Banks are quintessential to financial intermediation, engaging in two primary transformations:
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Maturity Transformation: Banks convert short-term deposits into longer-term loans. For example, a bank might use funds from savings accounts, which can be withdrawn at any time, to finance 30-year mortgages. This process is crucial for economic growth but introduces inherent liquidity risks.
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Fungibility Transformation: Banks transform highly liquid, fungible assets (like cash deposits) into less liquid, non-fungible assets such as loans or bonds. This function allows for the efficient allocation of capital throughout the economy.
With the advent of post-1950s financial evolution, the predominance of traditional banking has been paralleled by the emergence of shadow banking a sector characterised by similar financial activities undertaken by non-bank financial institutions subject to lesser regulations, which now comprise a significant portion of the market (up to 60%). Whilst in the past banks were more stringent with their cash reserves, these days they rely on forward rate agreements (FRAs) and credit as the main backstop to a liquidity crunch.
FRA explanation
FRAs are contractual agreements between parties to lock in interest rates for a future period on a specified principal amount. By fixing the interest rate today for a loan or deposit that will begin at a future date, banks hedge against the volatility of interest rate fluctuations, thus securing their financial positions. For instance, if a bank anticipates a rise in interest rates over the next six months, it might enter into an FRA with another financial institution to borrow money six months later at the current lower rate. This strategic use of FRAs helps banks manage the cost of funding and liquidity over time.
Additionally, inter-bank lending plays a critical role in daily bank operations by allowing banks to borrow from and lend to each other on an overnight basis. This mechanism ensures that banks can meet their liquidity requirements without compromising their operational stability. For example, a bank facing a sudden shortfall in liquid assets might borrow overnight from another bank, thus maintaining its required reserve ratios without needing to liquidate longer-term assets at a loss.
Stablecoins are a class of cryptocurrencies designed to minimise price volatility relative to a stable asset or a basket of assets. These digital currencies achieve stability through various mechanisms and are classified into three main types based on their backing assets.
They are primarily categorised into:
- Fiat-backed stablecoins: Pegged to traditional highly-liquid assets (e.g., t-bills, investment grade commercial papers), examples being USDC and Tether
- Crypto-backed stablecoins: Overcollateralised by holding other cryptocurrencies’ reserves to maintain stable value, like DAI
- Algorithmic stablecoins: Adjust their supply based on market demand to maintain a peg to a stable asset, similar to a central bank's monetary policy, for instance FRAX and Ampleforth.
Stablecoins, by design, embody several core functions of traditional banking, making them akin to digital banks in the cryptocurrency world. Primarily, stablecoins facilitate the transformation of volatile crypto assets into more stable forms of value, much like banks convert volatile savings into stable, standardised monetary instruments. Moreover, like banks, stablecoins engage in a form of maturity transformation although in a digital and decentralised context. They offer immediate liquidity to holders who can redeem stablecoins against underlying assets at any time, despite these assets often being held in longer-term reserves. This mirrors traditional banking practices where banks manage liquidity to meet the withdrawal demands of depositors. Lastly, stablecoins, especially those that are algorithmic, manage their supply in response to changes in demand—akin to a central bank’s role in managing money supply to stabilise currency value. For example, algorithmic stablecoins adjust their circulating supply based on proprietary algorithms aimed at maintaining a peg, which is somewhat similar to how central banks use monetary policy tools to stabilise national currencies.
Despite their similarities to traditional banks, stablecoins diverge significantly in their approach to risk management and liquidity provision. Traditional banks utilise various financial instruments such as forward contracts to hedge against interest rate risks and currency fluctuations. However, as highlighted by incidents such as the Silicon Valley Bank failure, stablecoins like USDC can depeg from their reference asset (e.g., USD) during financial distress, partly because they do not employ these conventional hedging tools.
When USDC briefly depegged, it underscored the vulnerability of stablecoins to sudden shifts in the underlying asset's stability, without the protective mechanisms typically available to traditional banks. Moreover, on-chain decentralised finance (DeFi) protocols, often proposed as mechanisms to absorb deviations in stablecoin values, present their own challenges. The liquidity in many DeFi platforms is not only lower compared to traditional financial markets but also tends to be highly speculative and driven by risk-seeking behaviors. This environment makes DeFi platforms less reliable as stabilisers for stablecoins. The speculative nature of these markets often exacerbates volatility rather than mitigating it, thereby limiting their efficacy as a corrective mechanism for stablecoin peg deviations. Consequently, the current DeFi solutions are yet to mature into viable alternatives for managing the systemic risks associated with stablecoin operations.
Liquidity, a cornerstone of financial stability, manifests differently across the traditional banking sector and the burgeoning realm of stablecoins. In traditional banking, liquidity is often categorised into three types:
- Monetary liquidity involving off-chain deposits held at correspondent banks
- Funding or Credit liquidity which is critical for maintaining ongoing operations and is facilitated through inter-bank loans or other credit facilities
- Market liquidity related to the ease of trading assets without causing significant price changes.
| Traditional Banking | Stablecoins | |
|---|---|---|
| Monetary Liquidity | 2% mandated reserve | Off-chain deposits at correspondent banks |
| Funding/Credit Liquidity | Inter-bank loans and credit facilities | none |
| Market Liquidity | TradFi secondary markets | Highly-liquid AMM pools |
Stablecoins, conversely, primarily depend on market liquidity, often ensured through deep liquidity pools on decentralised exchanges (DEXs). Unlike banks that rely on funding liquidity to affirm their solvency, stablecoins lack a comparable mechanism in the DeFi ecosystem, as credit and funding structures are minimally developed or entirely absent.
This reliance on market liquidity exposes stablecoins—and by extension, the on-chain financial systems—to heightened risks during financial crises. The inherent volatility of cryptocurrency markets, coupled with speculative trading behaviors, can lead to rapid liquidity evaporation, making these systems more brittle and less elastic compared to their traditional banking counterparts. As a result, during times of market stress, the on-chain financial system may struggle to maintain stability, reflecting its underdeveloped capacity to absorb shocks akin to those managed by traditional financial institutions.
The prolonged implementation of zero interest rate policy (in short ZIRP) by central banks has inadvertently fostered an environment conducive to the proliferation of stablecoins. ZIRP, aimed at stimulating economic growth by making borrowing costs negligible, also flattens the yield curve, resulting in forward and cash dollars trading at par. This unusual market condition diminishes the necessity for a robust forward market to hedge against future interest rate risks. In traditional finance, forward contracts are essential for managing such risks, but the absence of a similar market in the on-chain ecosystem has not impeded the growth of stablecoins under ZIRP.
In an environment where cash and future values of currency converge, stablecoins thrive as they can maintain parity without the need for complex hedging strategies typically employed by financial institutions in higher interest environments. This simplification of financial operations makes stablecoins particularly attractive in a low-interest world, as they bypass the complexities of forward markets and directly address the demand for stable, easily transferable digital assets. Consequently, while traditional banks must navigate the implications of ZIRP on their liquidity management and interest income, stablecoins capitalise on these conditions to enhance their market presence and utility.
If the history of real-world (hierarchical) money systems teaches us anything, it is that during crises everyone wants money, no one wants credit, and promises to pay money are tested. Defense is provided by the level immediately higher in the system (and in the extreme, by the ultimate settlement asset - central bank reserves), for which credit represents what counts as money in the level below. But as noted earlier, there is no such thing for crypto. Attempts to artificially shoehorn stablecoins within the hierarchy of money should contend with this fact: the promise will be tested, and when it is, high-level money will be called upon to act as backstop.
From: On par: A Money View of stablecoins by Iñaki Aldasoro, Perry Mehrling, Daniel H. Neilson