Stablecoins remind me of Superman. As our superhero flies in to save the day yet again, the cry goes up: “Is it a bird? Is it a plane? No, it’s Superman!” Similarly, when people used to the conventional financial system voice their fears about stablecoins, their arguments center on what stablecoins are, not on what they do. “Is it a bank? Is it a money market fund?” No, it’s a stablecoin!
Trying to regulate stablecoins on the basis of what they superficially resemble is like telling Superman to obey air traffic control. If Superman actually obeys air traffic control, he can’t do his job. Similarly, a stablecoin regulated like a bank or a money market fund (MMF) would not be able to do its job. And, as I shall explain, stablecoins have an immensely important job to do, not only in the crypto ecosystem but potentially also in the conventional financial world.
So rather than trying to work out what stablecoins are, let’s focus on what they do. How do people actually use them, and for what purposes? What is their role in the crypto ecosystem? What potential role might they play in the mainstream financial system?
These questions really arise from one of the most fascinating aspects of cryptocurrency. We don’t understand stablecoins because we haven’t understood how crypto has redefined – indeed is still redefining – the nature of money.
Money has three functions: store of value, medium of exchange, unit of account (numeraire). The problem is that combining all three is notoriously difficult.
An asset that is a good store of value tends to be a poor medium of exchange: Good long-term stores of value are typically scarce and illiquid, whereas good media of exchange need to be plentiful and highly liquid.
A medium of exchange needs to hold its value over the short run, so extreme volatility is death for a medium of exchange. But extreme volatility in a store of value is not a major problem as long as it appreciates over the long term.
And a unit of account must be generally understood, widely accepted and not subject to arbitrary redefinition, which might not be the case for either a store of value or a medium of exchange.
The crypto community has tried hard to convince the world that bitcoin, and to a lesser extent other cryptocurrencies, can fulfill all three functions better than any past or present currency or asset. But the way things are developing suggests that this battle has been lost. Bitcoin has become a major asset class and is showing signs of holding value over the long term. But although bitcoin maximalists like to insist that one bitcoin equals one bitcoin, the reality is that people tend to measure the value of BTC, and indeed all cryptocurrencies, in U.S. dollars. And despite recent attempts to improve bitcoin’s liquidity (through subdivision and layer 2 solutions), its high price and extreme volatility make it extremely risky as a medium of exchange.
So the U.S. dollar has become the numeraire of the crypto ecosystem, and bitcoin its premier reserve asset. But what is its principal settlement currency? It’s not the U.S. dollar. In the crypto ecosystem, dollars are far too scarce and illiquid to use as principal settlement currency. And it’s not bitcoin either, nor any other traded cryptocurrency. Right now, the principal settlement currency in the crypto ecosystem is tether.
Tether, or rather Tether’s U.S. dollar token USDT, is a pure medium of exchange. It is, in effect, the crypto equivalent of a fiat currency. Its value is maintained at approximately 1 USDT to 1 U.S. dollar by means of open market operations performed by its issuer through a network of partner exchanges, somewhat akin to the Fed’s broker-dealer network. At the time of writing, over 65 billion USDT have been issued, more than twice as many as the next largest dollar-denominated stablecoin, USDC.
So USDT is extremely liquid, but its nominal yield is zero and it pays no interest. It’s a zero-coupon perpetual U.S. dollar bond, if you like. And its quantity is both potentially unlimited and controlled by an opaque, unaccountable entity. Now, of what does this remind you?
Because USDT and USDC are pegged to the U.S. dollar, which is an inflationary currency, they have a negative real yield. So they are a terrible store of value. Absolutely no one holds these stablecoins as assets. To make money from stablecoins, you have to lend, trade or pledge them for something riskier. And that’s exactly what people do. USDT, and to a lesser extent other stablecoins, are cash collateral in crypto lending as well as settlement media in crypto trading.
It’s worth remembering that the distinction between lending and trading is a pretty fine one, especially if the assets you are pledging are rehypothecated (or reused for another financial purpose). Even though it is not much more than a decade since rehypothecation chains in the conventional financial system disastrously unravelled, crypto lending platforms routinely rehypothecate collateral.
Really, stablecoins are pure cash. They are denominated in U.S. dollars because that’s the crypto world’s unit of account, but that doesn’t mean people necessarily want to cash them in for dollars. Indeed, they might not be able to: Exchanges can suspend trading in stablecoin/USD pairs if they run out of dollar liquidity, and some stablecoin issuers impose limits on redemptions.
But many of those using stablecoins to play on the crypto casinos don’t want U.S. dollars anyway. They just want a highly liquid medium of exchange. Stablecoins – especially USDT and USDC – meet that need.
So the crypto world has successfully resolved the conflicted nature of money by adopting the U.S. dollar as numeraire, bitcoin (denominated in USD) as premier reserve asset and stablecoins as settlement currencies. It’s not at all what the founder or founders of Bitcoin intended, but finance has always been evolutionary and emergent. How things are used defines what they become.
And this also means the debates about whether stablecoins are more like banks or money market funds entirely miss the point. Stablecoins aren’t like either. People don’t place their dollars with Tether to keep them safe, nor to earn interest. They buy tokens with the intention of trading, lending or pledging them to earn money. The dollars they pay for those tokens are more akin to the tax payments that maintain the value of fiat currencies than to deposits in a bank or MMF.
Trying to regulate all stablecoins like banks or MMFs runs the risk that they will be unable to do their primary job of providing liquidity to the crypto ecosystem. I’m not sure this would benefit anyone.
Whether a stablecoin needs dollar reserves depends not on its role in the crypto ecosystem, but its actual or potential use in the conventional payments system. A stablecoin used only within the crypto ecosystem wouldn’t need 100% dollar reserves. It would only need sufficient dollar liquidity to maintain its peg – and if exchanges are compliant and redemptions restricted, that might not be very much. And if some stablecoins failed to maintain their pegs, would it really matter, if other stablecoins could take their place? Competing currencies in a free-market system. What’s not to like?
However, stablecoins have a second potential use that is extremely powerful but carries the seeds of disaster if not properly regulated. Stablecoins could replace conventional rails for international payments, potentially making them faster, cheaper and available 24/7. But stablecoins used for this purpose would need to be fully exchangeable for U.S. dollars or other fiat currencies on demand 24/7, and would therefore either need 100% dollar reserves or access to central bank liquidity.
Rather than wasting time and energy trying to regulate crypto-only stablecoins as if they are banks or MMFs, therefore, regulators should concentrate on ensuring that stablecoins that are, or show signs of becoming, payment media within the conventional financial system have 100% reserves and/or are licensed banks. After all, Superman also has a conventional life – and in that life, he plays by conventional rules.