When Global Stablecoins Fail

Global stablecoins refer to initiatives, such as Facebook’s Libra, that have the potential to reach a large customer base across the world. Such initiatives generally commit to providing consumers with the possibility of converting their holdings back into a reference fiat currency at any time, at a stable value (relative to a specified asset, or a pool or basket of assets).

Can global stablecoins, despite their name, potentially make the financial system unstable and adversely impact the real economy? The short answer, provided by national and international financial regulators, is yes (see G7, BIS, FSB, ECB).  In fact, while their current market cap is still small in relative terms, their foreseen transformative impact on the global financial system is large.1

This article investigates the channels through which the potential instabilities of a global stablecoin arrangement can have systemic implications.

We consider the risk transmission in three steps. First, how the fragilities of a global stablecoin may create the risk of a liquidity run impairing the functioning of the stablecoin arrangement. Second, the risk of contagion spreading to the wider financial system network, as a result of an arrangement’s distress. Third, the fallout of these as macroeconomic risks onto the real economy. 

Step 1: Fragilities of a Stablecoin Initiative

A stablecoin may be perceived by consumers as a cost-efficient alternative to current payment, money transfer or even banking services. Yet, at present, stablecoins may be more similar to investment funds that entail investment risks that can ultimately result a liquidity run.

The promise of a stable value and liquid holdings depend crucially on the value of the underlying assets or fund portfolio and ultimately on the governance and risk management of the initiative. In this respect, stablecoins are different from bank deposits that have a guarantee of redeemability at par, supported by a regulatory deposit guarantee scheme. 

A run on a global stablecoin arrangement could occur if end users lose confidence in the issuer or its network. An event which damages the global stablecoin arrangement’s reputation could lead to sudden selling flows out of the global stablecoin. Several scenarios can be envisaged, in which the credibility of an arrangement is compromised, resulting in the global stablecoin being exposed to runs or loss of confidence:

  • A cyberattack or a large-scale theft may compromise the credibility of the issuer, downgrading the perceived safety of the coin.
  • A sudden awareness of poor governance, such as non-segregated funds in the reserve, poor handling of legal obligations and bad practices.
  • Idiosyncratic or system shocks affecting bank deposits liked to global stablecoins, and transmitting credit risk and liquidity risk of the underlying bank
  • If proceeds from coin sales are not held in a depository but invested in non-zero risk financial assets, idiosyncratic or system shocks could expose credit, liquidity, market and foreign exchange risks associated with the holdings.

Falling reserve asset values (and falling confidence) could result in a gap between the notional value of the coin and reserve values. This gap would in turn trigger a run where users try to redeem their global stablecoins for the underlying assets.2 In such a scenario, the issuer would be forced to liquidate its assets below market value, and possibly default.3 

Step 2:  Global Stablecoin Contagion in the Financial Network

In the event of a run on a global stablecoin, the liquidation of assets to meet redemption requests could have negative contagion effects on the financial system. Whether such event reaches systemic scale will ultimately depend on the size of the stablecoin arrangement and its interconnectedness with the financial system.4

In the event of a run on a global stablecoin triggering a fire sale, several asset classes could be affected, especially bond markets and usually safe and liquid assets. For example, if a stablecoin reaches a dominant role in some bond markets, then a run on that coin would create price volatility and illiquidity spikes, affecting other market players and potentially creating panic and spilling over onto the rest of the financial sector.

Global stablecoins could also increase vulnerabilities in the broader financial system, and create additional amplification mechanisms through several channels. 

  • First, if users hold global stablecoins in deposit-like accounts, retail banks would be increasingly dependent on more costly and volatile sources of funding. This could increase the fragility of the baking sector making it more exposed to bank runs.
  • Second, bank profitability would be further compromised if the global stablecoin ecosystem also took over financial intermediation activity. Banks would be pushed toward more risky lending or investment opportunities.5
  • Third, the expansion of global stablecoins reserves could exacerbate the current shortage of safe assets, potentially affecting financial stability.
  • Fourth, dominant global stablecoins in short term government bonds, could impair the transmission of monetary policy, especially in the event of liquidation of assets and a fire sale.
  • In frontier countries, a global stablecoin more be perceived as more stable than the local currency, this could entail capital outflows, and create an additional destabilisation mechanism in a period of turmoil.

Step 3: Fallout on the Real Economy 

If a global stablecoin became dominant as a means of payments, means of settlement within financial markets, reserve asset, or store of value then any disruption to their ecosystem may result in a macroeconomic impact on real economic activity.

First, a disruption to a global stablecoin widely used as mean of payment would result in a freeze of transactions, and the temporary collapse of economic exchanges. If the global stablecoin were also used as a means of settlement within financial markets, the delays in transactions would create a liquidity freeze in the financial sector and additional financial stability risks. The impact would depend on the extent to which other payment systems could be adopted as close substitutes. In most extreme scenarios, if a global stablecoin had become a substitute for fiat currency, and hence undermined monetary sovereignty, the liquidity crisis would have large consequence and a central bank would have limited ability to reduce the macroeconomic impact of the shock.

Second, a global stablecoin as a reserve asset could entail significant implications for financial markets. In case of a run on a global stablecoin, the issuer would generate a fire sale to meet redemption request, moving market prices and potentially disrupt the funding of banks and companies. Banks and other financial institutions directly exposed to the global stablecoin could suffer large losses if the value of the global stablecoin collapsed or if other assets’ prices were to decrease due to contagion. Moreover, if there was borrowing denominated in a global stablecoin, fluctuations in its value could also exert balance sheet effects on firms.

Third, if a global stablecoin were used as a store of value, then any shock to its value would entail a wealth effect on its holders pushing consumers to adjust their consumption and spending plans downward.

Conclusions

To ensure the commitment to stable value, stablecoins initiative are supported by complex arrangements involving several components from asset management, to stabilisation of the value, to settlement within financial markets.
Such complexity can mask excessive risk-taking, make risk management difficult, and blindside regulatory efforts. Risks may build up into individual components of these arrangements and transmits to others via unpredictable interactions, ending up posing wider risks to the economy.  If such risks were not mitigated, a collapse of a global stablecoin arrangement could cause a financial crisis, similar to the global financial crisis in 2007 when redemption were suspended from securitisation vehicles.

Bibliography

Adrian, T., "Stablecoins, Central Bank Digital Currencies, and Cross-Border Payments: A New Look at the International Monetary System", remarks at the IMF-Swiss National Bank Conference, Zurich, May 2019

G7 Working Group on Stablecoins (2019), “Investigating the impact of global stablecoins”, October.

BIS, (2019) Investigating the impact of global stablecoins, A report by the G7 Working Group on Stablecoins: www.bis.org/cpmi/publ/d187.pdf

FSB, Addressing the regulatory, supervisory and oversight challenges raised by “global stablecoin” arrangements: Consultative document, April 2020, www.fsb.org/2020/04/addressing-the-regulatory-supervisory-and-oversight-challenges-raised-by-global-stablecoin-arrangements-consultative-document/

European Central Bank (ECB), (2020), A regulatory and financial stability perspective on global stablecoins, Macroprudential Bulletin: https://www.ecb.europa.eu/pub/financial-stability/macroprudential-bulletin/html/ecb.mpbu202005_1~3e9ac10eb1.en.html#toc8

Footnotes

1 Bitcoin.com estimate the current market cap of stablecoins at just over $7 billion. 
2 Global stablecoins that rely on market-makers to maintain a stable value could be exposed to these arrangements, if the market makers are not legally obliged to stabilise the price in all circumstances and hence could stop intervening in the case of strong selling pressure.
3 An important question posed by stablecoins is the one of who ultimately bears the implicit investment risks. If the stablecoin arrangement does not guarantee a fixed value for the currency, the end user bears the valuation risk and the stablecoin is equivalent to a fund share. Conversely, if the stablecoin arrangement guarantees a fixed value, then the ultimate bearer of valuation risk is the issuer. In this scenario, the end user Is exposed to issuer risk. 
4 Different components of the stablecoin arrangement – assets, risk management, customer base, etc – are likely to be scattered across different jurisdictions. A shock to the stablecoin arrangement that occurs in a market could be quickly transmitted to others creating global contagion.   
5 A Banks’ funding could also be impacted via other channels. For example, a banks’ reputation could be compromised if the bank were part of the stablecoin ecosystem.

Disclaimer

The material provided in this article is being provided for general informational purposes. Aaro Capital Limited does not provide, and does not hold itself out as providing, investment advice and the information provided in this article should not be relied upon or form the basis of any investment decision nor for the potential suitability of any particular investment. The figures shown in this article refer to the past or are provided as examples only. Past performance is not reliable indicator of future results.

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