Stablecoins as a euphemism for full-reserve banking

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Everyone has a personal theory of money.

And by and large everyone’s theory differs to everyone else’s. Because money is in part philosophical as well as technical, and hence hugely subjective.

Major arguments often result from one person’s view of money being different to somebody else’s. But to be fair, it’s probably right that there are many ways of thinking of money.

One very fashionable theory of money is that if money became a better medium of exchange — by way of the payments system becoming more frictionless and more instant — while improving its stability by being fully-reserved and less risky by being controlled entirely by the central bank, everything in the economy would be better and improved.

Today, this theory of money is often accompanied by the idea that the central bank should become the predominant issuer of digital stablecoins backed purely by central bank reserves or government debt. 

To wit, here’s Thomas Mayer, former chief economist at Deutsche Bank, writing in the FT on Monday: 

Banking union was supposed to complete EMU, but its most critical component, a common deposit insurance, is still missing due to political resistance to risk sharing. While the German finance minister Olaf Scholz recently proposed a potential compromise, critics argue that the euro is doomed.

I believe there is a solution: the creation of a truly digital euro. The first step towards such a digital euro would be to introduce a bank deposit fully backed with central bank money. The ECB could effectively create funds needed to cover the deposit by purchasing outstanding eurozone government bonds.

As for the argument that this sort of thing would crowd out the private sector, Mr Mayer says that won’t happen because “in a world of digital euros, commercial banks’ main role would be to take deposits and lend them to investors.”

When Alphaville penned this piece back in 2012 arguing for the introduction of an M-euro (because in 2012 the trendy thing was putting an M in front digital money initiatives rather than calling them stablecoins outright), we also thought and argued similar things to what Mr Mayer is arguing above.

But another useful and not entirely orthodox way of thinking of money is as a claim on continuously variable liquidity in the system. Or, more simply, as a rationing system designed to keep supply and demand in check and investment headed to where it’s needed.

And thinking of it that way made us realise that the argument in favour of stablecoins is really just an argument in favour of full-reserve banking. That is, when banks are required to hold cash against all deposits. 

To understand the vulnerabilities with that, one helpful definition comes by way of the IMF when it describes what a special drawing right (SDR) is.

As they note, an SDR is neither a currency nor a claim. It is “a potential claim on the freely usable currencies of IMF members”.

This, we think, is a good way of thinking about money in general. Not as a store of value, a medium of exchange or a unit of account, but rather as a potential claim on stuff that’s freely usable and available in the economy. 

The logic is as follows.

At any given time, the economy is producing stuff that we, the participants in the economy, all need or desire and consume eagerly. That includes material stuff such as food, clothes, shelter, cars. It also includes services from people such as waitstaff, journalists, babysitters, teachers, lawyers, etc.

If demand for any of the above outpaces supply, it’s generally very hard to increase the availability of such products at short notice — especially if the economy is running tight. At least not without some sort of price impact. Similarly, if demand undershoots supply, it’s very hard to ensure the stuff that’s already been produced (whether that’s perishable or longer-lasting goods, or professional skills) can be placed in the economy at the current price equilibrium to avoid being entirely wasted.

This is where finance and price mechanics come in. 

If demand and supply are balanced because the amount of stuff that’s being actively produced in the economy matches the amount of money — or “potential claims on stuff” — in the system (as well as their rate of redemption, a.k.a velocity as a function of the smoothness of the payment system), then prices tend to stay nice and constant. 

A price movement one way or the other, however, indicates a temporary mismatch in demand and supply. In such circumstances, to get the stuff a person or corporation wants or needs, they must give up “potential claims” upon something else to acquire the thing that is highly sought after. This helps to regulate and ration demand. (Unavailable things must in other words come at a greater sacrifice of other things to keep things in balance.) Demand as a result is transferred from one area to another area. To the contrary, if there is more supply than demand, prices must fall to incentivise those consumers who might otherwise not be able to afford to buy. 

Simple as.

(Okay, thanks for the economics 101 Alphaville. But what’s the point?!)

Well, the trade in goods and services we desire now must be differentiated from spending on investments or financial products. These highly specialised services come about specifically to help balance the economy vis-à-vis its capacity to produce stuff at any given time.

Hence, unlike conventional goods and services, financial goods and services are designed to incentivise people NOT to spend on things available in the economy today. Rather, their entire raison d’être relates to transferring potential claims from people who have them but probably don’t need them to people who don’t have them but could benefit from them (and who are prepared to pay up for the use of them to boot!)

Such people tend to be those creating more of the stuff that’s already oversubscribed in the economy or creating new stuff that might shortly be massively desired. It’s a process called maturity transformation, and it’s essential for maintaining investment in the sort of stuff we all want and benefit from. 

Arguably, it is by the power of maturity transformation that the wealthy often end up asset-rich but cash poor. It makes zero sense, after all, for the rich to store excessive amounts of “potential claims” in highly liquid cash form, when turning them into less liquid assets can return more value in the long run.

To wit, at a certain wealth threshold, the system makes it very hard for anyone to store all their wealth just in liquid “potential claim” cash form. Often there are all sorts of opportunity costs, risks and penalties that come into play to disincentivise such practices. And rightly so, because the more value that is stored in “potential claim” form in concentrated hands, the more risk the financial system has to absorb. The economy, in the end, has to back those claims up with available real-world goods and services, risking wasted resources if and when demand shifts or money velocity slows. This creates a cost of its own especially when regulatory conditions are designed specifically to prevent financial services from taking risk. 

And yet, if a billionaire isn’t prepared to reinvest his liquidity according to his own whim, someone else still will. And that someone usually is the bank with whom the billionaire’s liquid “potential claim” cash sits.

But there’s a problem. Post-crisis regulation dictates banks must lock up much of that spare liquidity in government debt or central bank cash reserves. This ensures a billionaire’s non-spending has de facto turned into government spending or, more worryingly for the economy, central bank spending.

Even before you enter into stablecoin territory, you already encounter two problems.

First, while government spending results in democratically approved public sector investment, which is a good and useful thing, it doesn’t necessarily always cater to everyone’s individual wants and desires. It can also lead to a tyranny of the majority and become economically (and eventually politically) unsustainable. In the worst-case scenario, it can crowd out more profitable and thus taxable private investment, especially when economic conditions are tight.

Central bank investing, meanwhile — even if it can be profit-generating in the long run — is either countercyclical in nature or focused excessively on government debt. The countercyclical stuff amounts to the cornering of markets which normal folk no longer feel inclined to support with organic demand. While the government debt factor amounts in unscrupulous cases to the cornering of the government debt market. 

The problem with strategic countercyclical investing

While it is justifiable to centrally prop up or corner markets to prevent needless value destruction during liquidity panics, there is a valid argument that sustained support can distort free markets and lead to dangerous outcomes — including major public resentment as things nobody wants keep getting produced in favour of stuff people actually want.

The Soviet Union’s state-banking system and its role in the economy’s collapse is a case in point. As that episode showed, too much countercyclical “propping-up” can make a mockery of price signals leading to major destabilisation. 

And that is why, in a climate where the central bank and state system is already bloated by “potential claim” cash float due to the additional daily liquidity needed to manage intraday payment settlements in a risk-free real-time gross settlements framework, regulatory requirements for risk-free cash liquidity and a general preference for risk-free cash reserves among savers, launching a digital stablecoin on a full-reserve basis is likely to crowd out the private sector, obscure free-market price signals and constrain credit creation.

Not only that, it is also likely to lead to more financial instability — the problem that stablecoins/full-reserve banking are supposed to solve. 

Love them or hate them, banks — especially when unconstrained by the need to keep investments liquid — offer a highly efficient economic service that the government or the central bank cannot emulate. That service is entirely connected to their ability to lend first and fund later, notably by finding appropriate liabilities to match against assets on a so-called “matched book” basis. This allows them to sidestep the economically costly requirement of having to acquire large sums of liquid cash float on an intraday basis to bridge any exchange. 

In a world where fully-reserved digital stablecoins reign supreme, however, banks would have to pre-fund (by liquidating assets first), increasing the relative amount of liquid cash float the whole system needs to operate. The cash float being what it is (mostly government-debt backed), that amounts to even greater sums of guaranteed funding for the government instead of the private sector. That inevitably crowds out private investment simply because of who controls go-to “potential claims” on the economy.

Chances are the private sector would then respond creatively and arguably even more riskily. 

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