Are Stablecoins In or Out? Regulators Have to Decide.
(Bloomberg Opinion) -- The 2021 Annual Report to Congress by the Financial Stability Oversight Council released Friday illustrates the attitude toward cryptocurrencies — and stablecoins in particular — of people so deeply embedded in 20th-century government-run finance that they can sense only challenges to that system, not risks of that system.
The report’s authors seem to have missed the fact that Bitcoin was created in 2008 largely due to lack of trust in the traditional financial system. It cites the volatility of Bitcoin as a threat to financial stability. But volatility is measured in dollars per Bitcoin, and it reflects uncertainty about both dollars and Bitcoin.
Today, you can buy a very nice car for one Bitcoin. Bullish Bitcoin holders do not necessarily think one Bitcoin will buy 10 nice cars in the future, many of them fear that it might take $500,000 to buy that car in 10 years, or that dollars will not be accepted at all, or that dollars they hold today will be taxed away or lost in a financial crisis. Certainly, a major driver of Bitcoin’s appreciation from $5,000 to $50,000 in the last two years is driven by fears of inflation, war, uncontrolled deficits, confiscatory tax proposals, exceptionally loose monetary policy, a worsening pandemic and a possible U.S. debt default more than any change in economic fundamentals of the cryptocurrency economy.
To a professional risk manager, Bitcoin volatility is good for financial stability because it shows the asset has value independent of the value of dollars. It is assets correlated to dollars that pose stability risks, because in financial crises they can all lose value at the same time. But if your career has you entrenched in the faith that dollars represent immutable value, volatile assets are like heresies to a religious fundamentalist (in 156 pages, the FSOC report fails to mention the possibility of any problem originating from the U.S. government — default, war, shut-down, wealth tax, perverse regulation, overspending, adverse Federal Reserve actions — yet many investors fear these more than problems with cryptocurrencies). In many plausible disaster scenarios, Bitcoin and other cryptocurrencies could be important mitigants, retaining value and facilitating transactions when traditional assets and payment mechanisms are failing.
The many mistakes in crypto — hacks and frauds and infighting and failures — have not slowed the overall growth. Rather they have helped the system evolve into something more reliable and stable. It is precisely this experimentation and diversity of approach that makes things safer. Even if all crypto goes to zero tomorrow, we will have learned much from the enterprise.
FSOC tunnel vision extends to stablecoins. The report claims without support that stablecoins were developed to avoid the volatility of other crypto assets. But the way to avoid exposure to crypto is not to buy any. All stablecoin users I know maintain extensive crypto investments.
The real reason people use stablecoins is regulations make it difficult to convert crypto assets to traditional assets. Stablecoins are a creature of regulation in the same sense that money market funds were created in the 1970s to get around government limits on interest banks could pay retail depositors while the economy was running at double-digit inflation. But regulators always see the potential problems of new ideas that mitigate the harms of their mistakes. Regulators discouraged and fought money market funds for 10 years before reversing course—after high inflation had been broken and banks were paying interest on checking accounts so the need had lessened—and taking them over so they posed similar risks to the banking system rather than being an independent alternative.
The FSOC worry about stablecoins is the same for any asset that promises a specific value, including bank accounts and money market funds. If doubt arises about the value of the asset, holders might redeem, which can put pressure on the value of the asset, and lead to a “bank run.” This can have downstream consequences as holders of the stable asset miss payments and managers of the stable asset dump collateral at firesale prices.
It’s true that stablecoins — whether collateralized or algorithmic — are less secure than U.S.-regulated bank accounts and money market funds. But from a stability perspective, that’s not the point. The bank-run risk for stablecoins is largely independent of the regulated economy, so it is a diversifying risk. Moreover, the risks of stablecoins are widely appreciated. It’s not risky assets that threaten stability, but risky assets thought to be safe. If FSOC were to ban stablecoins, we would lose an independent source of stable value. If FSOC were to regulate them for security, my guess is they would acquire more systemic risk not less. They would become more correlated to the existing financial system and the perceived reduction in risk would be much greater than the actual reduction in risk.
There is a fundamental choice here for regulators. They could embrace crypto and make it safer, or they could wall it off from the traditional financial system. The current mixed approach means we have a chaotic border region that includes stablecoins, Bitcoin ETFs and futures and decentralized finance. FSOC is worried about this border region because it’s messy and unpredictable. But systemic financial crises come from stable regions, not from the Wild West. The way to clean up the border is to have a clear, consistent approach to all of crypto — either it’s part of the financial system or it’s an alternative economy outside the regulatory purview.
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Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.
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