Chance Barnett is chairman of Jewel, a proposed Bermudian bank providing digital asset banking infrastructure to global businesses. He previously founded Crowdfunder, an equity crowdfunding investment platform. Michael Dowling is chief technology officer at Jewel and was the chief technology officer at IBM in its Blockchain Financial Services Group.
The U.S. dollar-backed stablecoin market has grown nearly 100% since January, jumping from roughly $5.5 billion in January to more than $11 billion in June (chart). But with demand for USD fiat-backed stablecoins experiencing tremendous growth, we think it will soon become clear that not all stablecoins are created equal and not all USD vehicles play the same role in pushing the industry forward.
Now, what’s this about wildcats? Well, many of the stablecoins of today lack standards and are fairly opaque surrounding what stablecoin holders are actually holding. Stablecoins differ greatly across their reserve backing, who they’re issued by, how they are redeemable, what their underlying legal and business structures and which blockchains they’re issued on. Even the anti-money laundering (AML) and know your customer (KYC) requirements some stablecoins operate under differ.
This creates an environment similar to the “Wildcat Banking” era in the U.S. in the 1800s, also called the "Free Banking" era.
From 1837 to 1863, many new, small U.S. banks were chartered under state regulators, largely free from federal regulation. These “wildcat banks” printed their own versions of the U.S. dollar (bank notes), which were often only redeemable at intentionally remote bank locations to make them hard to exchange for traditional and federal dollar notes, or could be traded for other notes or goods at discounts to face value.
The wildcatters had a solid run, but in response to some of the negative effects of wildcat banking involving redeemability and price variation, the U.S. government eventually stepped in with the National Bank Act of 1863. This put an end to wildcat bank notes and standardized the U.S. dollar notes by asserting the U.S. government’s monopoly on printing the U.S. currency.
And yet, we hadn’t seen the last of the wildcats.
The wildcat stablecoins today
Today we’re in the Wildcat Banking Era of Stablecoins, with a new cast of proverbial wildcatters issuing their own versions of USD as stablecoins.
Stablecoins are being issued by exchanges, money service businesses (MSB), trust companies and, soon, more banks, making for a complex web of legal structures, reserve backing, regulatory regimes, AML/KYC requirements, contractual rights and obligations, all on different Layer 1 blockchains.
In today’s Wildcat Banking Era of Stablecoins, a dollar is not necessarily a dollar.
The structures for stablecoins today might not always provide the stablecoin holder with rights to underlying fiat USD they might assume they have.
As the Bank for International Settlements (BIS) recently said in a paper about Central Bank Digital Currencies with reference to stablecoins, “current electronic retail money [fiat-backed stablecoins] represent a claim on an intermediary, rather than functioning as the digital equivalent of cash.” [emphasis added]
Take Tether's USDT, the largest USD fiat-backed stablecoin by issuance and trading volume, and a favorite among digital currency traders. USDT is issued by an MBS. Holders of USDT have a claim with Tether, although Tether does not hold USD funds in custody itself. Therefore, a USDT holder has no direct claim on underlying USD funds.
We call this the Tri-Party Model for stablecoin issuance. In the Tri-Party Model, a finance-focused technology company (the “issuer,” which is often a licensed MSB non-bank financial institution) partners with a financial institution as custodian (typically a trust, custodian or chartered bank) to accept deposits of fiat on behalf of the issuer and collects funds from the issuers’ users.
In exchange, stablecoins are issued representing a 1:1 claim on the deposits held at the separate custodial financial institution, with a consumer-level promise to redeem the fiat dollars held on deposit upon presentation (and burn) of the stablecoins issued.
This arrangement is safer today in terms of preservation of collateral held in custody than, say, algorithmic stablecoins such as dai, which focus on market forces to maintain a value peg (though algorithmic types may serve specific “DeFi” use cases).
There are hidden risks in the Tri-Party Model as well. These exist within the relationships between a regulated financial institution as the issuer of the stablecoin, the original depositor, the custodian of funds and the current legal recourse options for a stablecoin holder in case the issuer declares bankruptcy, as a deposit agreement is extended to the original depositor (the “issuer”) and its creditors before stablecoin holders.
It’s important to note that this hasn’t yet, and may not necessarily, play out as a critical shortcoming today within crypto trading. But as stablecoins move beyond trading and into broader use for payment and settlement, better and more sophisticated structures for stablecoins need to evolve.
Regulators put stablecoin wildcats on notice
On April 14, the Financial Stability Board (FSB) issued a lengthy review, "Addressing the regulatory, supervisory and oversight challenges raised by ‘global stablecoin’ arrangements.” (PDF report) of the current stablecoins landscape that outlined specific areas of concerns and provided a call for global regulatory review and changes.
This follows the FSB’s prior release "Regulatory issues of stablecoins” (PDF report), which was drafted in response to the G-20’s concerns about stablecoins.
The punchline here is, global regulatory and rule-making bodies are making clear statements about their stablecoin concerns and have a growing focus to address them through further regulation and guidance.
Global regulatory changes of this scope would shake up the current stablecoin market by forcing changes in the current stablecoin structures as a result of new regulations to follow, which likely won’t be fully in favor of the “small guys” and digital currency innovators, namely exchanges and MSBs that have provided the innovation and growth of stablecoins to date.
Further regulation will, for better or worse, likely tip the balance of power towards a stronger role for larger and more heavily regulated structures including trust companies and regulated banks, and eventually central banks (which also are looking to be underlying issuers of fiat-backed central bank digital currencies, or CBDCs, themselves).
Banks and central bank digital currencies
Banks and central banks will soon enter the market and enable new models and capabilities of fiat-backed digital assets as bank-issued stablecoins and CBDCs. These models will represent a structural disintermediation of today’s Tri-Party Model stablecoins, where the issuer and custodian holding reserves are one and the same.
This will provide for a more direct model and structure for stablecoin issuance, with issuance tied directly to deposits/reserves held at a single party. This will also provide stablecoin holders with a direct claim on deposits, not on an intermediary.
What’s more, these stablecoins/CBDCs will have advantages in the market as true cash equivalents, and will tie directly to bank accounts and enable real-time settlement to the bank account level, creating a seamless flow in and out of existing fiat rails.
This combination of factors, as well as bank and central bank acceptance of stablecoins/CBDCs, are likely to drive broader stablecoin utility in payments and settlement, beyond the trading stablecoin use cases of today.
Cooperate or compete?
But with banks and central banks making fiat-backed issuances of their own, will banks and central banks cooperate or compete?
The traditional role of central banks has been monetary policy and to provide for the control and management of the money supply within and among other banks and central banks, operationalized through commercial banks who service corporate and retail customers directly.
In recent times, central banks have discussed and implemented limited scope projects for direct issuance of M0 money as stablecoins tied directly to accounts at a central bank. With this kind of CBDC, business and retail customers would have the ability to open accounts and transact directly with money from central banks and enjoy some of the access to credit and cheap money that Wall St. has had access to for decades.
Central banks could possibly bypass commercial banks and allow for business and retail customers to directly open accounts and “bank” with central banks via CBDCs.
However, most central banks today are not unprepared for this. They likely do not see it as their role to take on the larger technical and operational roles beyond issuance and accounts.
It’s more likely that while central banks in some jurisdiction may provide for direct issuance and accounts, commercial banks will continue providing technology, servicing and credit and lending functions atop the money supply, but sit on a new set of DLT-based rails (CBDC rails).
In this case, digital asset-enabled banks already in the market will be early and well positioned to take advantage of the opportunity with both stablecoins and CBDCs on their ledgers. As such, rather than assume that commercial banks will retain their long-standing roles in a new CBDC paradigm, CBDC will encourage commercial banks to migrate to a new set of rails.
For banks that are early to embrace this change and provide a new set of core banking services facilitated on DLT rails, we believe this will accelerate new and improved models for payment and settlement with stablecoins and CDBDs.
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