How could stablecoins reshape the global financial system?

Paul Diggle

Hello and welcome to Macro Bytes, the economics and politics podcast from Aberdeen. My name is Paul Diggle

 

Luke Bartholomew

And I'm Luke Bartholomew.

 

Paul Diggle

And today we are talking about stablecoins. What they are, how they might affect the payment system, how they are, or will be, regulated and what they might mean economically in terms of public sector debt dynamics, the status of the US dollar, how central banks set monetary policy, whether stablecoins create new financial stability risks. And it's a really fascinating area. It's a way in which the crypto ecosystem may very quickly integrate and affect the conventional financial and economic architecture in a way that arguably hasn't happened so far, at least with Bitcoin and the like. So, we are really excited to get into it. And I think the place to start, Luke, is by just quickly asking and answering: what are stablecoins? Because not everyone will necessarily [have] heard of them. They are digital assets designed to maintain a stable value relative to a reference asset. So that's typically a fiat currency, typically it is the US dollar. And they do that by pegging through some sort of stabilisation mechanism their value to that fiat currency. And they offer, therefore, the transactional and programmability benefits of crypto, while seeking to avoid the volatility. And just a few stats to, sort of, get a sense of how big this market is: current stablecoin market capitalisation, is about $200 billion – so that's about 5% of the total $4 trillion crypto asset market capitalisation at the moment. And they are overwhelmingly issued and pegged to the dollar – about 95% of stablecoin market cap is dollar-pegged. And so, the big names, the big players, are Tether (UST) and the USDC issued by Circle.

 

Luke Bartholomew

And then a natural follow-up question to that would be: what the use case of such stablecoins is? And it is overwhelmingly as a payment and settlement mechanism, at least in developed market countries. They allow for on-chain settlement, so avoiding existing payment architecture around the banks, the big payment companies, it’s a new kind of payment [xxx], which has the promise of very low-cost, efficient, fast transaction. That's both domestically and also in cross-border payments as well. And cross-border payments do tend to be more expensive. So, bringing about cheaper cross-border payments can be quite significant for things like remittance flows and cross-border international e-commerce as well. And then some big companies are also looking into being able to issue stablecoins to encourage transactions on their own platforms. Again, potentially avoiding some of the costs and inefficiencies involved with the existing payment systems. And potentially, therefore, there are some benefits to be carved up between the sellers and the buyers if the existing payment system costs are avoided – potentially cheaper transactions could come about that way. And then in emerging markets, as this potential additional benefit, not just for payment and settlement, but also for providing access to effectively dollar deposits, that people can now hold some of their wealth in dollars by holding these dollar stablecoins. And that might be an important hedge against, for example, local currency instability.

 

Paul Diggle

Okay, so how do they do this? The magic of pegging their value to another asset? Well, I think, there's really three main ways to think about it. The first is what is known as ‘algorithmic pegs’, where there isn't actually a real asset backing up the value of the stablecoin. Instead, they use so-called ‘smart contracts’ to supply and burn units of the coin to try and keep its value steady. And the most infamous example of this type of a coin, I think, is Terra USD issued by Luna, which is, which have ultimately collapsed because this method, this algorithmic stabilising method turns out actually to be potentially very fragile and prone to so-called ‘death spirals’. And actually, Luke, we did a podcast back in 2022 when that collapse happened – looking at what had occurred there. The second stabilisation mechanism, then, is where the coin is backed up, is collateralised, but not with some other form of money. Instead, it's collateralised with perhaps other cryptocurrencies – Bitcoin and Ethereum – or with, perhaps, commodities. And especially in the case of crypto collateralisation, the advantage there might be that they continue, the stablecoin itself continues to benefit from the decentralisation of crypto. But the trade-off is you can still get a lot of volatility in the so-called stablecoin. And then the third, and really the one we're going to focus on today, is what is known as fiat-collateralised stablecoin. So this is USDC and Tether, as I was mentioning, where the coin issuer backs the coin one-for-one with highly liquid currency-adjacent safe collateral, such as short-dated Treasuries, so what are known as T-bills, with repos and with money market funds. So, for every dollar of the privately-issued fiat collateralised stablecoin, that issuer then also holds, to back up that value, an equivalent amount of highly liquid safe assets. And that is meant to be the most stable version of a stablecoin. And really, from here on in, that is what we're going to mean when we say stablecoin, because that's where all the recent regulatory effort has been focused, and where a lot of those use cases you were describing, Luke, where those occur. And it's also where the implications for mainstream macro, for mainstream finance, which is, you know, our usual bread and butter on this podcast, where they come from.

 

Luke Bartholomew

Well, let's talk a little bit about that regulatory focus that you mentioned there, Paul, because it is recent regulatory changes in the US that have made stablecoins top of the agenda for many people and, dare I say, is part of the reason that we are having this conversation. And the big regulatory change was the passing of the Genius Act in July. Now, Genius is apparently standing for Guiding and Establishing National Innovation for US Stablecoins Act. Although if you were to also think that there might be a reference to Trump's, purported status as a ‘very stable genius’, then I don't think you'd be making too much of a stretch in that. But I think it is worth reflecting on some of the key points of that legislation, because they are quite significant. So, the first is, as you were talking about there, Paul, it does establish fully-backed, with reserve, stablecoins as the legal standard. And what that requires is that they are backed with T-bills of less than 90 days’ maturity or other extremely liquid assets – repos and money market funds. And why is that? Well, it's because these kind of assets are the extremely low risk with very low maturity, duration risk, also very low credit risk. And so should be the perfect backing for a stablecoin which is meant to offer at par value on demand. You know, it doesn't have the kind of credit or, redemption risks, that you might expect with less liquid assets. And the second key feature is that they don't allow issuers to pay any yield on the stablecoin. And obviously that does create a little bit of a, of a mismatch, right? Because if these reserves have to be invested in T-bills, money market funds, etc., then there is an interest that's being generated there. But the stablecoin itself can't pass that on to the ultimate holder of the stablecoin. And the main reason for that is it's to avoid big disintermediation of the banking system, to turn these things effectively into deposit assets in the US, which potentially could quite radically transform the financial system without really intending to.

 

Paul Diggle

Yeah, and we'll get on to, sort of, what that might look like. But I think it is worth asking: is it actually sustainable that stablecoins don't pay interest or don't issue a yield? Because I'm not completely sure it is. Competitive pressures on issuers to attract demand, assets, deposits to their stablecoin might well push them in the direction of finding other synthetic ways to create interest or yields. And already that's actually happening – platforms are, sort of, minting, non-contract [xxx] or platform rewards. So, it's not the stablecoin issuer paying interest, it's the platform on which you hold your stablecoin minting some kind of non-interest reward or token on the platform. So, it is really already a, sort of, synthetic work around to interest. And, you know, as we'll get into, it is really very relevant, as you were saying, Luke, whether they pay interest or not, to how you think about some of the broader economic implications.

 

Luke Bartholomew

But just to finish off on this regulatory point, I mean, I think it is important to establish why the US, and the Trump administration in particular, has put so much political capital behind passing this legislation so quickly. What the intent is. And a big part of it is to create, sort of, an institutional architecture which legitimates stablecoins – is a very clear signal to the US, and indeed the rest of the world, that the US government is backing this, and it would like people to adopt to it, it’s to accelerate that adoption. And the reason for that is several-fold. One, because this is an area of genuine US leadership. As you mentioned, Paul, US dollars are overwhelmingly the currency of choice in which fiat stablecoins are issued. And so, yeah, a place of US leadership already that the US wants to reinforce, is the place of corporate profitability. And as we'll go on to talk about, is also because it will help reinforce demand for dollars, reinforce dollar dominance, and also provide an ongoing source of demand for US government debt, which for a variety of reasons is likely to be quite significant in terms of its new issuance over the coming years.

 

Paul Diggle

Well, let's get into that, the way in which stablecoins have the potential to be a new structural source of Treasury demand because of this requirement, or the way in which they work – purchasing T-bills to back up the stablecoin. I think in Treasury Secretary Scott Bessent's mind, who is sort of one of the drivers of the Genius Act and the broader push in this direction, stablecoins very much could be part of the US's strategic fiscal architecture, helping the US fund itself essentially. Already at a $200 billion market capitalisation, stablecoins are a similar size holder of outstanding US T-bills as China and big sovereign holders. In flow terms, stablecoin issuers were the third-largest purchaser of US T-bills last year. So they are very much already a source of demand, important demand, for T-bills. And then if they grow in market capitalisation, they'll become more important still. And there are a big range of estimates out there about quite how big the stablecoin market could be in the future. You know, we've seen, Luke, estimates of anything from $500 billion, so only a little bit more than a doubling from now, to $4 trillion by 2030 – you know, fully equivalent to the current total crypto market capitalisation. And maybe the average across all those we've seen is something like $2 trillion market capitalisation five years from now. And to put that into very ballpark context in terms of what it does to T-bills, how it stacks up against T-bill issuance. Pre-COVID patterns of debt issuance in the US saw an average of about $500 billion of T-bills issued each year. Post-Covid that's gone up – it's been years well above $1 trillion of issuance. But in very simple maths, theoretically a market that is growing to $2 trillion or so the next five years, absorbs up to all net US T-bill issuance over that period. And remember, T-bills are about 20% of outstanding total US public sector debt because there's also bills and bonds (longer maturity debt). But, you know, all this is to say this is a potentially, a new structural source of Treasury demand.

 

Luke Bartholomew

So, part of the reason I think it's, you know, these estimates for how much stablecoin adoption there will be are so large is because, part of the uptake will depend on the prevailing interest-rate environment. As we've already described, these are non-interest-bearing securities. So, it stands to reason that the higher the prevailing interest rate is on other assets, then the greater the opportunity cost is to holding stablecoin. So, you have to think that higher interest rates, all else equal, would lead to slower adoption, or less demand at the margin, and a bigger fall in interest rates, much lower interest rates, would make the opportunity cost of holding stablecoins lower and therefore encourage uptake. At least that's in the US. And then, as we sort of touched on, demand in emerging markets, in in other countries, for US assets will not only depend on the prevailing interest rate, but also just desire to hold US assets in that country. Perhaps you want to get out of the local banking system or the local currency, because you're concerned about inflation risks, or sovereign debt concerns, or appropriation risks, or whatever it might be. And so, yeah, a lot depends not just on stablecoin itself, but the economic environment in which it's operating. And then also, I guess, to sort of explain some of the difficulties in mapping as you were describing it there, Paul, the demand for stablecoins into demand for T-bills. A lot turns on where the money is coming from. And, you know, it could be the case that people are effectively selling money market funds, which are already heavily invested in T-bills, to go and buy stablecoins, which are, invested in T-bills – so, it's just a different vehicle for holding T-bills. Whereas if the money is coming out of, say, US or non-US bank deposits, then plausibly that is a new source of T-bill demand above and beyond what was there previously. So yeah, it is quite important to locate exactly where the relocation of funds is coming from. But there has been work already to suggest that stablecoin demand is having quite a large impact on the price of these T-bill securities. So, work by economists at the Bank for International Settlements estimated that for a 3.5 billion inflow into stablecoins, that reduces T-bill yields by up to five basis points, and that is actually pretty material when you think about it. Partly because, you know, if we are talking about 2 trillion as the eventual size of these things then, my goodness, that would imply a huge impact on the price of T-bills, which I think for reasons we can get [xxx], you should be a little bit sceptical about extrapolating that linearly. But even at face value, those five basis points, you know, we think of the front end of the curve as being largely just about interest rate expectations. There isn't meant to be much, as we've talked about on this podcast before, term premia at that part of the curve. So, it is quite surprising that these flows are having such material impact on the price. And I think quite significantly that research by the BIS did point to an asymmetry in the price impact, that it tends to be that sales of stablecoins have a much larger impact on the price of T-bills than purchases do. And that might be because when there're sales, those redemptions just have to occur on demand – you have to take whatever market conditions are operating at the time. Whereas with purchases, perhaps that can be timed a little bit more subtly to avoid market impact. But this asymmetry, this fact that sales redemptions of stablecoins do tend to have, it seems, more upward pressure on T-bill yields, will, I think, be quite significant for financial stability implications that we can talk about later. But one other thing that's worth saying at this point. I think part of the reason you can be, you know, relatively sceptical about extrapolating those ranges – the 3.5 billion, the 5 basis points – to the kind of flows that we're talking about and thinking that those magnitudes are maintained, is because presumably the US Treasury is going to look at all that extra demand, for that part of the curve, and just supply extra bonds. It will change its issuance profile to meet this new demand. So, yes, there'll be an increase in demand at that point in the curve. But you have to think, in time, there would also be an increase in supply as well to meet that extra demand. So, some of the price impact should be mitigated that way.

 

Paul Diggle

Okay, so big issues there about what it does to Treasury supply, demand, price. I think another interesting macro area of stablecoins is what it does to dollar dominance. And there are really two ways to, sort of, think about or frame dollar dominance. One is that the dollar is the global payment system, the most widely used invoicing, the global reserve currency. And that, as we’ve talked about on the podcast before, grants the US geopolitical clout via using financial sanctions or asset freezing and the like. And another one is the dominance of the dollar in the global financial system links the global financial cycle to US monetary policy in some way. And we'll go through each of those. So, let's start with, sort of, what it means for the dollar as the main payment system and therefore the geopolitical power that it gives the US. Because in many emerging markets with high inflation, with weak banking systems, with capital controls, it's very possible that the widespread availability of stablecoins, it is an encouragement to dollarisation. Dollarisation already occurs in, sort of like, really struggling, unstable emerging markets. But the widespread access to dollars without having to have a US-based bank account may be an accelerant of dollarisation – so it makes the dollar more dominant, therefore, globally. And indeed part of the US strategy behind regulating, pushing, stablecoins is to, I think, embed dollar payment infrastructure into digital finance to counter nascent de-dollarisation trends – where we've seen a reduction in the amount of global trade invoicing in dollars, or a reduction in central bank reserve demand for dollars especially in emerging markets, the push towards a BRICs digital currency, which is partly about circumventing the dollar payment system. And I think in many ways, the push behind the Genius Act, behind the strategic imperative that you see coming out of the current Trump administration, from Bessent, is actually to push back against that and reassert dollar dominance.

 

Luke Bartholomew

And as you say, Paul, one of the key features of dollar dominance has been the way in which the US has been able to exercise political power, international relations influence via the dollar system through, things like sanctions, asset conversation, etc. An interesting question is whether it will still be able to maintain those tools in a world of stable currency dominated dollar system. And the reason that's an interesting question is because the existing locus of dollar dominance is through the euro dollar system. So that is to say, dollar deposits in banks, offshore the US. And because euro dollars ultimately have to reside in the banking system, the US gets its control over that system through the way in which various correspondent banks have to interact with the US banking system to ultimately get access to the dollar payment nodes. So, it's bank-based and it’s through banks that the US can exert leverage. Now, that isn't the case with stablecoins. Stablecoins don't live in banks. They live on-chain. So, where the choke points are, where the points of leverage are, will have to change if the US is going to continue to influence the system. And there are plausible places where you can find these choke points. Maybe it's by blacklisting entities on-chain, various wallets or addresses, although there are differing views as to how plausible this might be. Or perhaps it's by policing the on/off ramps. You know, the payment companies, the stablecoin issuers, the way you get into and out of stablecoins where those interact with the fiat system. Although there potentially could be issues if those companies were to leave US jurisdiction. So, you know, it does raise a series of questions as to how the tools of US sanction policy might have to change in a world of greater stablecoin usage.

 

Paul Diggle

Okay, but we also said that another crucial part of dollar dominance is the global financial cycle is linked to US monetary policy. And I think stablecoins, they can affect that aspect of dollar dominance as well. There's certainly one telling in which stablecoins don't have a huge bearing on US domestic monetary policy setting and the transmission of monetary policy, and that's if stablecoins remain non-interest-bearing and therefore there's not a huge flight or trend movement of assets from current deposit accounts in the financial sector into stablecoins. You know, if it is purely a means of a frictionless, or low friction, low cost means of doing transactions, and it's not a long-term store of wealth, there may not be wholesale movement of deposits. And in that case, the Fed still very much maintains its current, one of its current transmission channels, which is affecting the interest earned on deposit, which then affects the margin, the preponderance to spend or save cash. I think, though, you can very much envisage ways in which stablecoins are impacting the way that the Fed thinks about monetary policy, sets monetary policy, transmits it to the broader economy. And that's if there is a buildup of deposits in sort of crypto-native environments, which then decouple from monetary policy, that are not affected by mainstream interest-rate decisions. And in that case, basically banks are being disintermediated, and the Fed loses some of its traction over the economy. So, you can perhaps think that it's having to do more with interest rates to get the same effect on the economy, because it's losing this transmission channel to stablecoins. And then I think another really interesting Fed consideration is that alongside the Genius Act, that big piece of regulation you were talking about, Luke, the US also passed the Anti CBDC Surveillance State Act i.e., an anti-central bank digital currency act. So this explicitly prohibited the Fed from issuing a central bank digital currency. And CBDCs are this whole other really interesting part of crypto and the way in which it interacts with mainstream finance and which the central banks themselves directly issuing a digital currency to consumers, to businesses, bypassing the financial sector. But in the US’s case, the proponents of stablecoins very much do not want that to happen. Their concern is about privacy, with the Fed i.e., the government itself, is issuing a digital form of money, not just the physical form of cash, and then leaving the digital side to the banking sector itself, there's privacy concerns there. And they look to sort of the e-yuan in China as a sort of warning. And they don't want to crowd out financial sector innovation or the benefits that that could bring to the US private sector. And they want to preserve this channel of bank intermediation.

 

Luke Bartholomew

It's interesting that that is a completely different approach to say, for example, the Eurozone where the European Central Bank is steaming ahead with its development of a digital euro – an ECB-issued central bank digital currency. And I think that reflects concerns that, you know, whilst the Fed might not be too concerned about the impact of stablecoins on monetary transmission in the US, assuming they remain a payment and transactions mechanism, there are lots of reasons for central banks elsewhere to be concerned about, effectively, the domestic payment system of these various countries becoming dollarised. You know that is a first order loss of sovereignty for a lot of central banks in how they think about what their role is, what they should be regulating and, and how they get a grip on their domestic financial system. So as far as the ECB is concerned, the central bank digital currency is the way that it, sort of, fights back against the dollar-dominance of stablecoins. But I think there is one other interesting point, and it relates to your distinction there, Paul, about the, thinking about the dollar financial system as a locus of dollar dominance as well. And one of the ways in which the dollar financial cycle plays out is that a lot of emerging market countries have significant dollar liabilities on their national balance sheets. You know, they have issued a lot of dollar debt. Perhaps that's their only way of accessing capital markets at size. And, you know, sometimes this is called ‘original sin’ going back to some of the literature on the Asian financial crisis and other emerging market financial crises in the 1990s. So, yeah, as things currently stand, emerging markets have a lot of dollar liabilities. And so, what tends to happen when the Fed increases interest rates for its own US domestic purposes. That puts upward pressure on the dollar versus other currencies. And so that increases the value of the liabilities of the dollar assets on emerging market central banks. And so that's an effective tightening of their financial conditions. But if stablecoins are adopted, quite significantly by households and firms in emerging markets as a form of storing wealth, so not just as a payment vehicle, but effectively as a deposit asset as well. Suddenly the national balance sheets of these emerging markets look quite different. Not only do they have the liabilities [xxx] preexisting dollar borrowing, but now there's a whole bunch of dollar assets as well in the form of these dollar stablecoins. And that, in a sense, almost acts as a bit of a natural hedge. So, when the dollar appreciates, yes, the value of the liabilities increases, but also so does the value of the assets. And so, in that way, despite the fact that perhaps their payment systems are more enmeshed in the dollar system, maybe the country's financial conditions feel somewhat less exposed to swings in the value of the dollar and what the Fed is doing in setting interest rates.

 

Paul Diggle

Great, so I think the last area of, sort of, macro implications of stablecoins, we want to talk about is: do stablecoins pose a new source of financial stability risk? What happens if they are not so stable, after all? And you know, on face value, the volatility of the fiat-backed stablecoins we've been talking about is actually quite low. And you can track historical volatility – it is lower than equities, let alone crypto currencies. But there are two, I think, big issues. One is that they can de-peg from the fiat currency. And then this can have broader contagion into the financial sector when that happens. So, de-pegging, which you can really think about as equivalent to money market funds breaking the buck, i.e. money market funds which are similarly backed or composed of lots of short-dated money-adjacent, high-quality assets. They can break the buck and disconnect from their one-for-one par value. That happened during the global financial crisis. It was one of the key, sort of, triggers or stages in the GFC. And it can happen with stablecoins as well. Indeed, it has happened with stablecoins, and it can be caused by transparency gaps if stablecoin issuers aren't clearly disclosing their reserves, the composition of those reserves, and that could fuel doubt and panic and selloff, of the coin. It could be caused by collateral impairment. So, if the collateralisation of the coin is actually risky – exposed to, say, commercial paper or crypto assets in these, sort of, non-fiat collateralised versions – you can get impairment of that capital value undermining confidence in the peg. It could occur in the event of liquidity mismatches if the reserves, the T-bills, the money market funds aren't necessarily instantly redeemable, say under stress conditions. That can trigger, I think, doubt about the peg and events self-fulfilling selloffs. And, you know, there's this whole other case that we talked about earlier of, sort of, algorithmic stablecoins where you can also get design flaws in the mechanism that tries to anchor the value of the peg itself. You know, even fully fiat-backed stablecoins can, and indeed frequently do albeit it might only be by a cent, half a cent at a time for short periods of time, disconnect from one-for- one par value with the currency that they're meant to be linked to.

 

Luke Bartholomew

And as you say, Paul, the very plausibility of that peg being broken then does open up the possibility of these self-fulfilling kind of dynamics, where the perception that the buck might be broken leads to an incentive for people to start selling, getting out of the stablecoin, which then puts pressure on collateral values, which makes it harder to sustain the peg. And so, selling begets selling and you get a very vicious feedback loop developing there. And in some senses, that's not too dissimilar to how bank runs are sometimes described as well. There is, there is a sense in which these stablecoins are innately fire-sellable, if you will. And that's even easier now is they’re digital, they can be preprogramed to do this, although there is a crucial difference between banks and stablecoins in that the banks are credit creation mechanisms as well. So, when you have a bank run that does have contagion for the entire credit creation, broader financial system, and that's [why] one of those can be so destabilising to the global economy. And it's not obvious at the moment that stablecoins have that kind of significance. But there are still ways in which there could be contagion from issues in a stablecoin to the broader financial system. And the first is in the crypto system itself. As we talked about, stablecoins are a standard on/off ramp to the broader crypto ecosystem and if one of those were to break, it would be very easy to see how that would ripple out through the entire crypto system, force fire sales – liquidations there. And in fact, that's what happened with previous algorithmic stablecoin breaking as well. The so-called ‘crypto winter’ of a few years ago followed the breaking of a stablecoin. And you would imagine a similar thing would happen, [if] some of the new fiat ones [were] to break as well. And then the other, as we've, as we've talked about, is that stablecoins are intimately now linked with T-bills. And T-bills and the Treasury market is really the beating heart of the global financial system. So, if there is some sort of problem with a stablecoin that's causing quite significant selling of T-bills, and as discussed there’s research that already shows that selling of stablecoins can have a disproportionately large impact on the price of Treasuries. Then you can imagine that the mechanism of contagion is that, suddenly this absolutely crucial financial market – the repos are based on, that settlement is based on that, you know, banks rely on as a source of liquidity – that becomes impaired. And that's the mechanism through which problems in stablecoins can become problems for financial stability, more generally. This umbilical cord link between stablecoins and T-bills: on the one hand, that is the foundation on which the stability is based – the T-bills are so liquid, it is, the best kind of reserve asset. But at the same time, if then were something to break, because T-bills are so crucial the whole thing could unravel and get quite nasty quite quickly. Anyway, I think that is all that we have time for this week. So as ever, please forgive me if I ask you to like and review the podcast if you've not already done so. And all that remains is for me to thank you for listening. So thanks very much and speak again soon.

 

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