Beware the stablecoin-induced inflation
Imagine a scenario where stablecoins are widely used as payment for goods and services, as opposed to the present where they mainly serve as payment means for non-stablecoin cryptocurrency trading. The global economy is facing high inflation. Many central banks have hiked policy rates to dampen demand-pull inflation, to be transmitted to market interest rates — money market rates, deposit rates, lending rates, and bond yields. Let’s assume inflation pressures from supply constraints are stable.
Then, how might stablecoin affect inflation? It depends on where the stablecoin issuers put the reserve assets at and whether the issuers are bank or non-bank.
Let’s focus on stablecoins — non-fiat money — that are anchored to local currency-denominated fiat money, such as banknotes and bank deposits, while being backed by the same fiat money-denominated reserve assets. It’s called domestic fiat-backed stablecoins.
People who want to hold stablecoin exchange their bank deposit money or banknotes with this non-fiat digital currency, which is currently issued only by non-banks. If the exchange rate of stablecoin against the fiat money is 1, non-bank stablecoin issuers only create stablecoins amounting to the amount of fiat money they get. Therefore, non-bank issuance of stablecoins by itself does not create additional money — in the total of fiat and non-fiat money. But accounting for reserve assets placement, it does.
The stablecoin issuers have to hold reserve assets as collateral to allow stablecoin holders redeeming a certain amount of their fiat money by selling back the same amount of stablecoins. The stablecoin issuers can hold the cash and bank deposits they get from issuing stablecoin as reserve assets. But they can also convert most of that fiat money into other forms of interest-bearing domestic financial assets, denominated in domestic fiat money. For instance, stablecoin issuers can buy government bonds, central bank securities, corporate bonds, money market funds, commercial paper, or certificates of deposits. This is problematic.
Unless the reserve assets are put in the domestic central bank, including in the form of wholesale CBDC, or as foreign assets, they remain in the domestic banking system as local currency-denominated bank deposits. Total money supply — both fiat and non-fiat — therefore enlarges, generating additional purchasing power. While the spending power of stablecoins holders — previously the fiat money holders — is unchanged, the sellers of the financial assets purchased by the stablecoin issuers enjoy the purchasing power of the selling proceeds in the form of bank deposits. Additionally, the non-bank stablecoin issuers generate lucrative private seigniorage income — the amount of money private entities (banks, e-money issuers, stablecoin issuers, cryptocurrency “miners”) make by creating money — , particularly in a given high interest rate environment.
This could lead to having “too much money chasing after too few goods”, as Milton Friedman said. Inflation. Demand-pull inflation. In particular policy rate hikes may be too weak to combat inflation that is partly driven by excess non-fiat money supply. In raising policy rates, monetary authorities expect a rise in market interest rates of fiat-denominated financial assets by adjusting the liquidity of fiat money. However there remains a substantial amount of non-fiat money — stablecoin — in circulation, potentially insulated from monetary policy.
What if non-bank issuers’ reserve assets are all placed as bank deposits?
Such stablecoin issuance followed by reserve asset placement at a bank’s current account or savings account deposits results in more money entering circulation since there is non-fiat money created, however the fiat money proceeds from stablecoin issuance is not expunged. But the bank deposit reserve assets cease its power to generate decent seigniorage income for the stablecoin issuers, provided the regulators can ensure the availability of the reserve money in a highly frequent time, preferably in real time. As a result, potential impact on inflation is minimized.
Non-bank stablecoin issuers may not like the idea of putting all reserve assets in bank deposits since they can’t make much profit. But besides inflationary concerns, there is another reason why regulators should require non-bank stablecoin issuers to hold their reserve assets in the form of bank deposits.
The non-bank issuers of stablecoins get seigniorage from placing reserve assets in the yield-bearing financial assets without even giving interest return to stablecoin holders. The issuers only provide payment services to stablecoin holders. Banks, in comparison, pay interests to the holders of bank deposits they create. Banks give credit and provide payment services with guarantees of bank deposit redemption, allowing withdrawal as banknotes or transferal to other bank accounts at the same value (convertible at par). On the other hand, non-bank stablecoin issuers, that do not place their reserve assets in bank deposits, might fail to keep their promises for redeeming stablecoins at a stable exchange rate. Furthermore, non-bank stablecoin issuers only add limited value to the economy by doing financial investment. Meanwhile, banks do lending by creating money to finance investment in the financial and real sector as well as household consumption, contributing largely to the economy. Resultingly, if stablecoin is to be widely used as money, it is reasonable that the non-bank stablecoin issuers’ ability to generate seigniorage income needs to be minimized to be smaller than banks’.
Should stablecoins then be issued only by banks?
The U.S. President’s Working Group on Financial Markets, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency, in their November 2021 Report on Stablecoins, proposed to the U.S. Congress “to limit stablecoin issuance, and related activities of redemption and maintenance of reserve assets, to entities that are insured depository institution.”
Inflation wise, this proposed model of issuance and redemption will have a neutral effect on demand-pull inflation since no additional money — in total fiat and non-fiat — are created. When a person buys stablecoin paid with her bank deposits, the bank destroys the buyer’s bank deposit money and creates stablecoins the same amount with the associated bank deposits. The reverse mechanism applies for redemption. This model is likely to benefit banks. A bank issuing stablecoin can get higher seigniorage revenue because it destroys interest-bearing deposits liabilities in exchange of creating non-interest-bearing stablecoin liabilities.
One issue of concern is the implication of this model of stablecoin arrangement on financial stability. If the issuance and redemption involves bank deposits, the risk to macro-financial stability is manageable. The bank does not have to back the stablecoins it issues by holding full-reserves assets as collateral, such as government bonds or 100% reserves at the central bank. When the stablecoin holders redeem their deposit money, the bank can simply re-create bank deposits — the commercial bank money — with the same value of stablecoin it has to remove from circulation.
Consequently, there are no risks of declining value of reserve assets in the event of massive redemption of fiat money, like what might happen when non-bank stablecoin issuers are forced to fire-sale their reserve assets. The stability of stablecoin’s rate of exchange with fiat money is therefore not an issue at all, as stablecoin and bank deposits become convertible at par. Yet as banks adopt a fractional-reserves system for bank deposits it also needs to hold reserves at the central bank, amounting to a fraction of stablecoin in circulation.
Risk to macro-financial stability is present when people exchange their central bank money — either banknotes, coins, or retail CBDC — with stablecoins and later redeem it. Under the fractional-reserves system, banks may not have enough of these central bank physical or digital currencies in their physical or digital vault to meet the redemption. This is similar to the risks banks face when the central bank issues retail CBDC. However, if the fiat-backed stablecoin is issued by insured banks, as proposed by the U.S. government, the insurance may be seen as providing “implicit additional reserves” for banks to back the stablecoin as if having “near full reserve assets”.
Another important issue is the relevance of banks to issue stablecoin as a DLT-based tokenized digital currency denominated in non-sovereign, non-fiat currency. If banks have the ability to provide such a type of digital currency and the corresponding payment services, they should also be capable of providing bank deposits with the same technology used in stablecoin — tokenized bank deposits. It serves as a complement to bank deposit accounts, similar to wholesale CBDC as a complement to bank accounts at the central bank. Both tokenized bank deposits and stablecoin are non-state-issued digital currencies, but tokenized bank deposits are denominated in sovereign fiat currency. So why should banks create both non-sovereign non-fiat currency and sovereign fiat currency?
Or, should stablecoin be granted a legal status as fiat money despite being denominated not in sovereign currency — to become non-sovereign fiat currency? As fiat-backed stablecoin has unitary convertibility with state-issued currency, eg. banknotes and retail CBDC, the non-sovereign denomination of stablecoin should no longer be relevant. Also, it is issued by banks as one of the money creation institutions in the two-tiered monetary system.
This should lead to studies and policy discussions on whether the existing two-tiered monetary system — the central bank creating bank reserves and banks creating bank deposits; simultaneously comprising sovereign fiat money — should be revisited and redefined if only banks are allowed to issue stablecoins.
