In 2014, the financial technology company Tether introduced the Realcoin, the first cryptocurrency pegged in value to the U.S. dollar. Since then, dozens of other so-called stablecoins have entered the market, promising all the advantages of Bitcoin and Ethereum—low transaction costs, ease of use across national borders, security—without the volatility. Tether (the rebranded name for Realcoin) has become the third-largest cryptocurrency in the world, with a market cap near $70 billion; the total value of outstanding stablecoins is estimated to be about $108 billion.
But as that number grows, so do the risks to the global financial system, write Gary B. Gorton of Yale SOM and Jeffrey Y. Zhang of the Federal Reserve Board of Governors in a new paper advocating for stronger regulation of stablecoins.
The one-for-one nature of stablecoins—in theory, one Tether token should always be worth one U.S. dollar—is the basis of their appeal, but also makes them exceptionally vulnerable to bank runs. If everyone tried to convert their stablecoins into U.S. dollars at the same time, the effect could be catastrophic.
“If stablecoins are large enough, that could result in a systemic crisis,” Gorton says. We’re not there yet, “but it’s better to start thinking about these issues now, rather than wait for the next financial crisis.”
Stablecoins may seem newfangled, but we’ve seen this movie before, Gorton and Zhang argue. Tether, Paxos, USD Coin, and their counterparts hearken back to the “free banking” period in American history—the years from 1837 to 1863 when states, rather than the federal government, chartered banks. The result was a proliferation of privately issued banknotes, ostensibly backed by each bank’s reserves of state bonds.
But this theoretically free system made it tricky to do business in practice. Trust broke down: how could a merchant in New Haven know for sure that a banknote from a bank in Chicago was really worth what it said? “It wasn’t economically efficient,” Gorton says. “The banknotes never became money that was accepted at face value.”
“Every country on Earth has said, ‘We think that the production of money should be done by the sovereign,’ because they’re the only ones who can create money that’s accepted at par without people spending a lot of effort researching it.”
Private money, whether it’s private banknotes during the 19th century or stablecoins today, consistently fails to engender the same degree of confidence as money produced by the government, Gorton says. “That’s why every country on Earth has, at some point or another, said, ‘We think that the production of money should be done by the sovereign,’ because they’re the only ones who can create money that’s accepted at par without people spending a lot of effort researching it.”
Another, more contemporary parallel to stablecoins is the money market fund, a type of mutual fund that offers stability and modest returns, write Gorton and Zhang. Because of their structure—consumers buy shares at $1, and receive an implicit guarantee that they can always redeem that investment on demand—many people treat them, in practice, as being tantamount to checking or savings accounts. But runs on money market funds during the 2008 financial crisis and the early months of the coronavirus pandemic have revealed the limits of this purportedly “safe” investment, as well as the systemic threat money market funds can pose.
Like money market mutual funds, stablecoins encourage buyers to see their money as being as safe as it would be in a federally insured savings account, but they actually come with significant risks. Because stablecoin issuers are not treated as banks, they are not subject to the same reserve requirements; companies say they have sufficient assets to handle a sudden surge in transactions, but we have only their word for it.
To Gorton, the parallels between the free banking era and money market mutual funds point in one direction: stablecoins needed to be regulated—and, possibly, regulated out of existence. For all their fancy packaging, “stablecoin issuers are banks and a stablecoins are like demand deposits. It’s debt and you can go back and redeem it at par on demand. The technological manifestation of this bank money has changed, but they are banks and it’s bank money.”
In the paper, he and Zhang outline possible approaches to regulating stablecoins, which involve requiring issuers to have more solid backing for their tokens. But these have downsides: for instance, requiring stablecoins to be backed by Treasury securities would create a shortage of Treasuries in the economy.
In the end, Gorton says, “our general sense is that you should get rid of them… We should go back to having the government issue money.” That doesn’t mean he’s opposed to digital currency—he just thinks the government should be the one making it.
Creating a well-functioning digital currency will require time, experimentation, and infrastructure development—and the time to start is now. Other countries are already diving in: “Every central bank in a developed country except the Fed is involved in an actual cross-border experiment with one or two other central banks, to figure out how a cross-border central bank digital currency would work,” Gorton says.
There are signs the government is beginning to take the question of stablecoins more seriously. In July, Treasury Secretary Janet Yellen convened the President’s Working Group on Financial Markets to discuss stablecoins, and in September officials at the Treasury Department held meetings with industry participants to discuss their benefits and dangers.
Regulators are “between a rock and a hard place,” Gorton acknowledges. Leaving stablecoins alone has dangers, but intervening too forcefully could come with accusations of squelching innovation and stymying the free market. “I don’t know what they’re going to do, but I think they recognize they have to do something.”