Blockchains are encrypted databases—the ledger—controlled by a dispersed web of private validators who update and maintain a record of transactions by appending a new block through consensus among the network. It has always been an invention searching for a definitive application.
Initially used as the basis for Bitcoin— which was to replace money, but has become the ultimate speculative asset—it morphed into de-fi or decentralised finance. The latest incarnation is ‘stablecoins’, tokens using public blockchains (for example, Ethereum) with a value pegged to and backed by fiat currency asset. They were originally designed to allow crypto traders to transfer holdings or convert them into cash. It avoided high transaction costs of crypto-to-fiat conversions and overcame some cryptocurrency exchanges’ lack of normal bank accounts for deposits or withdrawals. Stablecoins such as Tether, Circle, and EUR CoinVertible are now being positioned as an alternative global payment system.
The impetus is driven by greater regulatory clarity in major jurisdictions, particularly in the US via the Genius Act. The interests of Trump enterprises and those of some close supporters in the crypto sector are, of course, coincidental. Stablecoins also create demand for dollars and interest-bearing short-dated US Treasury bills helping the American government fund its deficit. Current investment, which totals a modest $200 billion of shortdated Treasury bills (2 percent of outstandings), is expected to grow rapidly.
Proponents cite several advantages. Stablecoin payments are borderless and more efficient than current arrangements that rely on bank-to-bank systems with layers of fees. They offer near-instant settlement while traditional payment systems can take up to 5 days, especially for foreign payments. They are significantly cheaper and available 24/7 through modern digital interfaces. This last benefit is overstated as modern bank fund transfer platforms are similar, although the settlements are restricted to business hours. With every technology entrepreneur trying to ‘improve the world’, there is the customary claim of inclusion with stablecoins helping provide access to underserved members of the community.
But there are concerns. Existing systems process $5-7 trillion in global money transfers daily. In contrast, stablecoin transactions facilitate $20-30 billion a day. Scaling up and improving speed requires compromises including processing transactions off-blockchain or revising consensus verification protocols. They used inherited data from an underlying layer reducing security and require centralisation with a few large users playing a dominant role moving away from the fully decentralised, democratised original technology.
The stability and acceptance of stablecoins requires provable high-quality reserves, typically cash or short-dated government obligations. Verification of holdings remains problematic with some issuers based offshore and concerns around audit processes. There has been occasional de-pegging from the underlying unit of currency, mostly triggered by concern about reserve backing.
Unlike normal transfer systems that are backed by central banks with highly controlled access, blockchain-based systems are more open, with a corresponding loss of security. In addition, traditional systems have protection via manual interventions and detailed checks, while digital currencies are less protected. The biggest risk is if the access point, vulnerable to wallet, custody, or private key theft, is breached. Transactions are largely irreversible, and catastrophic losses may result where security is compromised, or codes and keys lost.
Stablecoins’ claims of transparency are exaggerated. In theory, each step in a chain is known, but public blockchain transactions often use pseudonymous wallet addresses that hide individual users’ identities. This contrasts with traditional banking, where verified personal information is required. While stablecoins protect privacy, it comes at the cost of accountability and financial integrity. In contrast, the legacy systems allow the routing to be traced and claims to be re-established if needed.
Unlike fiat money, the amount of stablecoins is limited by the amount of available collateral, potentially interfering with economic activity, credit availability, trading and monetary policy execution. If stablecoins become established, they will absorb outstanding securities and affect prices and liquidity of government securities. While stablecoins decrease short-term Treasury yields, with effects comparable to that of small-scale quantitative easing on long-term yields, outflows have asymmetric effects in raising yields. A financial crisis could be exaggerated as depositors concerned about solvency may switch to stablecoins, exacerbating a bank run. As they provide access to foreign currencies, stablecoins may facilitate capital flight, reducing a country’s monetary sovereignty. They create new channels for spreading shocks within the financial system.
Stablecoins lack legal protection. There is no entitlement to the underlying assets in law and, in the event of bankruptcy of the issuer, holders will be unsecured creditors. This is complicated by the fact that the vast majority are issued by private firms frequently based in tax havens.
As digital bearer instruments using borderless public blockchains, they bypass safeguards. While this overcomes access hurdles for underserved citizens, it can facilitate illegal use, including for financial crime and terrorism, as individual users’ identities are hidden behind addresses circumventing anti-money-laundering and know-your-client regulations.
Money is ultimately based on trust and acceptance. It is an agreed mechanism for trading and storing value. It is settled at par against a common safe asset (monetary reserves) provided by the central bank, which has a mandate to act in the public interest and is backed by the full faith and credit of the state.
Blockchain-based stablecoins seek to replace this with a dispersed network of self-interested, private record keepers. The incentive structures are complex and may create an insecure system where need for speed, handling volume and profit will dilute standards on what constitutes unanimous consensus.
So they are, essentially, an attempt by privateers who use high-minded technological arguments to capture a lucrative essential function for profit, not social advancement. While far from perfect, replacing a system which is tried and tested risks undermining trust especially when improving settlement times and reducing costs in traditional payments is achievable.
Satyajit Das | Former banker and author of The Age of Stagnation
(Views are personal)
