, such as real estate, by allowing fractional ownership of tokenized assets and more transparent price discovery. For payment versus payment (PvP) transactions, such as cross-currency swaps, tokenization would also allow for near-instant execution, rather than the market’s current traditional T+2 framework, where payment of a swap is made by two business settlements days after the swap occurs. Additionally, for both types of transactions, tokenized financial markets would benefit from the programmability of DLT, which could automate security services and regulatory requirements, such as required holding periods. If financial markets were partially or fully tokenized, this could drive further growth in stablecoin usage.
Next generation innovation
Finally, stablecoins have the potential to support the next generation of innovation. One example of such innovation is Web 3, which could see a shift away from centralized web platforms and data centers toward a decentralized web. Under this paradigm, revenue for internet services and social media platforms would shift from advertising to microtransactions, aided by the emergence of efficient, integrated online payment systems. For example, one could imagine a search engine or video streaming platform supported by near-instant micropayments from stablecoins, rather than advertising revenue and the sale of user data. If this shift in web services comes to fruition, it could drive further growth for stablecoins.
In summary, the current use of stablecoins is mainly driven by cryptocurrency transactions, limited peer-to-peer payments, and DeFi. Looking ahead, stablecoins may achieve further growth by promoting more inclusive payment and financial systems, tokenization of financial markets, and possible next-generation innovations such as Web 3.
Hook stability
The stability of stablecoins’ pegs to their reference values is a core question. It is not the focus of our paper, but we briefly discuss this important issue here. In this section, we will first outline the sources of peg instability for current public reserve-backed stablecoins and discuss how these sources can be addressed. We will then review how stablecoins can serve as potential safe assets in digital markets and provide evidence that current public reserve-backed stablecoins may already play this role in cryptocurrency markets.
Currently, peg instability for public reserve-backed stablecoins comes in two forms: investor redemption risk at the issuer and secondary market price dislocation. The former is related to the security and soundness of the stablecoin reserves. If stablecoin holders lose confidence in the soundness of the stablecoin backing, panics could occur. A run on a stablecoin carries the risk of spillover to other asset classes as stablecoin reserves are sold off or unloaded to meet redemption demand. Moreover, a run on a stablecoin could cause further distress by disrupting markets and service smart contracts that rely on the stablecoin through interoperability. We believe this type of instability can be addressed with appropriate institutional and/or regulatory guardrails, such as transparent financial audits and adequate requirements on the liquidity and quality of stablecoin reserves. Concerns around redemption risk and the extent to which they can be addressed were recently mentioned in Quarles (2021).
The second form of peg instability for public reserve-backed stablecoins stems from supply-demand imbalances in the secondary market. Because these stablecoins are traded on both centralized and decentralized exchanges, they are vulnerable to demand shocks that could temporarily decouple their pegs until the stablecoin issuer adjusts the supply. In particular, because public stablecoins serve as a store of value for markets based on public blockchains, these stablecoins experience high demand during crypto market distress as investors rush to liquidate their speculative positions into stablecoins.
During these events, the prices of major public reserve-backed stablecoins tend to appreciate temporarily until the issuer adjusts the supply. As an example, the chart shows the cryptocurrency market crashes of March 12, 2020 and May 19, 2021. The first event occurred during a period of general market volatility surrounding concerns about the spread of Covid-19. The second event occurred during a crypto market downturn associated with massive deleveraging. During both periods, the prices of major public reserve-backed stablecoins rose sharply as the prices of speculative cryptocurrencies Bitcoin and Ethereum plunged 30% to 50%.
For these episodes of extreme crypto market distress, stablecoins appreciate as a digital safe-haven asset while more speculative crypto assets are temporarily in free fall until stablecoin issuers are able to increase their supply and reserve purchases and/or the stablecoins experience falling price pressure from arbitrageurs. The behavior of these public stablecoins is unique and different from prime money market funds, which experienced large outflows during the worst of the 2008 global financial crisis and the 2020 COVID-19 pandemic.
These events demonstrate the potential of stablecoins to serve as digital safe havens during periods of market distress. While discussions of financial stability risks of publicly-backed stablecoins have focused primarily on redemption risks specific to individual stablecoin reserve forms, our analysis suggests that countercyclical secondary market demand for stablecoins can reduce redemption risk during broader market downturns. With appropriate safeguards and regulation, stablecoins have the potential to provide stability comparable to traditional forms of security of value.
Potential impact of stablecoins on credit intermediation
If stablecoins become widely adopted across the financial system, they could have significant effects on the balance sheets of financial institutions. Regulators, market participants, and academics are particularly concerned about the potential for stablecoins to disrupt bank-dominated credit intermediation. In this section, we analyze several possible scenarios for reserve-backed stablecoins to become widely adopted across the financial system. We focus on reserve-backed stablecoins rather than algorithmic stablecoins because reserve-backed stablecoins are currently the largest and most closely linked to the existing banking system. Using these scenarios, we highlight how the impact of stablecoin adoption on credit provision depends critically on two factors: the sources of inflows into stablecoins and the composition of stablecoin reserves.
We summarize our results. We find that in most of the cases we consider, credit provisioning is likely not to be negatively affected. In fact, replacing physical money (banknotes) with stablecoins may allow for more bank-led credit provision. One notable exception, which may lead to large-scale credit disintermediation, is that stablecoins need to be fully backed by central bank reserves, which we call a narrow banking framework. In this framework, redemption risk is minimized at the cost of greater credit disintermediation.
Inflow Source
If stablecoins are widely adopted, the main inflows are likely to come from three sources: physical currency (banknotes), commercial bank deposits, and cash equivalent securities (or money market funds). First, as a form of digital money, stablecoins will replace some of the banknotes in circulation, especially as the economy becomes more digital. In some of our scenarios, we see an increase in the supply of credit as users substitute from physical cash to reserve-backed stablecoins. This is because banknotes are a direct liability of the central bank and are replaced by reserve-backed stablecoins, which, depending on the reserve framework, can create credit through loans or securities purchases.
Second, stablecoins could see inflows from commercial bank deposits if households and firms prefer to hold stablecoins rather than traditional balances at commercial banks. This source of inflows is of great interest to policymakers because of the widespread concern that large substitutions for deposits could disrupt the supply of credit at commercial banks. We show that the effect of deposit substitution on credit supply can be positive, negative, or neutral, depending on the reserve framework. Finally, stablecoins could see inflows into cash-equivalent securities (or money market funds). This may have no effect on credit supply because it requires recycling funds back into the banking system, as we discuss in a later section.
Reserve composition
The impact of widespread adoption of reserve-backed stablecoins on credit provision also depends on the composition of stablecoin reserves. We propose three reasonable stablecoin reserve frameworks: narrow banks, two-tier intermediaries, and securities holdings. As shown above.
Under the narrow banking framework, stablecoins would need to be backed by commercial bank deposits, which in turn are fully backed by central bank reserves. Equivalently, it would be possible for commercial banks to issue fully stablecoins (or tokenized deposits) backed by central bank reserves. The narrow banking approach would roughly correspond to a retail central bank digital currency, where the digital currency is a liability of the central bank but can be used by households and firms through intermediaries such as commercial banks or fintech firms. The People’s Bank of China has adopted this framework for its state-backed digital currency (called Digital Currency and Electronic Payment), the digital renminbi, or e-renminbi. The possibility of requiring stablecoins to be held in central bank reserves is also mentioned in the proposed STABLE Act in the United States.
While the narrow bank framework can guarantee the stability of the stablecoin’s peg, as it is effectively a pass-through 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 large transfer of regular commercial bank deposits into narrow bank stablecoins, which could disrupt credit supply. While this credit disruption effect could be mitigated by limiting stablecoin holdings and differential reserve rates, the overall structure of the bank’s narrow approach to stablecoin reserves could undermine the stability of the banking system. In addition, the narrow bank approach could lead to an expansion of the central bank’s balance sheet to accommodate the demand for reserve balances by stablecoin issuers.
These concerns about narrow bank stablecoins reflect more general concerns about narrow banks, which the Federal Reserve has taken note of. In a recently proposed regulation that would affect narrow banks (officially known as pass-through investment entities, or PTIEs), the Fed expressed its “concern that [narrow banks] could disrupt financial intermediation in unanticipated ways and could also have negative effects on financial stability” (Regulation D: Reserve Requirements for Depository Institutions, 2019). In addition, the Fed outlined serious concerns about the demand for reserve balances, stating that “[narrow banks’] demand for reserve balances could become substantial. To maintain the desired monetary policy stance, the Federal Reserve may need to meet this demand by expanding its balance sheet and the supply of reserves.”
In contrast to the narrow banking framework, under the two-tier intermediation framework, stablecoins would be backed by commercial bank deposits used for fractional reserve banking. Similarly, it is possible for commercial banks to issue stablecoins or offer tokenized deposits for fractional reserve banking. To be clear, this does not mean that stablecoins are not fully backed. On the contrary, stablecoin issuers rely on commercial bank deposits as assets, and commercial banks use stablecoins and/or stablecoin deposits to practice fractional reserve banking, which means that stablecoins are ultimately backed by a combination of loans, assets, and central bank reserves. It has the effect of effectively re-labeling a portion of regular deposits as stablecoin deposits. Importantly, for bank intermediation to remain unchanged, stablecoin deposits must be treated the same as non-stablecoin deposits in terms of legal reserve requirements, liquidity coverage ratios, and other regulatory and self-imposed risk limits.
Finally, instead of keeping funds at commercial banks, stablecoin issuers can hold cash-equivalent securities, such as Treasury bills and high-quality commercial paper. These securities can be purchased directly or indirectly through money market funds. This is the main framework currently adopted by issuers of stablecoins backed by public reserves, such as Tether, which Federal Reserve Chairman Jerome Powell recently noted is "like a money market fund."
Scene Construction
In our scenarios, we consider the impact of one or more fiat reserve-backed stablecoins gaining widespread adoption in a stylized version of the banking system. The baseline balance sheet for this banking system is shown in Figure 1. Specifically, we consider the case where households and firms substitute $10 for banknotes, commercial bank deposits, or securities, and then we perform accounting work to determine how stablecoin adoption affects the balance sheets of the central bank, commercial banks, and households and firms. We analyze how this impact varies depending on the stablecoin's reserve framework and the sources of its inflows.
It is important to note that in constructing these scenarios, we make several key assumptions. The first is that we do not know the specific form of the stablecoin that is 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 stablecoins adopted are institutional tokenized deposits, stablecoins circulating on a public blockchain, or some other form. Second, we only show illustrative advantage cases. In reality, stablecoins can see inflows from multiple sources and hold a variety of assets as reserves. Third, these scenarios do not capture secondary knock-on effects or feedback loops, nor do they address heterogeneous effects within the industry. Finally, we assume a 10% statutory reserve requirement on traditional deposits at commercial banks.
To illustrate the complex flows between various parts of the banking system that support our edge case scenario, we visualize a subset of the stablecoin inflows and reserve allocations we have discussed in Figure 1. Specifically, we use diagrams to show the inflows of commercial bank deposits (inflow A) and paper money (inflow B) into stablecoins, and the allocation of these funds into reserves (reserve flow A) and securities (reserve flow B) in the form of commercial bank deposits.
In the figure, we see how stablecoin inflows and reserve flows are interconnected. Firms and households substitute stablecoins for deposits (inflow A) and banknotes (inflow B). Stablecoin issuers deposit some of these funds into the commercial banking system as commercial bank deposits holding reserves (reserve flow A), and use these funds to purchase securities as reserves (reserve flow B). These securities purchases also circulate funds back into the banking system, as sellers of securities ultimately take the proceeds of the securities sales and deposit them back into the banking system. As shown in the figure, these flows affect central banks, which maintain cash and central bank reserves as liabilities, and firms and households, which receive loans from commercial banks. While this figure does not capture the full range of flows between these entities, it symbolizes how widespread adoption of stablecoins could reshuffle the complex financial relationships within the banking system.
Scenario Analysis
Narrow banking framework:
As discussed earlier, the narrow banking framework poses the greatest risk to credit provisioning, depending on the source of inflows. In our narrow banking scenario, as shown in the table, we find that physical cash flows into narrow bank stablecoins will have a neutral effect on credit supply, while commercial bank deposits will disrupt credit supply.
In Panel A (cash inflow scenario), we see that stablecoins replace cash on household and corporate balance sheets. The inflow of cash leads to an indirect increase in commercial bank balance sheets and commercial bank reserves. The central bank's balance sheet is restructured, with reserve liabilities replacing cash liabilities. The net effect is an expansion of commercial bank balance sheets, but no change in credit provisions. This scenario assumes that banks are not constrained by the size of their balance sheets. That is, narrow bank deposits and related reserve holdings are exempted from the leverage ratio calculation. This leverage ratio exemption for central bank reserve holdings has been adopted by regulators in different jurisdictions.
Panel B presents a narrow banking scenario in which deposits migrate to stablecoins. Since stablecoin deposits remain entirely on commercial banks’ balance sheets, banks must reduce their asset holdings to accommodate the decline in non-stablecoin deposit funding. The central bank’s balance sheet would then expand to accommodate the increased demand for reserve balances without offsetting the decline in cash liabilities. In this scenario, we assume that the central bank will meet the increased demand for reserves by purchasing securities. This assumption of central bank easing is suggested by the Federal Reserve’s previous rulings on narrow banking, as discussed above, in connection with Regulation D: Reserve Requirements for Depository Institutions (2019). However, if the central bank determines the size of its balance sheet, we present two alternatives in Table A1 of the Appendix. In the first alternative, commercial banks shrink their balance sheets significantly to compensate for the shortfall in deposit funding. In the second scenario, commercial banks compensate for the lost deposit funding by issuing debt securities. The result is a further reduction in bank-led credit creation.
We do not envision a scenario where narrow bank stablecoins have large inflows from securities holdings. In this case, the effect on credit provisioning is likely to be neutral. Under the same assumptions as above, the net effect on credit provisioning should be minimal if the central bank meets the increased demand for reserves by purchasing securities (from households). Unlike holding securities directly, the move to stablecoins would leave households with stablecoins backed by central bank reserves, which in turn are backed by securities. This scenario also assumes that increased narrow bank reserves are not affected by the leverage ratio, as discussed above.
Two-layer mediation framework:
For the two-tier intermediation framework shown in the table below, we find that large inflows into stablecoins would have a neutral to positive effect on credit supply. Panel A shows the scenario of exchanging cash for stablecoins. As commercial banks engage in fractional reserve banking via stablecoin deposits, their balance sheets expand as credit and securities holdings expand, accounting for most of the expansion. The central bank contracts on a net basis, with reserves increasing slightly and cash liabilities decreasing significantly. Households accumulate more assets, funding the expansion in bank lending. The effect on credit provisioning is positive. Panel B shows the two-tier intermediation scenario with deposit substitution. There are no changes in commercial bank and central bank balance sheets and asset holdings overall. The only change is in the composition of commercial bank liabilities as time deposits are converted into stablecoin deposits. As mentioned earlier, this scenario assumes that stablecoin deposits are treated the same as non-stablecoin deposits with respect to legal reserve requirements, liquidity coverage ratios, and other regulatory and self-imposed risk limits.
Securities Holding Framework:
As the table below shows, the impact of widespread adoption of security-backed stablecoins is the most difficult to predict. Many scenarios are possible. In Panel A, we present a scenario in which a security-backed stablecoin sees inflows of commercial bank deposits. We assume that the stablecoin issuer sources securities from commercial banks rather than from the household and corporate sectors. In this scenario, as households swap deposits for stablecoins, commercial banks replace lost deposit funds by issuing their own securities. In addition, commercial banks could reduce their securities portfolios to replace losses in deposit funds. If banks adjust the asset side of their balance sheets primarily by changing their securities holdings, the size of the bank’s loan portfolio may remain unchanged. In this scenario, the central bank’s balance sheet also shrinks slightly due to losses in bank reserves.
Panel B presents a scenario in which households exchange their holdings of cash-equivalent securities for stablecoins. This would result in the effective tokenization of cash-like securities without directly affecting the supply of credit in the banking system. We also consider an alternative scenario (not shown) in which a security-backed stablecoin experiences deposit inflows from the household and corporate sectors and concurrently sells securities to commercial banks. The sellers of securities are the households and corporate sectors, rather than the commercial banks described in Panel A of Table 7. The net effect on credit provision is neutral because the commercial bank deposit balances held by households and firms that purchase stablecoins are ultimately recycled back into the banking system by transferring them to other households and firms that sell securities to the stablecoin issuer. This restructuring of security holdings is illustrated in Figure 3 by inflows A and reserve flows B. The net result is a change in the balance sheet, identical to that in Panel B.
Finally, we do not describe scenarios in which security-backed stablecoins experience inflows from physical cash. However, this could have a neutral or positive effect on credit creation. If stablecoin issuers use banknotes to purchase existing securities and those banknotes do not end up in the banking system, this will not affect the supply of credit, as this would constitute a direct exchange of banknotes for securities. However, if banknotes used to purchase existing securities are deposited in the banking system, or if those banknotes are used to finance the issuance of new securities, this could increase the supply of credit by increasing commercial bank lending and securities purchases, or by reducing the equilibrium cost of issuing securities. All in all, the likely effect is a modest increase in the supply of credit.
Summarize
Stablecoins have grown significantly over the past year as digital assets have gained wider adoption and the use cases for programmable digital currencies have been clarified. This rapid ascent has raised concerns about possible negative impacts on banking activities and the traditional financial system. In this report, we discuss the current use cases and potential growth of stablecoins, analyze historical episodes of peg instability, and illustrate different scenarios for the impact of stablecoins on the banking system. As stated in the introduction, this paper does not consider all potential effects 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 range of plausible assumptions.
We examine reserve-backed stablecoins and find that the impact of stablecoin adoption on traditional banking and credit provision may vary depending on the source of inflows and the composition of stablecoin reserves. A two-tier banking system could support stablecoin issuance while maintaining traditional forms of credit creation in various scenarios. In contrast, a narrow bank-stablecoin framework could lead to the greatest stability, but with the potential cost of credit disintermediation. Finally, if dollar-pegged stablecoins are believed to be adequately collateralized, they could serve as a safe haven compared to other crypto assets during market distress.
