Are asset-backed stablecoins fundamentally incapable of large scale use?
Liquidity issues, financial stability questions and low yields on reserves may keep coins like Libra stuck under a glass ceiling.
In a new report, JPMorgan has taken a dive into blockchain and cryptocurrency use.
In the report, it repeated that old chestnut about Bitcoin energy consumption per transaction.
"Using currently popular technology, migrating a significant fraction of global e-commerce, and especially broader retail payments would put significant strain on energy resources," JPMorgan says.
It looks like JPMorgan fell into the trap of assuming proof-of-work blockchain energy consumption is based on transaction volume, when it's actually a more straight-forward reflection of cryptocurrency prices. Energy consumption will simply grow to whatever ceiling the current price allows. Transaction volume has a negligible impact on Bitcoin energy consumption, except insofar as it may increase prices.
More interestingly, the report dives into fiat-backed stablecoins such as Libra and makes the interesting argument that in a world of negative yields and fractional reserves, most asset-backed stablecoins will naturally hit a glass ceiling of liquidity problems long before they can take a serious slice of global payments.
The potential implications of this problem raise some big questions around what the future of stablecoin adoption and regulation looks like.
The glass ceiling
First, JPMorgan points out that global payments are dominated by B2B transactions in developed markets. Anyone trying to carve a significant slice of the international payments market has to crack the developed economy B2B market, rather than worrying about little things like banking the unbanked or reducing the outrageous remittance and payment costs in developing economies.
Essentially, the report suggests that the only way for a stablecoin to go big is if it goes really, really big because that's a lot of zeros. If a stablecoin wants to be both fully collateralised and widely used, it's going to need enormous reserves. So the next question is how big a stablecoin needs to be if it wants to start handling trillions of dollars of payments.
To answer it, the report looks at existing real-time gross settlement (RTGS) systems for examples of how money moves in these large payment systems. In some ways, RTGS systems are a good baseline because they're quite similar to stablecoins in that both are made in real time and both are gross payments.
Following this line of reasoning, the report then looked at how the Federal Reserve balance sheet impacts the use of overdraft facilities in RTGS systems. In other words, the report looks at how much cash is swimming around these big-time payment networks and how that amount impacts the level of borrowing among participants. If there's enough liquidity, there's less borrowing. If there's not enough liquidity, there's more borrowing.
"Thankfully for our purposes, the Fed conducted precisely this experiment when it expanded its balance sheet as part of QE," the report says.
In it, we see how injecting a bunch more cash into the system reduced the use of overdrafts in RTGS systems to almost zero, which gives us a nice, clear indication of how much available cash is needed to support certain payment volumes in those kinds of systems.
"Based on this experience, we estimate that roughly $600 billion of stablecoin would be required to facilitate $1 trillion of daily transactional activity without frequent disruptions," the report says.
This number should be taken with a grain of salt because by comparing Libra to existing RTGS systems, we're looking at apples and oranges.
Libra aims to be fully collateralised and available for direct peer-to-peer payments without any intermediaries. Stablecoin payments can settle almost instantly without needing to pass through banks, and there is no need to move any of the Libra reserves between separate financial institutions as you do with most traditional payments.
Without seeing how people actually use systems like Libra on a large scale, it's impossible to say how much money you'd actually need to support certain transaction volumes.
The report is comparing apples and oranges, but if you assume that apples are oranges, $600 billion of collateral for $1 trillion of transactions per day might be what they taste like.
But even if the exact numbers are off, the underlying point is still relevant. If a fully-collateralised stablecoin payment network wants to make a meaningful break into developed economy B2B payments, where most of the volume is, it will need an enormous pool of reserves.
Libra was pictured using bank deposits and short-term government securities, from stable and reputable central banks, for its collateral. The idea was that any excess interest earned from the collateral can fund Libra activities, while the money itself will always be enough to fully back all Libra stablecoins in circulation.
Meanwhile, an over-collateralised reserve could let the Libra Association provide intraday liquidity to keep things running smoothly, solving some of these problems as they arise.
However, when you look at how much money Libra theoretically needs in its reserves, and the current state of the bond markets, it's not clear whether the stablecoin could amass sufficient reserves that are simultaneously safe and able to bring enough returns to support network operations.
More than a third of global bonds now trade with a negative yield. This is even more pronounced in short-term bond markets, which are more concentrated in USD and GBP, and of which more than half now offer negative yields, JPMorgan says.
But Libra is designed to earn returns from its reserve. That's where its operating budget comes from. It can't really afford to earn negative returns, and if it passes those costs onto its users in the form of higher transaction fees, it's at risk of accidentally implementing a "tax on spending" that reduces consumer spending at a time when the economy is already fragile.
This means Libra's choice of collateral is a bit more limited, and it's questionable whether the planet has enough securities to collateralise a network like Libra, the report says.
If you take all the short-term highly-liquid government securities issued by the top 10 countries most active in e-commerce and retail payments that are not subject to capital controls — which is presumably what Libra wants for its collateral — and then cut out everything without positive yields, you're left with around $2 trillion of assets.
Of that $2 trillion, more than 70% is US treasury bills and short coupons. And of that $1.4 trillion in treasury bills and short coupons, $750 billion is already held by US money market funds and $300 billion is in foreign official hands.
"This leaves quite a bit less free float in positive yielding, short-term government assets not subject to capital controls than broader market aggregates would suggest," the report says.
As well as leaving Libra somewhat short of the collateral it needs to take over the world, it also means Libra would be deeply exposed to the US dollar and the decisions of the Fed, which kind of defeats the purpose of having that currency basket in the first place.
In that light, it makes a lot of sense that Libra is reportedly considering abandoning its basket, and just becoming a straight-forward USD-backed stablecoin.
But regardless of whether Libra retains its basket or just shifts to USD only, its reserves will have to be dominated by the greenback, and given the way it's designed, this is arguably Libra's Achilles heel.
Any move into negative rates from the Fed would disrupt Libra's operation and risk causing its reserves to shrink faster than the number of Libra in circulation, which throws out that whole "fully collateralised" thing.
Furthermore, it would theoretically ruin the value of Libra Investment Tokens. These are the tokens held by Libra's governors, which entitle them to earn dividends from any surplus interest earned by the reserve. But if the reserve is actually losing money in a negative-yield world, those tokens start looking more like a liability than an asset.
"It would be natural to question the value of remaining a member of the Association under those circumstances," JPMorgan says.
If those members leave, Libra risks falling apart and leaving token holders out of pocket.
One way or another, it's possible that there simply isn't enough money in existence for safe, fully-collateralised stablecoins to rule the world, and that Libra's reserve won't work as currently designed.
But despite these potential issues with Libra, the report paints an overall rosy picture for the future of stablecoins.
The rise of Libra saw a lot of central banks get, somewhat understandably, very defensive about the right to print money.
But as the report points out, fractional reserve banking is basically the same thing as private companies printing money. Commercial bank deposits are the liability of private commercial entities, but they're also almost universally accepted as money.
In fact, more than three-quarters of the world's "money" is now made up of this type of privately printed currency.
It's a bit silly to say that printing money is solely the domain of central banks when the vast majority of money in the world was "printed" by commercial banks rather than central banks.
Commercial banks are given this privilege because they're highly regulated, the report says, and because as a result of all that regulation, they can be trusted not to destroy the global economy by leveraging themselves into oblivion.
In the end, it's possible that large stablecoins will end up resembling banks, JPMorgan suggests, and that they will be encumbered with additional bank-like regulatory obligations as well as privileges like fractional reserves. At that large scale, those additional regulatory obligations could pose an obstacle to business models like Libra's.
"A private stablecoin issuer acts as a de facto bank in certain respects. Not a traditional bank, to be sure, but a form of narrow bank. That is because the value of their liabilities (coins) are in most cases fully backed by a pool of high-quality collateral. However, they would perform some similar functions... In that sense, it would not be surprising for any stablecoin issuer who reaches a certain scale to be subject to some form of bank regulatory requirements. This could substantially increase operating costs, which the income from a reserve account would not necessarily be sufficient to cover," the report says.
A narrow bank is a bank that strictly holds deposits fully backed by the central bank or which enables consumers to hold deposits directly with the Federal Reserve. And so far, efforts to start narrow banks in the United States have been thwarted by the Federal Reserve in much the same way that central banks have strongly opposed Libra.
It's likely that central banks are facing identical financial stability concerns from narrow banks and stablecoins. This suggests that stablecoins will always be prevented from directly accumulating too many central bank assets, which severely limits the kind of reserves an asset-backed stablecoin can build. In some ways, the future of fully-collateralised stablecoins is probably quite closely tied to the result of the narrow banking discussion.
In a nutshell, it may be possible that fully-collateralised stablecoins backed by safe assets can't work on a large scale due to a combination of liquidity issues, the economic climate of today and the financial stability concerns they raise.
This could suggest that algorithmic stablecoins have an interesting future as they manage to sidestep this issue entirely. In the nearer term though, the report sees a bright future for stablecoins but implies that they'll mostly be built on the foundations of the existing fractional reserve banking system.
"Is the world ready for private money? Very much so, in our view. Thanks to the ubiquity of fractional reserve banking, most of the money in the world comes from private issuers. But if the experience of traditional banks is any guide, the privilege of doing so comes with significant regulatory oversight and costly compliance obligations."
Disclosure: The author holds BNB and BTC at the time of writing.
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