Stablecoin Paradox

Original Author: Eswar Prasad, Professor of Economics at Cornell University

Original Compilation: Eric, Foresight News

The early revolutionaries of cryptocurrency aimed to break the monopoly of central banks and large commercial lending institutions over financial intermediation. The grand goal of the original cryptocurrency, Bitcoin, and the blockchain technology behind it, was to bypass intermediaries and connect trading parties directly.

This technology aims to achieve financial democratization, allowing everyone, regardless of wealth, to easily access a wide range of banking and financial services. Emerging financial institutions would leverage this technology to provide competitive financial services—including customized savings, credit, and risk management products—without the need to establish expensive physical branches. All of this is intended to clear out the old financial institutions that lost public trust during the global financial crisis and establish a new financial order. In this new decentralized financial world, competition and innovation would thrive, benefiting both consumers and businesses.

However, this revolution was quickly subverted. Decentralized crypto assets like Bitcoin, which are essentially created and managed by computer algorithms, have proven to be unviable as a medium of exchange. Their value is highly volatile, and they cannot process large volumes of transactions at low cost, making them unsuitable for everyday use and leading to their failure to achieve the intended goals. Instead, Bitcoin and other crypto assets ultimately became what they were never meant to be—speculative financial assets.

The emergence of stablecoins filled this gap, becoming a more reliable medium of exchange. They use the same blockchain technology as Bitcoin but maintain value stability by being pegged one-to-one with central bank currency reserves or government bonds.

Stablecoins have facilitated the development of decentralized finance (DeFi), but they themselves are contrary to decentralization. They do not rely on decentralized trust mediated by computer code but rather on trust in the issuing institutions. Their governance is not decentralized either; users do not decide the rules through public consensus. Instead, the issuing institutions of stablecoins determine who can use them and how they can be used. Stablecoin transactions, like Bitcoin, are recorded in a digital ledger maintained by a decentralized network of computer nodes. However, unlike Bitcoin, it is the stablecoin issuing institutions that validate these transactions, not computer algorithms.

Payment Channels

Perhaps the grander goal is more important. Stablecoins can still serve as a channel for people across income levels to access digital payments and DeFi, weakening the privileges that traditional commercial banks have long enjoyed and, in some ways, narrowing the gap between wealthy and impoverished nations. Even small countries can benefit from easier access to the global financial system, reducing friction with payment systems.

Stablecoins do indeed lower payment costs and reduce payment friction, especially in cross-border payments. Economic migrants can remit money to their hometowns more conveniently and economically than ever before. Importers and exporters can complete transactions with foreign partners instantly, without waiting days.

However, beyond payments, DeFi has devolved into a stage for financial engineering, spawning many complex products whose value is questionable aside from speculation. DeFi activities have done little to improve the lives of impoverished families and may even harm the interests of retail investors who are lured by high returns while ignoring risks due to their lack of experience.

Regulatory Shift

Will the recent U.S. legislation allowing various companies to issue their own stablecoins promote competition and curb some disreputable issuers? In 2019, Meta attempted to issue its own stablecoin, Libra (later renamed Diem). However, due to strong opposition from financial regulators, the project was ultimately halted. Regulators were concerned that such stablecoins could undermine the effectiveness of central bank currencies.

With the shift in the regulatory environment in Washington and the arrival of a new government that is friendly toward cryptocurrencies, the door has opened for private stablecoin issuers. Stablecoins issued by large U.S. companies like Amazon and Meta, backed by their robust balance sheets, could sweep away other issuers. Issuing stablecoins would enhance the power of these companies, leading to increased market concentration rather than intensified competition.

Large commercial banks are also adopting some new technologies to improve operational efficiency and expand their business scope. For example, converting bank deposits into digital tokens that can be traded on the blockchain. It is foreseeable that large banks may one day issue their own stablecoins. All of this will weaken the advantages of smaller banks (such as regional and community lending institutions) and consolidate the power of large banks.

International Dominance

Stablecoins may also reinforce the existing structure of the international monetary system. The demand for dollar-backed stablecoins is the highest and they are the most widely used globally. They may ultimately enhance the dollar's dominance in the global payment system and weaken potential competitors. For instance, Circle, which issues the second most popular stablecoin, USDC, sees low demand for its other stablecoins (pegged to major currencies like the euro and yen).

Even major central banks are feeling uneasy. There are concerns that dollar-backed stablecoins could be used for cross-border payments, prompting the European Central Bank to issue a digital euro. The payment system within the Eurozone remains fragmented. While it is possible to transfer money from a bank account in Greece to a bank account in Germany, using funds from bank accounts in other Eurozone countries to make payments in another Eurozone country is still not convenient enough.

Stablecoins pose a survival threat to the currency composition of small economies. In some developing countries, people may trust stablecoins issued by well-known companies like Amazon and Meta more than their local currencies, which suffer from high inflation and exchange rate volatility. Even in economies with reliable central banks and sound management, people may find it hard to resist the allure of stablecoins, as they are convenient for both domestic and international payments and are pegged to major global currencies.

Inefficiencies of Traditional Payment Systems

Why have stablecoins gained such significant attention so quickly? One reason is that high costs, slow processing speeds, complex procedures, and other inefficiencies continue to plague the international payment systems and even domestic payment systems of many countries. Some countries are considering issuing their own stablecoins to prevent their national currencies from being marginalized by dollar-backed stablecoins. However, this approach is unlikely to succeed. They would be better off addressing the issues within their domestic payment systems and collaborating with other countries to eliminate friction in international payments.

Stablecoins may seem safe, but they harbor numerous risks. Firstly, they could facilitate illegal financial activities, making it more difficult to combat money laundering and terrorist financing. Secondly, they would establish independently managed payment systems run by private companies, threatening the integrity of payment systems.

Solutions

The solution seems obvious: effective regulation can reduce risks, leave room for financial innovation, and ensure fair competition by curbing the excessive concentration of economic power among a few companies. The internet knows no borders, so regulating stablecoins at the national level is far less effective than a cooperative model involving multiple countries.

Unfortunately, in the current climate of scarce international cooperation, where countries are actively protecting and advancing their own interests, such an outcome is unlikely to be realized. Even major economies like the U.S. and the Eurozone are acting independently on cryptocurrency regulation. Even if a more coordinated approach is taken, smaller economies will find it difficult to participate in decision-making. These countries have weak financial systems, limited regulatory capacities, and high hopes for a sound regulatory framework, and they may be forced to accept rules imposed by major powers that disregard their own interests.

The role of stablecoins is to reveal the widespread inefficiencies in the existing financial system and to demonstrate how innovative technologies can address these issues. However, stablecoins may also lead to greater concentration of power. This could give rise to a new financial order—not the innovative and competitive system envisioned by cryptocurrency pioneers, with a fairer distribution of financial power, but one that brings greater instability.