Topic question In pursuit of a global currency is stablecoin the answer

Topic question: In pursuit of a global currency: is stablecoin the answer? Course Financial Markets BAFI3182 Assignment Assignment – Research paper Student’s name Phan Thai Binh Student ID s3804785 Lecturer Mr James Murphy Class time Friday 11.30am Table of contents Abstract Introduction .3 Literature Review .4 3.1 What are stablecoins? 3.1.1 Definition 3.1.2 Types of stablecoins 3.2 Contemporary problems in the global payment system 3.2.1 Shortcomings of fiat money .7 3.2.2 Shortcomings of the cross-border payment system 3.2.3 Shortcomings of the first-generation cryptocurrencies 3.3 How stablecoins can address these problems 3.3.1 Acting as a true currency 3.3.2 Promoting financial inclusion and currencies resilience 3.3.3 Allowing regulations and governance 10 3.4 Economic issues raised by stablecoins 10 3.4.1 Illicit financial acts and cyber risks 11 3.4.2 Risk of a bank run 11 3.4.3 Spillover effects and monetary sovereignty undermining 11 3.4.4 Changes in bank business model 12 3.5 Central banks and officials’ views towards stablecoins 12 Conclusion 13 Limitations .13 References .14 Abstract This paper aims to examine the potential of stablecoins as a global payment instrument and their possible impacts on the financial markets As a literature review, my research concentrates mainly on evaluating the findings of different authors in the field of stablecoins and analyzing how these findings correlate with each other Ultimately, this paper seeks to apply some financial markets theories to the way stablecoins operate and financial actors behave This study encompasses the discussions of existing issues in the financial sector, the advantages of stablecoins and economic problems ensuing them It also includes the analysis of four main types of stablecoins and authorities’ opinions on these digital assets Finally, no data is included since this paper is conceptual Introduction With the advent of blockchain technology, the financial market is witnessing the emergence of assets that operate on the digital platform – cryptocurrencies Among the apparent benefits, there still exist an array of pitfalls hidden beneath these assets’ shells that can wreak havoc on global financial stability A notable example would be the price crash of Bitcoin in 2018 which caused a lot of investors to incur serious losses In light of this extreme volatility of cryptoassets, stablecoins appear to be the solution with their ability to stabilize their value over time Various studies have found that a global stablecoin not only can complement the first breed of cryptocurrencies but also improve the global payment system and currencies ecosystem However, does the concept of a stable global currency sound too perfect that it can only exist in a utopia? Bearing that wonder in mind, I have decided to choose stablecoins as the topic of my literature review, which begs the question: In pursuit of a global currency, is stablecoin the answer? In Part 3.1, I will examine the concept as well as the pros and cons of four distinct breeds of stablecoins Next, I will shed light on some contemporary shortcomings inherent in the global payment system that stablecoins aim to address, specifically the weaknesses of the fiat currencies, cross-border payment system and the first-generation of cryptocurrencies (Part 3.2) After that, in Part 3.3, I will elaborate on the strong features of stablecoins that can help uproot the aforementioned problems This part will boil down to stablecoins’ capability of being a true currency, advancing financial inclusion and currencies flexibility as well as how they can incorporate regulations into their system Then, the main focus of Part 3.4 is on the notable economic risks that stem from stablecoins These include illegal financial activities, cyberattacks, the classic bank run, concerns regarding the spillover effects along with monetary sovereignty disruption, and the situation where stablecoins subdue the role of the banking sector Subsequently, Part 3.5 will present the opinions of global financial authorities on this type of digital asset Finally, I will recapitulate the main points of this paper and illustrate some limitations existing in this study Literature Review 3.1 What are stablecoins? 3.1.1 Definition To be able to fully analyze stablecoins, it is of great essence to first comprehend their concepts According to Dell’Erba (2019), stablecoins are cryptocurrencies whose value remains stable against a target benchmark, or as Chohan (2019) puts it, a new generation of cryptocurrencies Brainard (2019) extended the definition and added stablecoins’ working principles to limit volatility – by pegging these coins to an asset or a group of assets and by algorithmic mechanisms 3.1.2 Types of stablecoins With the differences in the operational principles and level of decentralization, stablecoins are generally divided into four types: fiat-collateralized stablecoins, off-chain collateralized stablecoins, on-chain collateralized stablecoins, and non-collateralized or algorithmic stablecoins 3.1.2.1 Fiat-collateralized stablecoins As the name has stated, fiat-collateralized stablecoins are cryptocurrencies that use fiat money as collateral The most famous coin of this type is Tether which is tied with the ratio 1:1 to USD Using real fiat money like USD to back, this type of stablecoins requires a central entity to secure the collateral funds and ensure that these funds are redeemable (Bullmann, Klemm & Pinna 2019) In their paper, Demirag, Seyedehmahsa, and Clark (2019) found that fiat-backed stablecoins hold the same price and volatility in their value as the collateral fiat currencies In another study on stablecoins, Kuznetsov (2019) asserted that while fiat-backed stablecoins hold some advantages for its simplicity and stability, they also have a downside as this type of stablecoins needs a certain amount of trust towards the central body to be able to operate This is consistent with the findings of Berentsen and Schär (2019) These authors elaborated more on the disadvantages of fiat-backed stablecoins by adding concerns about the profitability of the issuer To achieve high stability, assets in the reserves need to be liquid, and since liquid assets usually get low returns, the stablecoins issuer would gain poor profits (Berentsen & Schär 2019) 3.1.2.2 Off-chain collateralized stablecoins Off-chain collateralized stablecoins are cryptocurrencies whose value is pegged to physical assets like commodities or real estates For example, Digix Gold Token (DGX) is a stablecoin using gold as collateral Similar to fiat-collateralized stablecoins, this breed of stablecoins involves a custodian who ensures that the collateral reserves are kept safely at a specific place (Bullmann, Klemm & Pinna 2019) These authors also found that due to mild volatility in the price of these assets, many off-chain backed stablecoins are obliged to be over-collateralized and there happens a process called compulsory redemption when the value of the collateral falls below the over-collateralization minimum level required To be specific, a user’s collateral would be liquidated if he does not top up the amount of collateral to the minimum level when receiving the margin call (Bullmann, Klemm & Pinna 2019) In his study, Kuznetsov (2019) pointed out that this type of stablecoins is beneficial for their stability and real assets backbone but also bears some disadvantages stemming from audit costs, transparency, and trust issue for the central body 3.1.2.3 On-chain collateralized stablecoins On-chain collateralized stablecoins are cryptocurrencies that are backed up by other cryptocurrencies A popular example would be MakerDAO, whose value is backed by Ether Because the collateral is also digital assets, the whole system of these stablecoins runs completely on a blockchain and thus are absolutely decentralized (Bullmann, Klemm & Pinna 2019) Demirag, Seyedehmahsa, and Clark (2019) supported this point by asserting that the exchange rates of the backing cryptocurrencies are constantly updated by a smart contract called an oracle, not a real custodian The collateralization ratio required by these stablecoins stands as high as 150% (Bullmann, Klemm & Pinna 2019), which stems from the fact that many cryptocurrencies are highly correlated with significant volatility (Yi, Xu, and Wang 2018) Due to the unstable nature of the collateral assets, Kuznetsov (2019) believed that on-chain backed stablecoins would not be a useful tool for payments 3.1.2.4 Non-collateralized stablecoins (Algorithmic stablecoins) Non-collateralized stablecoins are cryptocurrencies that use stabilizing algorithms to limit volatility and not need any assets to back up The most well-known and potential stablecoins of this kind are Basis and NuBits In his research, Dell’Erba (2019) demonstrated the working principles of non-backed stablecoins: when the cryptocurrency price falls below a certain level, the smart contract will issue and sell bonds to users, in exchange for the coins which will be burned and destroyed so as to reduce the coins supply and vice versa Therefore, in a sense of managing the money supply, the smart contract appears to play a role of a real central bank as it controls the volume of money in circulation (D’Monte 2019) This discovery falls in line with the study of Lee (2018) who pointed out the similarities between the smart contract and a central bank In his paper, Kuznetsov (2019) argued that although algorithmic stablecoins are extremely stable and not affected by counterparty risks, this class of stablecoins is difficult to be launched due to complex technology 3.2 Contemporary problems in the global payment system 3.2.1 Shortcomings of fiat money The ecosystem of fiat currencies, while seems to run on a smooth course with discrete monetary sovereignty of each government, has been proved to contain some drawbacks Firstly, according to the findings of Kuznetsov (2019), the price of fiat currencies is not backed up by any real assets with intrinsic value but rather depends on the economy in the issuer country, hence tends to fluctuate on a daily basis due to news and public opinions This is certainly true in the forex market Theoretically, movements in exchange rates of currencies hinge on supply and demand of the currencies, which in turn depend on the speculation and confidence of investors in the emitting countries Secondly, Rey (2015) found that due to the global spread of the US dollars, any economic swings of the US economy would lead to a spillover effect and exert a multiplier impact on the rest of the world This notion is consistent with the study of Carney (2019), in which this author emphasized the unhealthy dependence of the global economy on the USD and stated that the depreciation of USD could result in tighter credit conditions, especially in emerging economies 3.2.2 Shortcomings of the cross-border payment system Payments carried out between countries play an important role in both international trade and domestic context As stated in the paper conducted by G7 Working Group on Stablecoins, three factors are to be blamed for a slow and costly cross-border payment Firstly, since a huge proportion of the world population lack access to financial services, the current payment system is not efficient in facilitating worldwide transactions (Cœuré et al 2019) Secondly, these authors stated that the AML/CFT (Anti Money Laundering and Counter Financing of Terrorism) program requires safety measures at multiple steps in the transaction, thus significantly driving up the cost of international payments Lastly, incertitude about contractual obligations emanating from different legal frameworks across jurisdictions have added a lot of frictions to the efficiency and slow down the contemporary cross-border payment system (Cœuré et al 2019) 3.2.3 Shortcomings of the first-generation cryptocurrencies The first wave of cryptocurrencies emerged in 2009 when Bitcoin was issued by Satoshi Nakamoto, followed by an array of cryptoassets like Litecoin or Ethereum In spite of many advantages offered by the blockchain technology, this first-generation of cryptocurrencies still hold some noticeable drawbacks that limit their potential to become a method of global payment The first disadvantage of these cryptocurrencies lies in their high volatility According to Berentsen and Schär (2019), as these coins’ value depends completely on market expectations about its future movements, their price usually fluctuates startlingly and becomes a target for market manipulation Because of such instability, Klages-Mundt and Minca (2019) and Abraham (2019) in their paper asserted that this first breed of digital assets is often used by speculators to take advantage of the volatile market rather than a means of payments Secondly, these cryptocurrencies have raised serious concerns regarding governance and regulations (Cœuré et al 2019) In his study, Conesa (2019) corroborated this statement by arguing that since the system does not have a central entity, a possible attack vector is stealing the private key of the owner to fake the transactions without being inspected by any authority Ultimately, Brainard (2019) considered this lack of transparency and a governing body to be a major reason for high barriers to the adoption of this first-generation cryptoassets as an instrument for payment 3.3 How stablecoins can address these problems In light of the aforementioned issues, stablecoins have been shown to hold a profusion of advantages that can help alleviate these problems and increase their potential to become a global means of payment 3.3.1 Acting as a true currency First of all, Dell’Erba (2019) asserted that stablecoins have the ability to perform the essential functions of a currency: a store of value, a medium of exchange and a unit of account This author elaborated on this point and stated that the price stability of stablecoins can subdue the amount speculations, hence fitting their utility as a means of exchange and store of value In their paper, Clark, Demirag, and Moosavi (2019) consolidated this idea with their finding that stablecoins are more evolved than the first breed of cryptocurrencies in a sense that they are able to play a role of a true currency, whereas the likes of Bitcoin can hardly stand a chance with their extreme volatility 3.3.2 Promoting financial inclusion and currencies resilience Secondly, stablecoins are believed to have the prospect of advancing financial inclusion This new wave of cryptoassets will likely grant access to financial services for the portion of the population that currently lacks connection to the payment system when being launched on a global scale (Natarajan et al 2017, cited in Kuznetsov 2019) In their paper, Bullmann, Klemm, and Pinna (2019) also asserted that due to the simplicity and stability, stablecoins can be used for retail payments in developing countries where confidence in the domestic payment system is low Furthermore, stablecoins hold a large potential to become a solution for people living in a country with high inflation because they can secure and elevate consumers’ purchasing power (Bilal, cited in Kuznetsov 2019) Additionally, stablecoins can increase the flexibility of the currency ecosystem Abraham (2019) found that fiat-backed stablecoins can provide a gateway to popular currencies such as USD or EUR for developing regions, thus facilitating international trade and commerce In his study, Dell’Erba (2019) complemented this point and stated that at the same time, stablecoins can also reduce global dependence on the US dollar since they can serve as the perfect replacement of the USD for their limited volatility 3.3.3 Allowing regulations and governance Another innovation that stablecoins can bring about is their openness to governance and regulations Lee (2019) showed that there is a growing desire of crypto companies to incorporate regulations into their operations as an attempt to adopt safety protocols like KYC (Know Your Customer) or AML (Anti Money Laundering) Owing to the stability, financial institutions and banks would be more likely to authorize and integrate stablecoins into their traditional system, hence raise the opportunity to exercise regulations on this type of cryptocurrency (Bowater 2019) A different approach of stablecoins to allow governance is to fuse the responsibility of private sectors and banks into their operations In their paper, Adrian and Mancini-Griffoli (2019) comprehensively explained one hybrid solution is to peg fiat-backed stablecoins to the currencies in central bank reserves, and the epitome of this mechanism is when The People’s Bank of China demanded AliPay and WeChat Pay to back their coins with banks assets Since the reserve is safely secured by the central bank, this approach can promote transparency and ease of transactions (Adrian & Mancini-Griffoli 2019) Proponents of this method are Copeland (2019) and former IMF chairman Christine Lagarde (Dell’Erba 2019), who believed that statebacked stablecoins have a large potential to become an authentic digital currency, especially on a domestic level where they can gain trust from customers with the involvement of the central bank So in short, it is obvious that stablecoins take the best features of traditional currencies and cryptocurrencies, specifically the stability and trustworthiness from fiat money and the ease of circulation from cryptoassets 3.4 Economic issues raised by stablecoins Although stablecoins hold a great prospect to address the existing issues in the financial market, many researchers have raised a red flag and found that this type of cryptocurrency can give rise to various economic pitfalls if not controlled properly 3.4.1 Illicit financial acts and cyber risks According to Cœuré et al (2019) and Bullmann, Klemm, and Pinna (2019), the decentralized peer-to-peer network on blockchain of stablecoins poses a lot of risks for cyber-attacks and 10 illegal acts This finding falls in line with those of Woensel, Kritikos, and Fanni (2019) who took a specific example of Libra – the stablecoin of Facebook – and pointed out that Libra operates on mobile network, information technology system and data flows, which are all susceptible to cyber-attacks and fake transactions in money laundering Additionally, Cœuré et al (2019) argued that stablecoins can promote tax evasions and illegal goods trading This author explained that because the transactions through blockchains are rendered anonymous and thus hampering the detection of shady activities, stablecoins can potentially create room for the aforementioned illicit schemes 3.4.2 Risk of a bank run Stablecoins have been proved to be extremely prone to a bank run behavior The working group on stablecoins of G7 stated in their study that since a global stablecoin is built on trust of users, any incident that tarnishes this coin’s reputation can strongly discourage people to hold that stablecoin as asset, hence resulting in a bank run and imposing downward pressure on the value of the coin (Cœuré et al 2019) This finding is also consistent with the research of Chohan (2019) and Kuznetsov (2019), who demonstrated a range of factors contributing to bank run activity in stablecoins, including the robust rise of other currencies in the case of NuBits crash in 2016 3.4.3 Spillover effects and monetary sovereignty undermining Regarding the worldwide operating scale of a global stablecoin, The Federal Reserve System (2019) asserted that if an excessive number of participants in the financial market places their assets in stablecoins, it is reasonably foreseeable that a defect in the operations may result in single points of failure and amplify the damages to the whole system This idea is supported by the study of Brainard (2019) This author argued that the spillover effects can be intensified if banks and traditional financial institutions refrain from adopting stablecoins into their system and providing liquidity when needed to help stabilize the market Furthermore, Cœuré et al (2019) found that stablecoins might debilitate the power to implement monetary policies of a government and disrupt the domestic financial market if a huge proportion of residents in that country switch from domestic currencies to stablecoins to secure their assets 11 3.4.4 Changes in bank business model Another economic impact that a global stablecoin can bring about is that its existence can alter the role of banks in the financial market According to Brainard (2019), stablecoins with their stability and flexibility might induce customers and investors to shift their deposits from bank reserves to digital wallets This author also added that this transition will squeeze banks’ funding and hence dampening their ability to make loans to make money In another study, Cœuré et al (2019) strengthened this argument by stating that with this shortage of funds, banks would have to raise money from more costly and riskier sources or, in extreme cases, be forced to shut down business, which leads to the situation of disintermediation From my perspective, this is not necessarily a bad thing but steps need to be taken to prepare the financial sector for such change and prevent any abrupt disruption in the market 3.5 Central banks and officials’ views towards stablecoins Taken into consideration the advantages as well as economic risks that stablecoins can create, financial authorities around the world have expressed their cautiousness, and at the same time, their willingness to embrace such a leap of development The G7 Working Group on Stablecoins, which represents the voice of seven leading countries, has stated that although being expected to address the challenges in the financial sector, stablecoins still pose a lot of serious economic, legal and regulatory risks that need to be identified (Cœuré et al 2019) The central bank of the US conveyed the same perspective The Fed believed that while stablecoins are capable of improving global financial services, it is of great essence for this nascent type of cryptocurrency to satisfy all legal and economic standards before going into circulation (Federal Reserve System 2019) Ultimately, the G7 asserted that no stablecoin should be launched until all the risks are carefully and sufficiently addressed (Cœuré et al 2019) 12 Conclusion In conclusion, stablecoins hold a large potential to address the long-standing issues in the financial markets but strict oversight of such projects is of great essence With various mechanisms to stabilize their prices, stablecoins can serve as a true currency and reduce global dependence on the US dollar They can also provide financial access to the population that lacks connection to the payment system and open the door to regulations, which renders them more beneficial than both fiat money and the first wave of cryptocurrencies However, stablecoins raise many economic risks that need to be addressed Operating on the blockchain technology which allows anonymity, stablecoins can easily become the target for cyber-attacks and illicit financial acts such as money laundering or trading of prohibited goods They can also debilitate the role of banks by cutting their sources of fundings, hence promoting disintermediation In regards to stablecoins, leading financial authorities are remaining alert but open to any innovation that can help improve the financial sector Particularly, the G7 emphasized the importance of careful preparations prior to the launch of any stablecoin Limitations There is a limitation that restrains the scope of my paper Since stablecoin is a nascent topic that has just drawn mass attentions only after the announcement of Libra by Facebook, there have not been many authorities looking into it This paper thus only includes the voice of the leading countries in the Group of Seven Consequently, there is a lack of opinions of financial regulators in developing countries, where stablecoins are envisioned to exert the most influence on This limitation may therefore diminish the worldwide perspective on stablecoins of this literature review References Abraham, R 2019, ‘Stablecoin: The new kid on the block(chain)’, The Economic Times, 17 May, viewed 20 December 2019, 13 Adrian, T & Mancini-Griffoli, T 2019, ‘From Stablecoins to Central Bank Digital Currencies’, IMF Blog, 26 September, viewed 20 December 2019, Berentsen, A & Schär, F 2019, ‘Stablecoins: The quest for a low-volatility cryptocurrency’, in Fatas A, The Economics of Fintech and Digital Currencies, CEPR Press, London, pp 65-71 Bowater, J 2019, ‘Stablecoins - An Elegant Solution For Crypto Chaos’, City AM, February, viewed 21 December 2019, Brainard, L 2019, ‘Digital Currencies, Stablecoins, and the Evolving Payments Landscape’, Speech at The Future of Money in the Digital Age, Peterson Institute for International Economics and Princeton University’s Bendheim Center for Finance, Washington, D.C Bullmann, D, Klemm, J & Pinna, A 2019, ‘In search for stability in crypto-assets: are stablecoins the solution?’, European Union: Occasional Paper Series, no 230 Carney, M 2019, ‘The Growing Challenges for Monetary Policy in the current International Monetary and Financial System’, Speech at Jackson Hole Economic Policy Symposium 2019, Federal Reserve Bank of Kansas City Chohan, U 2019, ‘Are Stable Coins Stable?’, Discussion Paper Series: Notes on the 21 st Century Clark, J, Demirag, D & Moosavi, S 2019, ‘SoK: Demystifying Stablecoins’, SSRN, Conesa, C 2019, ‘Bitcoin: A Solution for Payment Systems or a Solution in Search of a Problem?’, Banco de Espana Ocassional Paper, no 1901 14 Copeland, R 2019, ‘A Global Stablecoin: Revolutionary Reserve Asset or Reinventing the Wheel?’, SSRN, D’Monte, L 2019, ‘Stablecoins gain traction amid volatility in bitcoins’, Live Mint, June, viewed 22 December 2019, Dell’Erba, M 2019, ‘Stablecoins In Cryptoeconomics From Initial Coin Offerings (Icos) To Central Bank Digital Currencies (CBDCs)’, New York University Journal of Legislation and Public Policy, forthcoming G7 Working Group on Stablecoins 2019, Investigating the impact of global stablecoins, G7 Working Group on Stablecoins Klages-Mundt, A & Minca, A 2019, ‘(In)Stability for the Blockchain: Deleveraging Spirals and Stablecoin Attacks’, IDEAS Working Paper Series from RePEc Kuznetsov, Y 2019, ‘Adaptation of stablecoins as the reserve currency’, Review of Business and Economics Studies, vol 7, no 1, pp 57-61 Lee, P 2018, ‘Are stablecoins the reinvention of money?’, Euro Money, November, viewed 21 December 2019, Rey, H 2015, ‘Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence’, NBER Working Paper, no 21162 The Federal Reserve System 2019, Financial Stability Report on November 2019, The Federal Reserve System, Washington, D.C 15 Woensel, L, Kritikos, M & Fanni, R 2019, ‘What if Libra disrupted the financial system?’, European Parliamentary Research Service Paper 16 ... model Another economic impact that a global stablecoin can bring about is that its existence can alter the role of banks in the financial market According to Brainard (2019), stablecoins with their... field of stablecoins and analyzing how these findings correlate with each other Ultimately, this paper seeks to apply some financial markets theories to the way stablecoins operate and financial actors... careful preparations prior to the launch of any stablecoin Limitations There is a limitation that restrains the scope of my paper Since stablecoin is a nascent topic that has just drawn mass attentions