By George Ward
Absence Of Money Market Stability
The Bank for International Settlements (BIS) conducted a study on stablecoins, revealing the flaws and the absence of mechanisms that provide stability similar to fiat money markets. The study argues that a regulatory model with central bank oversight is superior to privately issued stablecoins.
In addition, the researchers analyzed stablecoin functionalities using a “money view” approach, comparing stablecoin settlement mechanisms to the dynamics of onshore and offshore USD settlements. Their analysis showed that stablecoin systems have inherent flaws that make them vulnerable to maintaining stability, unlike traditional fiat currencies.
Moreover, the study used the late-2000s financial crisis to illustrate this fragility. Back then, the US Fed provided a $600 billion liquidity with other central banks to enable Euro-dollar holders to retrieve their funds.
The authors’ analogy between stablecoin operations and the complex interplay of currencies during a crisis highlights the inherent limitations of current stablecoin architectures. Stablecoins are vulnerable to market volatility, which affects their ability to navigate periods of economic stress.
This is because they lack robust mechanisms similar to those central banks use during financial crises.
Stablecoin As An On-Chain And Off-Chain Bridge
Stablecoins bridge the gap between digital currencies and traditional finance by maintaining parity with the US dollar. These coins use three distinct but interconnected mechanisms to maintain their peg to the USD. These mechanisms are reserves, over-collateralization, and algorithmic trading protocols.
Reserves are an equivalent value of secure short-term dollar assets, and are the foundation of stablecoin’s stability. However, an insightful analysis reveals that a fundamental misconception underlying stablecoins is mistaking liquidity for solvency.
The authors opined that this incorrect assumption underpins the stablecoins’ ability to meet short-term and long-term demands, notably through reserves. Notably, the fiat money market links reserves to stablecoin stability, tying it to the prevailing conditions in this domain.
While traditional financial mechanisms strive to keep banks liquid during economic downturns, stablecoins lack similar safeguards, making them vulnerable during market stress. Furthermore, the requirement for stablecoins to maintain parity with the USD poses a significant challenge.
The authors’ comparison of blockchain bridges to foreign exchange dealers is insightful, especially their analysis of dealers’ reliance on credit to absorb order flow imbalances. Meanwhile, stablecoins face a comparable challenge but don’t have the necessary tools to mitigate it. Moreover, elevated on-chain interest rates make this task more difficult for stablecoins.
Solutions For Stablecoin Predicament
Furthermore, the study proposed the Regulated Liability Network as the solution to the increasing ambiguity surrounding stablecoins and their relationship with fiat currencies. This model provides a comprehensive framework for settling all financial obligations within a single ledger that operates under a strictly regulated perimeter.
Notably, it advocates integrating a full-fledged banking system, with involvement from the central bank, to instill credibility that is lacking in current private crypto stablecoins. This proposal aims to introduce oversight and accountability previously lacking in the decentralized landscape of stablecoin operations by consolidating all claims and transactions within a regulated jurisdiction.
Importance Of Central Banks’ Involvement
The expected participation of central banking institutions within this framework enhances increased stability and boosts the system’s credibility. In addition, this proposal comes at a time when global financial authorities, particularly the BIS, focus more on stablecoins.
A BIS study in early November showed that stablecoins sometimes lose their peg, highlighting the risks of these digital assets. The increased focus of regulatory bodies in Europe, the United Kingdom, and the United States corroborates the growing importance of stablecoins in the global financial sector.
As regulatory scrutiny surrounding stablecoins grows, the Regulated Liability Network could be a beacon of hope for them to maintain stability. A side benefit of this model is that it could provide a structured and regulated framework that could ease the persistent challenges modern stablecoin systems face.
Regardless, stablecoins have become an essential part of payment settlement systems globally.