Stablecoin is actually a backward institutional arrangement

Author: Qinghe Zhibensha President

Recently, the United States, the European Union and Hong Kong, China are launching or have launched laws/regulations related to stablecoins. The digital currency field is excited about this, and the traditional financial market is also paying close attention to this event.

However, in terms of the basic logic and institutional evolution of the financial market, stablecoins are a relatively backward institutional arrangement, a backward and mediocre monetary system with mandatory equal reserves, rigid redemption, fixed prices, restricted digital currency bank markets, and strict constraints on policy initiative and liquidity creation.

What is the prospect of stablecoins in the future?

The logic of this article

1. What is a stable currency?

2. Why is the stable currency an outdated system?

3. How will the future currency form and banking system evolve?

What is a stable currency?

Stable currency is not a new thing created by recent laws. Before this, there were two major stable currencies, USDT and USDC. At the same time, Facebook and digital currency exchanges have also launched their own stable currencies.

It stems from the fact that Bitcoin fluctuated greatly and lost its currency function before. Traders need a stable currency to enter the digital currency market to buy and sell digital assets. Stablecoins serve as a pipeline and payment function in and out of the digital asset market.

Why does the government need to introduce stablecoin-related laws?

For the United States, there may be three major intentions: one is to bring stablecoins and digital currencies under regulation; the second is to embrace new technologies, new finance, and new trends to prevent the United States' financial advantages from being marginalized due to technological innovation and market transfer; the third is to increase the reserves of US dollars and US debts. Today, stablecoins have absorbed about $1.8 trillion in US debts, which exceeds the holdings of the Japanese government.

What is a stablecoin?

Stablecoins are defined by the laws being introduced. Based on the relevant laws and regulations of the United States and Hong Kong, China, stablecoins have several common points:

First, they are anchored to legal tender (US dollars/Hong Kong dollars) and are mainly used for payment and settlement; second, they must reserve legal tender and issue short-term government bonds at a 1:1 ratio; third, they are subject to strict supervision and information disclosure and must comply with anti-money laundering requirements; fourth, private companies that meet the requirements can apply to be stablecoin issuers; fifth, interest payments to stablecoin holders are not allowed.

It can be seen that stablecoins are a type of currency with asset attributes, which can be understood as: a value-stable currency that is anchored to legal tender, 100% reserves legal tender/bonds and is issued only for payment and settlement.

How to understand stablecoins?

Stablecoins are first of all a type of currency that follows the ancient law of demand for currency.

We know that money has many functions, but its most basic function is pricing and payment. In the era of physical currency, after countless games, the market competed for some stable currencies, such as gold. However, a huge flaw of physical currency is that it is inconvenient and inefficient.

Since the 15th century, trade in Western Europe has begun to rise, and the defective physical currency is not enough to support the rapidly growing trade. Therefore, private banks in Europe issued banknotes to solve this problem. Banknotes are also issued by reserve gold and belong to the gold standard system, which is equivalent to the securitization of gold. Merchants can use banknotes to pay and settle in different places, which is more convenient and efficient. In the early days, a large number of private banks in Europe and the United States issued their own banknotes as currency.

Banknotes solved the problems of convenience and efficiency, but the problems of stability and security were exposed.

At that time, the phenomenon of excessive issuance of banknotes was extremely common. In the era of free banking, there were more than 8,000 issuing banks in the United States. Some small banks opened in the countryside were like small shops and could run away or go bankrupt at any time. These banks were jokingly called wildcat banks.

The excessive issuance of banknotes meant that banks could not stick to the exchange rate between banknotes and gold, and banknote inflation was serious, even triggering a banking crisis. After a financial crisis, the British government intervened in 1844 and launched the Peel Act, ending the currency issuance rights of more than 200 private banks in the UK at that time, and authorizing the Bank of England to issue pounds as the only issuing bank.

The Bank of England reserves 14 million pounds of securities and precious metals as issuance reserves and issues banknotes of the same amount. If the limit of 14 million pounds is exceeded, gold and silver must be used as reserves, of which the issuance of silver reserves shall not exceed 25%.

This means that the Bank of England became the only central bank, and other countries followed suit to establish their own central banks and legal tender.

After that, the currency evolved in these two directions at the same time: the pursuit of more efficient payment and settlement, and the pursuit of more stable value.

The pursuit of more efficient payment and settlement is mainly achieved through technological innovation to change the form of currency, from paper to electronic, networked, and digital.

Why do many people use Alipay and WeChat Pay today? It is because this electronic currency and online payment channel are convenient and efficient.

Why are so many people chasing stablecoins today? It is because the legal currency and financial system in the world today have low efficiency and strict review of cross-border payments, while stablecoins using distributed technology have higher efficiency and more secretive cross-border payments.

The pursuit of more stable value is mainly through institutional construction to constrain the value of currency and the issuance of currency. Since the introduction of the Peel Ordinance, the government has begun to monopolize the right to issue currency, introduce the central bank system, intervene in currency prices, and try to maintain the stability of legal currency.

The early practice was to abide by the gold standard. The most stringent requirement was to issue the local currency with 100% reserve gold, and the price of the local currency was fixedly linked to the gold price.

The culmination of the gold standard is the Bretton Woods system. The Bretton Woods system designed in 1944 is a gold standard system and a fixed exchange rate system with the US dollar as the core. It requires the US dollar to be pegged to gold, and initially implemented a fixed official price of 35 US dollars to 1 ounce of gold; it requires the currencies of other member countries to be pegged to the US dollar, and the exchange rate fluctuation against the US dollar cannot exceed 1%.

Why is the official stablecoin decree launched today?

In fact, it is also hoped that a similar gold standard system will be introduced to ensure the stability of the stablecoin value.

In 2022, the collapse of USDT triggered a stablecoin credit crisis. This made many people wonder whether USDT has enough US dollar assets in reserve. In fact, USDT has defects. This automatic trading mechanism does not really understand the logic of finance, especially the liquidity crisis. In 2023, the Silicon Valley Bank crisis caused a sharp drop in USDC, which had a large amount of assets in Silicon Valley Bank. These two events made more people realize that stablecoins are not safe and need to be regulated.

Today's institutional arrangements for stablecoins have the shadow of the Bretton Woods system. Stablecoins are issued with 100% reserve of local currency (US dollars) and maintain a fixed ratio with local currency.

However, compared with efficiency progress, value stability is obviously more difficult. In the past 200 years, central banks have taken the initiative to break the gold standard many times. For example, the Federal Reserve broke the gold ratio during World War I, announced decoupling from gold during the Great Depression, and closed the gold exchange window in 1971-leading to the disintegration of the Bretton Woods system and the end of the gold standard.

So, is the institutional arrangement of stablecoins reliable?

Why is stablecoin an outdated system?

As mentioned above, stablecoin is an outdated institutional arrangement. It does not refer to stablecoin itself, but to the stablecoin-related laws and regulations introduced by the United States and Hong Kong, China.

Below, I will analyze the problems of stablecoin-related laws from the perspective of the nature of currency and institutional evolution.

The first is the problem of asset reserve constraints.

For a long time, sufficient and reliable asset reserves have been considered the basis of monetary credit and price stability. In the era of the gold standard, economists debated whether banks needed equal/excess reserves of gold to issue currency, among which Mises advocated 100% reserves. However, until the collapse of the gold standard, no bank insisted on equal/excess reserves.

Why is this?

There is a paradox in the equal/excess reserve system. There is no "enough" and "reliable" asset in the world. Gold is scarce, and the issuance of currency with equal reserve gold means that the currency is also constrained by the scarcity of gold. In this way, the supply of currency cannot meet the needs of international trade and financial transactions, and it is bound to be limited to deflation.

Therefore, as the demand for payment and settlement expands, the money supply will outperform the gold supply for a long time, and the price ratio of currency to gold will continue to decline, and eventually decouple from gold. This is one of the main reasons for the disintegration of the Bretton Woods system. In fact, since the 1960s, the United States has continuously lowered the dollar-gold exchange rate. In 1971, traders attacked the dollar on a large scale in the black market.

Is it possible for stablecoins to encounter a "Bretton Woods moment" in the future?

Stablecoins require 100% reserve of US dollars/short-term US Treasury bonds. If the supply of stablecoins is not large, this system can be maintained, but it is meaningless. If the supply of stablecoins continues to expand, short-term US Treasury bonds will become scarce and prices will rise. The US federal government can certainly expand the supply of US Treasury bonds to lower prices, but the problem is that according to the current decree on stablecoins, the utilization rate and liquidity of US dollars/US Treasury bonds will decline.

The problem lies in the fact that the decree "does not allow interest to be paid to stablecoin holders" (to be analyzed below), which means that the regulation does not allow the development of stablecoin commercial banks, then the ability of stablecoins to create money will be greatly reduced, and the money multiplier and liquidity will also decline. If the short-term US Treasury bonds of stablecoin reserves increase to 10 trillion US dollars, it means that 10 trillion US dollars of liquid assets are locked.

This system is similar to the previous mandatory reserve system, which was later abolished due to lack of efficiency and increased bank risks, and was replaced by a voluntary reserve system.

If liquidity risks are expected, the U.S. federal government may further issue patch decrees to make some rigid regulations on the asset structure of stablecoins. This falls into the above paradox again. Reliable assets are naturally scarce, and rigid regulations will reduce the reliability of reserve assets.

Therefore, the 100% asset reserve constraint seems to be the safest institutional arrangement, but in fact it will bring greater financial risks due to the lack of allocation efficiency.

The second is the problem of fixed price constraints.

Stablecoins, as the name suggests, have fixed prices, and stablecoins are anchored to the local currency. However, today, very few countries/economies implement a fixed exchange rate system.

The disintegration of the Bretton Woods system in 1971 declared the collapse of the fixed exchange rate between the U.S. dollar and gold. Countries no longer reserve gold to issue their own currencies, and at the same time abolish the fixed exchange rate with gold. The Latin American sovereign debt crisis in the 1980s ended the fixed exchange rate between Latin American currencies and the US dollar. The Asian financial crisis in 1997 ended the fixed exchange rate between Asian countries and the US dollar. Today, looking around the world, the only economy that has implemented the most successful fixed exchange rate is our Hong Kong.

In fact, the current stable currency system is very similar to Hong Kong's linked exchange rate system. The Hong Kong Monetary Authority authorizes three banks to issue Hong Kong dollars. Banks deposit their US dollar reserves with the Hong Kong Monetary Authority, and then issue Hong Kong dollars at a fixed exchange rate of 1 US dollar to 7.8 Hong Kong dollars based on the deposit certificate issued by the Hong Kong Monetary Authority.

Hong Kong's linked exchange rate system has been maintained since 1983 and is an important institutional guarantee for Hong Kong to become a global financial center. However, in recent years, the survival of Hong Kong's linked exchange rate has attracted widespread attention.

Why is it difficult to maintain a fixed price/exchange rate?

Fixed prices violate the basic principles of economics. Fixed prices mean that prices have lost their ability to regulate supply and demand, and cannot warn, release and regulate risks. This is the second main reason for the collapse of the Bretton Woods system.

On the surface, 100% reserves are the most likely to maintain fixed prices, but as analyzed above, the full reserve system has a paradox and cannot support the continued expansion of currency demand. Economies that maintain fixed exchange rates, such as Hong Kong, have to rely on more reserves and transactions to maintain fixed exchange rates, which depends on the local economy to maintain lasting prosperity. The reason why Hong Kong has been able to maintain a fixed exchange rate for a long time is that the Hong Kong economy has been able to outperform the United States in the past 40 years. When the economy enters a recession-depression period, the fixed exchange rate will face selling pressure challenges.

The third is the problem of policy initiative constraints.

Many people do not realize that the US regulatory bill on stablecoins has greatly constrained the policy initiative of stablecoins and locked up the new financial market for stablecoins. This is what regulators want to see.

Pay attention to two policies:

One ​​is the fixed exchange rate. According to the Mundell Impossible Triangle, the fixed exchange rate and free capital flow of stablecoins mean that the issuers of stablecoins have lost the initiative in policy. The issuance volume and interest rate of stablecoins are forced to serve the fixed exchange rate target, just like the Hong Kong dollar under the linked exchange rate system. Under the fixed exchange rate system, if the interest rate of stablecoins is much lower than the interest rate of the US dollar, this will trigger capital arbitrage, and a large amount of capital will sell stablecoins to chase the high-interest US dollar, which will in turn impact the fixed exchange rate.

The other is more fatal, "interest is not allowed to be paid to stablecoin holders." This means that it is difficult for stablecoins to establish a legal banking system, and liquidity will drop significantly. We know that most of the liquidity in today's financial markets is created by the deposit-loan mechanism of commercial banks. This regulation has ruined the imagination space of stablecoin new finance and reduced the issuers of stablecoins to "obedient central banks."

What will happen if "interest is allowed to be paid to stablecoin holders"?

It can be predicted that the new financial market of stablecoins will emerge, the liquidity of stablecoins will increase exponentially, and the exchange risk of stablecoins will also follow.

In the Bretton Woods system, individuals cannot exchange US dollars for gold from the Federal Reserve, but member governments have such power. Since the mid-1960s, as the US trade deficit continued, a large amount of US dollars were imported into Europe, and the French government brought a large amount of US dollars to the Federal Reserve for gold. This is a problem of the rigid payment system.

Today's financial system is far more complex than in the 1960s, and the currency derivation ability is stronger. If banks are allowed to derive stablecoins, then the stablecoin run crisis will be inevitable.

It can be seen that the rigid payment of the issuing bank and the derivation mechanism of commercial banks are a set of contradictions. The problem lies in the rigid payment, not the derivation mechanism of the financial market. "Not allowing interest payments to stablecoin holders" means denying the liquidity creation function of the financial market, which is wrong.

Today, no country/economy adopts a rigid redemption system, and basically adopts open market operations. Today, the Hong Kong Monetary Authority also maintains a fixed price of Hong Kong dollars/US dollars through open market operations.

Therefore, stablecoins are actually a backward financial system with mandatory equal reserves, rigid redemption, fixed prices, and strict constraints on policy initiative and liquidity creation.

How will the future currency form and banking system evolve?

How will stablecoins develop in the future?

Of course, the above analysis of the institutional arrangements of stablecoins does not deny the prospects of stablecoins, but allows us to deduce the development of stablecoins from an institutional perspective.

First, it is worth affirming that the introduction of the stablecoin regulatory decree means that the government recognizes the legitimacy of privately issued currency. This is the greatest significance of this decree, and many people are not aware of this.

Since the emergence of the Peel Ordinance, privately issued currency has gradually been nationalized, the central bank has become the only currency issuing institution in a country, and legal tender has become the only currency in circulation within the country, which is monopolistic and legal. If it were not for the emergence of Bitcoin, many people would not know that currency can be non-nationalized. However, since the birth of Bitcoin, theft, fraud and currency flooding in the field of digital currency have been extremely rampant, no less than the era of free currency in the United States, and many people are disappointed with digital currency and private currency.

Today, the introduction of the stablecoin decree marks that the country has taken the initiative to break the monopoly on the right to issue currency. Although the government has imposed "five flowers" on stablecoins, and although stablecoins must reserve 100% of legal currency assets, it is still a historic event for private currency to gain legal status.

Secondly, the introduction of the stablecoin regulatory decree means that the government recognizes the legitimacy of the on-chain payment channel.

The real value of Bitcoin is that it has created a distributed cross-border payment network. Compared with the existing financial payment and clearing network, the on-chain payment network is more efficient, less expensive, and more hidden.

Of course, the decree will certainly increase the transparency of on-chain payments and increase supervision of on-chain assets and transactions, which will to a certain extent lose the advantages of the on-chain network. However, this cannot negate its advantages. In fact, in the past two years, some governments have been worried that on-chain has become a general trend, and have seized the pipeline and promoted the on-chain of their own currencies.

It can be predicted that stablecoins are ushering in an institutional dividend of "joining the system."

On the one hand, as the legitimacy of stablecoins is confirmed, market expectations have improved significantly, the channels to enter the digital currency market will be smoother and wider, transaction fees will be lower, and market liquidity will increase, which will drive the expansion of the stablecoin market and the rise of digital asset prices.

On the other hand, the expansion of stablecoin demand will increase the reserves of US dollar/US Treasury assets, and the number of individual indirect investors in US Treasury bonds will increase, which will help enhance the price and credit of US Treasury bonds and reduce the pressure on the international market to reduce US Treasury bonds.

However, in the long run, the development of stablecoins will be constrained by current rules. Some people say that stablecoins are backward systems, which are intended to allow stablecoins and digital currencies to develop more robustly. In fact, I prefer to understand it as a product of compromise between state monopoly and market demand.

Stablecoins are like a machine with advanced technology, but the state organization has installed a backward system from the previous era on it - a monetary system similar to the gold standard era/Bretton Woods system.

First, mandatory equal reserves indicate that stablecoins are typical asset attributes, while current credit currencies such as the US dollar are debt attributes. I don't think this needs to be modified. After all, the current stablecoins can only attract users through reliable assets and do not have the ability to create debt currencies. However, in the future, equal reserves may not be required to provide space for the creation of debt currencies.

Second, fixed prices are attractive, but they are prone to cause the price adjustment mechanism to fail. I don't think this needs to be modified, and it can be adjusted to floating prices later.

Third, rigid redemption needs to be abolished and replaced by open market operations, that is, stablecoin issuers maintain fixed or stable prices through open market operations.

If rigid redemption is maintained, it must be "not allowed to pay interest to holders", which means that the prospects of stablecoin new finance are directly killed. But in reality, stablecoin banks will definitely appear (in fact, they are now), and they will also create some liquidity. If liquidity is too large, it may bring about the risk of bank runs.

Fourth, "interest is not allowed to be paid to holders", this point should be abolished, and the development of stable currency banks and new financial markets should be allowed under supervision.

Of course, objectively speaking, no matter how the current stable currency system is adjusted, it cannot be compared with the US dollar. Credit currencies such as the US dollar are still the most advanced monetary system (digital currency wins in technical pipelines).

Credit currency is a debt-attributed currency. The US dollar is a super bond that circulates globally without paying interest and will never be repaid.

The Federal Reserve issues base currency by purchasing US bonds in the bond market. In other words, the US dollar is "created out of thin air". There are a large number of US debt assets lying on the Federal Reserve's balance sheet. Many people think that the US dollar is also issued by reserving US bonds. This is a common misunderstanding, and the debt attribute of credit currency is not understood.

When traders get bonds such as US dollars, they can neither ask the Federal Reserve for interest nor ask the Federal Reserve to repay the principal (non-rigid redemption), and the price fluctuates from time to time (not fixed), but global traders still want to get US dollars.

Therefore, credit currency, this bond-type currency, is a high-dimensional currency. Bond-type currency requires strong credit support, and the credit of credit currency comes from strong national sovereignty. At present, the credit of stablecoins cannot compete with the credit of national sovereignty.

In the future, in the era of national markets, private currencies and legal currencies will compete with each other. The key to digital currency challenging legal currency lies in digital assets-huge and reliable digital assets based on distributed technology that transcend national sovereignty and physical levels. Perhaps, physical assets on the chain and metaverse digital assets are the credit cornerstones of future digital currencies.

In short, this world is not short of currency, pipelines, but credit.