Thread by @dandolfa

Attended a workshop on stablecoins yesterday. Very timely in light of recent events! I was asked to provide my thoughts on the financial stability risks of stablecoins. Thought I'd share them👇 (usual disclaimer applies).

First, what are stablecoins? From my macroeconomist point-of-view, they look like unilateral fixed exchange rate regimes. This is where a country attempts to peg its currency relative to another country's currency, like the USD.

This is to be distinguished from a multilateral (cooperative) fixed exchange rate regime, like Bretton Woods. Unilateral pegs can persist for a long time (e.g., hkma.gov.hk/eng/key-functi…). But they very often fail too (e.g., en.wikipedia.org/wiki/Convertib…).

Macroeconomists have warned forever that unilateral pegs (w/o sufficient backing or commitment) invite speculative attacks, e.g., www-personal.umich.edu/~ssalant/salan… and stonecenter.gc.cuny.edu/files/1979/08/…

The basic idea is that the entity trying to defend the peg will either be successful or not. If successful, then short position entails minimal pain. If not, then a short pays off big time. Speculators are therefore incentivized to short, resulting in a self-fulfilling prophecy.

Stablecoins (SCs) also resemble MMFs and uninsured banks (both of which offer liabilities pegged to the USD). SCs differ in some ways. At the front-end, they may offer permissionless access and use. At the back end, they may employ blockchain-based database management protocols.

SCs also come in a variety of flavors. I like to classify them into two groups, depending on whether they employ CeFi or DeFi securities as collateral. USDC and Tether are examples of former; DAI and Terra examples of the latter).

Apart from these details, there is nothing much new here in terms of financial stability risks. I agree with the FSB principle toward regulation, supervision and oversight: "same business, same risk, same rules." fsb.org/2022/02/assess…

This FSB approach should work well enough for SCs that hold CeFi securities; at least, for the ones that appear willing to submit themselves to regulators. Many, perhaps most of them, appear willing to do so.

Others, like Tether, appear less willing. If these "shadow bank" entities grow to be very large, then they may pose a systemic risk for all the usual reasons. Would a run on Tether leading to a firesale of CeFi securities elicit a central bank intervention? This is a tough Q.

This may be less of a concern for SCs backing their liabilities w/ cryptoassets. A firesale of Luna or ETH/BTC may have spillover effects through the usual channels (wealth effects, margin calls). But a firesale of (say) BTC is not the same as with (say) commercial paper.

I suppose this latter effect depends on how interconnected the crypto world is w/ CeFi. If there's a connection, then regulators can focus on these meet-points, e.g., impose portfolio restrictions on CeFi entities working with crypto (risk-weighted capital requirements, etc.)

But is there a better way? SCs are satisfying a marketplace want. Rather than relying on potentially heavy-handed regulation (which may be infeasible in the case of DAOs), why not consider the strategy of offering a competing product?

Some wants--like permissionless access--are likely off the table. It's not that it can't be done. It's more to do with the usual KYC/AML concerns. So, fine, let SCs continue to provide permissionless access to those that value the service. Not much we can do about this anyway.

But another thing people want is a set of options for fast, reliable, cheap and secure domestic and international payments services. This is something CeFi can do! Of course, this is already happening.

But one way to spur this development along may be to offer a wholesale-CBDC. Imagine letting qualified fintech firms, possibly from around the world, access Fed Master accounts & competing among themselves to provide the most efficient global payment services.

This would, of course, require additional oversight and supervision, but qualified firms could be made to pay this cost. And if their assets are restricted to be central bank settlement balances (like narrow banks), there may not be too much work to do here.

But if competition works its magic here, then the demand for SCs as the preferred vehicle for international transfers and/or payments among firms in the global supply chain may be diminished. (This is the use case most often considered, not their current use in crypto trading).

The goal is not to drive SCs out of business (probably infeasible anyway). Coexistence of CeFi & DeFi in this space is both possible and desirable, I think. The idea is to keep SCs from dominating to an extent where they might pose a systemic risk for global financial markets.