CAI0011

Written evidence submitted by Dr John Whittaker

The crypto-asset industry

A response to the call for evidence from the House of Commons Treasury Committee

I am an economist at Lancaster University, specialising in monetary policy, banking and financial markets, and central bank operations.

Preamble

1.              The majority of the US$ 1 trillion of crypto-assets[1] currently in existence such as Bitcoin are unbacked, speculative instruments that cannot default because they are not claims on any other asset. The fluctuating value of these unbacked instruments makes them generally unsuitable as media of exchange.

2.              Stablecoins are different. They are crypto-assets with an identifiable issuer that undertakes to maintain their value against a national currency and offers redemption (‘cashing out’) on demand, supporting this promise by holding suitable backing assets.[2] The possibility that they could become a significant means of payment, alongside commercial bank money, has raised concerns that financial stability may be endangered.

3.              In this submission, I focus on stablecoins and, in particular, on the first question in the call for evidence:

“To what extent are crypto-assets when used as digital currencies (such as stablecoin) likely to replace traditional currencies?”

Summary of conclusions

4.              National currencies will not be replaced by crypto-assets as unit of account. For example, £-sterling issued by the Bank of England will remain as the unit of account in the UK: the values of goods, services and assets in the UK will continue to be commonly measured in £-sterling, undisturbed by the presence of stablecoin or any other crypto-asset.

5.              However, stablecoin could find greater usage as a means of payment.

6.              If the use of stablecoin reached sufficient scale, this might justify regulating stablecoin issuers in the same manner as commercial banks, requiring minimum capital and liquidity, the ability to hold reserve accounts at the central bank and the provision of central bank lender-of-last-resort support.

7.              A plausible end result could be the convergence of stablecoin companies’ and banks’ business models, distinguished only by the method of accounting: mainly centralised ledgers for banks and decentralised ledgers for stablecoin companies.

Stablecoins will not replace national currencies a unit of account - - -

8.              A nation’s unit of account is its dominant measure of value; for instance, retail prices of goods in UK are quoted in £-sterling issued by the Bank of England. Payments are thus transfers of £-sterling and, apart from some small usage of cash (i.e. Bank of England banknotes and coin), the dominant means of payment is transfers of bank liabilities (deposits) that are claims on the unit of account. Bank deposits are thus the UK’s ‘money’ and the banks uphold the £-sterling value of deposits by means of a commitment to exchange them for cash on demand. To maintain this commitment, the banks back their deposit liabilities by holding their own deposits at the central bank (bank reserves) that may be unconditionally exchanged for cash. Banks are highly regulated because of the key part they play in payments and the financial system.

9.              Stablecoins are the ‘money’ of the crypto-asset world. They trade on blockchains whilst also being tied to and exchangeable into national currencies, thus being a convenient means of payment in trading other crypto-assets such as Bitcoin. Most current stablecoins are tied to the US$, although stablecoins tied to some other currencies have recently been introduced.[3] The most prominent stablecoin is Tether (total value $68bn, September 2, 2022) of which USDT is the US dollar version: one unit of USDT is a claim on one dollar.

10.              Since the value of a stablecoin is tied to a national unit of account, it is not possible for stablecoins to replace the national unit of account. For instance, it makes no sense to talk of USDT replacing the US$.

- - - but they could become a significant means of payment - - -

11.              The prospect of stablecoins becoming a common means of payment for ‘real-world’ goods and services has been widely studied by the Bank of England (2021)[4], the Treasury (2022)[5], and other national and international financial authorities[6]. The Treasury (Sect. 3.8) reports opinions that the Distributed Ledger Technology (DLT) used by stablecoins could improve transactions, potentially providing ‘greater operational efficiency, reduced risk, greater transparency and traceability of transactions, and increased resilience.’ It acknowledges the challenges, however (Sect. 3.11), in providing sufficient interoperability between existing settlement processes and blockchains and between different blockchains.

12.              At the retail level, to derive benefit from stablecoins, both payer and payee would need DLT accounts: the payee would need to be able to draw from his/her stablecoin account (in a ‘wallet’, for instance) and the payee (e.g. a retailer) would need to accept stablecoin. There would be no gain from using stablecoin if, at any point in the transaction, the stablecoin needed to be ‘cashed out’ (converted into currency or a bank deposit). Stablecoin could only become a common medium of payment, making inroads into the role currently played by commercial bank money, if a large proportion of those transacting were connected into DLT networks.[7]

- - -  justifying regulation of stablecoin issuers as if they were commercial banks

13.              Despite these impediments to the use of stablecoins as a common means of payment in the real economy, the possibility of this occurrence has nonetheless focussed attention on risks to financial stability. If doubts arose about the quality or liquidity of assets backing the stablecoin, this could lead to a ‘run’ and inability to pay out[8]. This could cause stablecoin holders to default on their ordinary (off-chain) liabilities which could, in turn, raise defaults within the established banking sector, threatening the payments system as a whole.

14.              This could not occur if stablecoins were 100% backed by liquid assets such as government debt and central bank reserves that can be immediately and reliably cashed and paid out (i.e. if the stablecoin issuer were structured as a ‘narrow’ bank). However, to become significant players in the payments system outside the confines of the crypto-world, stablecoin issuers would need to compete with commercial banks by offering some combination of more convenient, faster and cheaper payment arrangements; higher interest than transaction deposits in banks; and greater safety. It is hard to see how any stablecoin issuer could offer such attractions while remaining viable over the long term, without holding some higher-earning private sector assets. Even if stablecoin issuers wanted to back their stablecoins with 100% of short-term government debt, there is a limited available stock of such paper. A large demand for such short term ‘safe’ assets would drive up their price, reducing the yield and making this strategy increasingly untenable.

15.              Indeed, the largest current issuer of stablecoins, Tether, only holds about 50% of its asset portfolio in highly liquid US$ Treasury bills and cash. The rest is in foreign assets and private sector assets including secured loans (6.8%), commercial paper and corporate bonds (June 2022)[9].

16.              In other words, in order to compete with banks, systemic stablecoin issuers would need to behave like banks, which implies that they should be regulated like banks. They would then be subject to capital requirements related to the risk of the issuer’s asset portfolio, liquidity requirements and reporting requirements. Safeguarding the payments system also implies that the issuer of a systemically important stablecoin should be able to access lender-of-last-resort support from the central bank (‘liquidity insurance’ from the ‘discount window’ at the Bank of England). These, broadly, are the conclusions reached by numerous national and international regulatory authorities.[10]

17.              Despite the burden of compliance with banking regulation, stablecoin issuers might welcome the legitimacy conferred by being within the regulatory net. Indeed, several US stablecoin issuers are considering applying for banking licences, bringing the additional benefit of deposit insurance.

The effect on the financial system

18.              In an ‘illustrative scenario’ presented by the Bank of England[11], 20% of UK bank deposits (roughly £700bn) migrate into GBP stablecoin. With such a large loss of deposits, the Bank of England deduces that banks would turn to more expensive wholesale funding, causing them to raise their lending rates. Their borrowers, particularly higher-risk borrowers, might then seek credit outside the formal banking sector. Stablecoin issuers could be among possible alternative sources of funding.

19.              With stablecoins encroaching on the banks’ normal business of taking deposits and lending, one may speculate that the banks would adapt their own behaviour. If DLT accounting were perceived to be at the root of their loss of business to the stablecoin companies, they might be inclined to offer DLT accounting themselves, with tokenised deposits and loans, as an alternative option to standard accounting methods.

20.              When these developments have run their course, banks and stablecoin companies would have similar businesses and similar regulation, the main difference lying only in their accounting technology (centralised vs distributed ledgers). And if DLT accounting truly presents advantages, the banking industry would have evolved to incorporate them.
 

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