Digital Currency and the Next Financial Crisis
In 2019 when Facebook announced plans to issue a new global stablecoin, Libra, governments took notice. The potential for Libra to be seamlessly adopted by more than 2.3 billion Facebook users challenged the idea that governments alone are vested with the power to issue “money” and raised legitimate concerns about the impact of stablecoins on financial stability.
The G-20 governments directed the Financial Stability Board (FSB) to study the implications of privately issued stablecoins and make recommendations regarding the need for new regulations. In addition, several central banks, including the Federal Reserve, began studying the idea of issuing their own “digital currency” to directly compete with stablecoins. When recently questioned about the Fed’s position on digital currency, Chairman Powell responded, “You wouldn’t need stablecoins, you wouldn’t need cryptocurrencies, if you had a digital US currency. I think that’s one of the stronger arguments in its favor.”
If a major reserve currency central bank like the Federal Reserve issued its own digital currency (FRDC) and made it available globally, it would diminish the appeal of stablecoins. Although FRDC may reduce the financial stability issues associated with stablecoins, they create their own stability issues. In this essay, I provide an overview of stablecoins and central bank digital currency, and discuss the financial stability concerns associated with both forms of digital money.
What is a Stablecoin?
Stablecoin cryptocurrencies, as exemplified by Facebook’s original Libra proposal, are not actually currencies. They are digital coins that can be traded and used as a store of value and a means of payment. The Libra Association proposed a mechanism that will encourage these digital tokens to trade at stable values relative to a reference fiat currency, but there is no guarantee they will maintain a stable fiat-currency value.
The original Libra plan was to base Libra on a basket of fiat currencies. Diem, the successor organization to Libra, will initially launch a single-currency stablecoin called Libra denominated in US dollars. The plan is to create and maintain Libra on a one-to-one exchange basis with the US dollar.
After a Libra coin is purchased, it can be used as a medium of exchange by transferring Libra coins using Diem’s privileged distributed ledger system. “Diem validators” access the ledger and charge fees to process Libra transactions. According to Diem documents, “The Libra network would not itself provide for, record, or settle conversions between Libra coins and fiat currency or other digital assets…any such exchange functionality would be conducted by third-party financial service providers.” In other words, Libra cannot be redeemed for fiat currency, it must be sold on a cryptocurrency exchange.
Presuming Diem is successful, additional single currency-based versions of Libra are planned to be introduced over time. Eventually, Diem will offer a basket-currency Libra coin comprised of a portfolio of single-currency Libra coins with fixed portfolio weights.
The Diem organization mechanism is to maintain a one-to-one exchange rate between the US dollar and Libra. When a Libra coin is created, the dollar proceeds are used to purchase an equivalent value of high-quality, short-term, liquid dollar-denominated assets held by the Diem “Reserve.”
Libra coins do not have any legal ownership claim on Reserve assets, the Diem organization owns the Reserve. The Reserve’s interest income will be used to offset the cost of running the Diem payments system. If necessary, the Diem organization has pledged to maintain the fixed exchange rate with the US dollar by liquidating Reserve assets and using the proceeds to purchase Libra coins on cryptocurrency exchanges and retire them when Libra coins trade below the target value. Conversely, Diem organization members will issue new Libra coins if the coin trades above that exchange rate. Should the value of a Libra coin be depressed by extreme selling pressure, the Diem organization has the option of suspending stabilization operations to avoid selling Reserve assets at “fire sale” discounts.
There are some parallels between stablecoins and money market mutual funds (MMFs). Under normal market conditions, MMFs can be redeemed at par—meaning a share in an MMF with $1 net asset value can be redeemed for $1 in US government fiat currency. Unlike stablecoins, MMF shares cannot be used to directly pay for goods and services. Shares must first be redeemed with the MMF fund and exchanged for US dollars which in turn can be used to pay for goods and services using traditional payments systems to settle transactions.
The FSB began analyzing issues associated with privately issued stable coins in 2019. In a report issued in 2020, the FSB concluded that, unless stablecoins are properly designed, managed, and required to comply with appropriate regulations across the globe, stablecoins could well create important stability risks for the financial system. The FSB identified significant issues in the design, governance, safety, soundness, and anti-money laundering regulations that should be addressed before governments allow global stablecoins to gain momentum. The Diem organization’s planned launch of the Libra coin was delayed so Diem organization plans could be revised in light of FSB’s recommendations.
Among the most concerning issues identified by the FSB is the risk that stablecoin investors might lose confidence in the value of the coin and “run”— i.e., rush to sell their coins for fiat currency, forcing stablecoin issuers to liquidate reserve assets en masse to support the stable coin’s market value on cryptocurrency exchanges. Massive reserve asset liquidations could depress reserve asset valuations further, depleting confidence in the stablecoin’s value, and disrupting important short-term funding markets like those for commercial paper.
Stablecoins are designed to attract investors that prioritize liquidity and the safety of their account balances. Any mechanism that attempts to maintain a stable exchange rate between stablecoins and the underlying currency by liquidating reserve assets that are not immediately convertible into fiat currency, at least not without a significant discount, is susceptible to runs. If stablecoin Reserve assets are sold at a discount, the remaining Reserve balances will no longer fully back the outstanding stablecoins’ value. Remaining coinholders will be forced to bear the losses generated by forced asset sales thereby creating an incentive for all coinholders to seek redemptions at the first sign of liquidity stress.
The widespread adoption of privately issued stablecoins would likely create a new source of financial stability risk—the risk that investors would lose confidence in the value of the coin and run, flooding cryptocurrency markets with sell orders, thereby creating the losses in coin value feared by investors.
MMFs faced similar issues in the 2008 financial crisis. Post-crisis regulatory reforms attempted to remove MMF shareholder incentives to rush redemptions. New regulations imposed asset maturity and liquidity requirements on MMF asset holdings and allowed MMFs to impose redemption fees or temporary redemption suspensions when faced with excessive redemptions. Similar features have been introduced into Diem’s revised operating plan.
The events of March 2020 demonstrated that post-crisis MMF reforms were insufficient to stop massive redemptions at Prime MMFs whose assets include a significant percentage of liquid, high-quality, short-term corporate debt. Fearing Covid-driven corporate downgrades and defaults, institutional investors ran to avoid potential MFF redemption fees preferring the safety of investments with a government guarantee. To restore investor confidence and ensure that short-term corporate funding markets continued to function, the Federal Reserve was forced to create special lending facilities to liquefy MFF assets without creating fire-sale losses. Unlike MMFs, there is no lender of last resort to liquefy stablecoin assets at favorable prices should these coins experience a run.
Will the Government FRDC Make the Financial System Safer?
One approach for attenuating the financial stability risk created by stablecoins is to limit their growth by offering a more competitive alternative. Many people, including Federal Reserve chairman Powell, believe that central bank digital currency, if issued by a major reserve-currency central bank like the Federal Reserve, would be a more attractive alternative to stablecoins.
The Bank for International Settlements defines central bank digital currency as, “a digital payment instrument, denominated in the national unit of account, that is a direct liability of the central bank.” To purchase FRDC, should it ever be issued, one would provide the central bank or a designated intermediary of the central bank with Federal Reserve Notes (paper money) or a bank deposit transfer and receive in return an account with an equivalent amount of FRDC.
FRDC could be designed like an electronic coin that can be transferred over the internet using a system similar to Diem’s permissioned distributed ledger. More likely, FRDC would be transferred electronically on a single ledger maintained by the Fed. The Fed would likely use approved intermediaries to interface with retail account holders so the Fed did not have to keep track of retail accounts or satisfy anti-money laundering and other requirements that banks and money transfer services must comply with. Intermediaries would accept paper dollars or bank deposits and credit the customer’s intermediary account with an identical amount of FRDC. The intermediary would be required to back each retail account FRDC dollar issued with a FRDC deposit in an account at a Federal Reserve bank.
If the Fed decided to issue FRDC, it could well reduce the appeal of privately issued stablecoins and reduce the urgency of the globally coordinated efforts needed to ensure financial stability. The catch is FRDC may create its own source of systemic risk.
FRDC is the ultimate safe dollar asset. Large uninsured deposit balances at banks and MMFs can experience losses when banks fail, or the net asset values of MFFs shares fall below $1 (a.k.a. “break the buck”). FRDC is a direct liability of the Federal Reserve so there is no risk that FRDC will default.
The ultra-safe nature of FRDC creates a destabilizing force opposite of a stablecoin run. FRDC facilitates panicked uncontrolled disintermediation in a financial crisis. Faced with an elevated risk of default losses in a financial crisis, institutional investors holding large balances in uninsured bank deposits and MMF accounts will pull their balances from banks and MMFs to purchase FRDC. In a financial crisis, private sector financial institutions would likely hemorrhage funds as investors ran to the safety of FRDC. The mass transfer of bank and MMF balances into FRDC will constrict the availability of credit to businesses and consumers because the Fed will not replace the business and consumer credit provided by banks and MMFs.
Deposits are typically a bank’s cheapest source of funding and the primary instrument banks use to fund loans and other investments. A run from bank deposits into FRDC will force banks to contract their lending and replace lost deposits with a more expensive source of funding. Withdrawals from MMFs will prevent them from purchase commercial paper and other short-term liabilities that are an important source of funding for many large businesses and corporations. Either way, a run into FRDC would restrict the availability and raise the cost of private sector credit. To prevent further economic damage, the Fed would likely be forced to establish new emergency lending facilities to replace the contraction in bank and MMF credit caused by an institutional investor run into FRDC.
The widespread adoption of privately issued stablecoins would likely create a new source of financial stability risk—the risk that investors would lose confidence in the value of the coin and run, flooding cryptocurrency markets with sell orders, thereby creating the losses in coin value feared by investors. Panic selling pressure will require massive reserve asset liquidations to stabilize coin values. The forced sale of illiquid assets will depress the prices of the liquidated and comparable assets, reinforcing the incentive to run, and disrupting private short-term credit markets. The key weakness of privately issued stablecoins is the lack of a credible lender of last resort with the power to liquefy illiquid private sector debt instruments into a stablecoin’s base fiat currency.
Central bank digital currency is often promoted as a way to solve the financial stability issues associated with stablecoins. Unfortunately, the ultra-safe nature of central bank digital currency creates a new source of financial instability: the risk of a massive run into central bank digital currency out of bank deposits and MMF accounts. Widespread disintermediation would severely restrict the supply of short-term private credit and likely force the Federal Reserve to use its lender of last resort powers to create emergency lending programs to support private credit markets.
This article was published by Law and Liberty and is reproduced with permission.