Original Article Title: "Stablecoins: Growth Potential and Impact on Banking"

Original Article Authors: Gordon Y. Liao and John Caramichael

Original Article Translation: Dooon BlockBeats

On January 31, 2022, the Federal Reserve released "Stablecoins: Growth Potential and Impact on the Banking System." In the paper, the Federal Reserve is very optimistic about stablecoin innovation, focusing on the potential impact of stablecoins on the banking system and credit intermediation.

It is important to note that this is an "International Finance Discussion Paper (IFDP)," which is preliminary material distributed to stimulate discussion and critical comment. The analysis and conclusions presented are those of the authors and do not necessarily indicate concurrence by other members of the research staff or the Board of Governors. Therefore, the Federal Reserve's stance cannot be conclusively determined, but based on the Federal Reserve's recent attitudes, they are indeed very interested in stablecoins.

Below are the key points of the Federal Reserve's "Stablecoins: Growth Potential and Impact on the Banking System." Dooon BlockBeats has translated the full text for readers' convenience.

TL;DR

A stablecoin is a type of cryptocurrency whose value is pegged to an external reference, usually the US Dollar (USD). Stablecoins play a critical role in the digital market, and their growth potential could stimulate innovation in the broader economy. Over the past year, there has been an explosive growth of US Dollar stablecoins circulating on public blockchains, with the total circulation supply nearing $130 billion as of September 2021, a growth of over 500% from a year ago.

As stablecoins garner more attention, a series of issues have been raised, including their pegged stability, consumer protection, KYC and compliance, and the scalability and efficiency of settlements. We will focus on discussing the potential impact of stablecoins on the banking system and credit intermediation. While a range of stablecoin-related issues can be addressed through appropriate institutional safeguards, regulations, and technological advancements, the continued growth and circulation of stablecoins will ultimately impact the traditional banking system in significant ways.

In this briefing, we first discuss the fundamental knowledge of stablecoins, their current use cases, and their growth potential. Next, we examine the historical behavior of stablecoins during past cryptocurrency and broader financial market distress. We find that stablecoins pegged to the US Dollar exhibit a secure asset quality, as their secondary market prices temporarily rise above the pegged price during times of extreme market stress, encouraging more stablecoin issuance. We also emphasize the "run" risks of stablecoins backed by noncash equities.

Finally, we outlined potential scenarios for stablecoins involving bank reserves, credit intermediation, and central bank balance sheets as stablecoins gain broader attention. Our research indicates that the widespread adoption of asset-backed stablecoins could be supported within a two-tier partial reserve banking system without adverse effects on credit intermediation. In this framework, stablecoin reserves would be held as commercial bank deposits, with commercial banks engaging in partial reserve lending and maturity transformation similar to traditional bank deposits. We also found that replacing physical cash (banknotes) with stablecoins could lead to more credit intermediation. In contrast, requiring stablecoin issuers to back their stablecoins with central bank reserves under a "narrow" banking framework would minimize stablecoin "bank runs" risk but could reduce credit intermediation.

Stablecoin Basics

A stablecoin is a digital currency recorded on a Distributed Ledger Technology (DLT), usually a blockchain, pegged to a reference value. Most circulating stablecoins are pegged to the U.S. dollar, but stablecoins can also be pegged to other fiat currencies, a basket of currencies, other cryptocurrencies, or commodities like gold. As a value store and exchange medium on DLT, stablecoins enable value exchange or integration with other digital assets.

Stablecoins differ from traditional digital currency records, such as bank deposit accounts, in two main ways. First, stablecoins are cryptographically secured. This allows users to settle transactions almost instantly without the need for double-spending or a settlement-facilitating intermediary. On a public chain, this also enables 24x7x365 trading. Secondly, stablecoins are typically built on programmable DLT standards, allowing for service composability. In this context, "composability" means stablecoins can act as independent building blocks that interact with smart contracts (self-executing programmable contracts) to create payment and other financial services. These two key features underpin current stablecoin use cases and support innovation in both financial and non-financial sectors.

Since 2020, the usage of stablecoins on public chains such as Ethereum, Binance Smart Chain, or Polygon has surged. As of September 2021, the circulating supply of the largest USD-pegged public stablecoin approached $130 billion. The chart shows a particularly strong growth in circulating supply of public stablecoins in early 2021, with an average month-on-month growth of around 30% in the first five months of this year.

Current Stablecoin Types

Stablecoins are a nascent, broadly defined technology that may take various forms. The technology is currently implemented in specific forms, which we will describe below and summarize in Table 1. However, please note that stablecoin technology is in its early stages with high innovation potential. The current implementations of stablecoins discussed below, as well as their current regulatory status, do not fully reflect all potential deployments of stablecoin technology.

Circulating supply of the top ten market-cap-ranked USD-pegged public stablecoins. Data from January 2019 to September 2021. Other categories include Fei, TerraUSD, TrueUSD, Paxos Dollar, Neutrino USD, and HUSD.

Public Reserve-Backed Stablecoins

Most existing stablecoins circulate on public blockchains such as Ethereum, Binance Smart Chain, or Polygon. Among these public stablecoins, most are backed by cash-equivalent reserves like bank deposits, treasury bills, and commercial paper. These reserve-backed stablecoins are also known as custodial stablecoins as they are issued by intermediaries acting as custodians of cash-equivalent assets and provide 1-to-1 stablecoin redemption in USD or another fiat currency.

The full backing and robustness of some public reserve-backed stablecoins have been questioned. In particular, Tether, the largest stablecoin by circulating supply, agreed to pay $41 million to settle a dispute with the U.S. Commodity Futures Trading Commission, which accused Tether of misrepresenting the adequacy of its USD reserves. Other widely used reserve-backed public stablecoins pegged to the US dollar with varying levels of financial audits include USD Coin, Binance USD, TrueUSD, and Paxos Dollar.

Public Algorithmic Stablecoins

Some stablecoins use alternative mechanisms to stabilize their price rather than relying on the robustness of underlying reserves. These stablecoins are often referred to as algorithmic stablecoins. While reserve-backed stablecoins appear as liabilities issued on the balance sheet of a legally registered company, algorithmic stablecoins are maintained by specialized smart contract systems operating on public blockchains. The control of these smart contracts is typically governed by holding governance tokens, which are tokens specifically designed to vote on protocol or governance parameter changes. These governance tokens can also serve as a direct or indirect claim to future cash flows of the stablecoin protocol.

The public field of algorithmic stablecoins is highly innovative and hard to categorize. However, these stablecoins' designs are generally thought to be based on two mechanisms: (1) a collateralization mechanism and (2) an algorithmic pegging mechanism. When a user deposits unstable cryptocurrency (such as Ethereum) into Dai's smart contract protocol, collateralized public stablecoins like Dai are minted. The user then receives a loan of Dai pegged to the US dollar with a collateralization rate exceeding 100%. If the value of the Ethereum deposit falls below a certain threshold, the loan is automatically liquidated.

In contrast, the algorithmic pegging mechanism uses automatic smart contracts to protect the peg through buying and selling the stablecoin with related governance tokens. However, these pegs may encounter instability or design flaws leading to "depegs," as seen, for example, when the algorithmic stablecoin Fei briefly depegged shortly after its launch in April 2021.

Institutional or Private Stablecoins

In addition to reserve-backed stablecoins circulating on public blockchains, traditional financial institutions have also developed reserve-backed stablecoins, also known as "tokenized deposits." These institutional stablecoins are implemented on permissioned (private) DLT and are used by financial institutions and their clients for efficient wholesale transactions. The most well-known institutional stablecoin is JPM Coin. JPMorgan and its clients can use JPM Coin for intraday repo settlements and other transactions to manage internal liquidity.

These private, reserve-backed stablecoins functionally and economically resemble products offered by certain money transmitters. For example, PayPal and Venmo (a subsidiary of PayPal) allow users to make near-instantaneous transfers and payments within their networks, with balances held by these companies similar to reserve-backed stablecoins. The key difference is the use of a centralized database rather than permissioned DLT.

Use Cases and Growth Potential of Stablecoins

Strong use cases are driving the current growth of various forms of stablecoins. We summarize these use cases. The most significant current use case for stablecoins is their role in cryptocurrency transactions on public blockchains. Investors often prefer using public stablecoins to trade cryptocurrencies as it enables near-instantaneous 24/7/365 trading without relying on non-DLT payment systems or custody of fiat balances.

In addition to being used for crypto transactions, both public and institutional stablecoins are currently used for near-instantaneous 24/7 non-intermediated payments with potentially low fees. This is particularly relevant for cross-border transfers, which typically take multiple days and incurr high fees. Companies also use institutional stablecoins to transfer cash almost instantly between their subsidiaries to manage internal liquidity and facilitate wholesale transactions in existing financial markets, such as repo transactions. Lastly, due to the programmability and composability of public stablecoins, they are extensively used in decentralized, public blockchain-based markets and services known as Decentralized Finance or DeFi. DeFi protocol systems allow users to interact directly with stablecoins and underlying protocols to participate in various crypto-related markets and services like liquidity provision, collateralized loans, derivatives, and asset management without traditional intermediaries. As of September 2021, around $600 billion worth of digital assets are collateralized (locked) in DeFi protocols.

Future Growth Potential

The defining characteristics of stablecoins, cryptographic security, and programmability underpin the strong use cases currently driving the widespread adoption of existing public and institutional stablecoins. However, these functionalities have the potential to drive innovation beyond current use cases, which are primarily limited to the cryptocurrency market, certain peer-to-peer payments, and large-scale bank institutional liquidity management. Looking ahead, stablecoin technology may witness diversified implementations across multiple growth areas and drive innovation: more inclusive payment and financial systems, tokenized financial markets, and advancements in technologies like Web 3 through microtransactions.

More Inclusive Payment and Financial System

Stablecoins have the potential to stimulate the growth and innovation of the payment system, thus enabling faster and cheaper payments. Since stablecoins can be used for nearly instant, low-cost point-to-point fund transfers between digital wallets, stablecoins may reduce payment barriers and put pressure on existing payment systems to provide better services. This is particularly important for cross-border transfers, which may currently take days to settle and incurr high fees. These fees and delays are burdensome for low- and middle-income countries.

Stablecoins may also support a more inclusive financial system through the growth of DeFi, which may require stablecoins as a necessary component. It should be noted that DeFi faces significant challenges, including complex user experiences, lack of consumer protection, frequent hacks, protocol vulnerabilities, and market manipulation. Additionally, almost all DeFi protocols only support transactions or lending with cryptocurrencies or non-fungible tokens (NFTs). If DeFi protocols mature beyond their current state and integrate with the broader financial markets to support real-world economic activities, then DeFi can promote a more inclusive financial system, allowing investors to participate directly in markets without intermediaries. This growth of DeFi could drive an increase in stablecoin usage.

Tokenized Financial Markets

Furthermore, stablecoins may play a key role in the tokenization of financial markets. This would involve converting securities into digital tokens on DLT and using stablecoins for transactions and services. For Delivery versus Payment (DvP) transactions, such as securities purchases, tokenized markets would enable real-time settlement at very low costs. This can enhance liquidity, transaction speed, and transparency, while reducing counterparty risk, transaction costs, and other market participation barriers. By allowing fractional ownership of tokenized assets and more transparent price discovery, this may be particularly advantageous for certain asset classes, such as real estate. For Payment versus Payment (PvP) transactions, such as cross-currency swaps, tokenization would also allow for near-instant execution, as opposed to the current traditional T+2 framework in which the payment of a swap occurs days after the exchange of two businesses settles. Additionally, for both types of transactions, tokenized financial markets would benefit from the programmability of DLT, which can automate security services and regulatory requirements, such as required holding periods. If financial markets are partially or fully tokenized, this could further drive the increase in stablecoin usage.

Next-Generation Innovation

Lastly, stablecoins have the potential to support next-generation innovation. One example of this innovation is Web 3, which could shift from centralized network platforms and data centers to decentralized networks. In this paradigm, the revenue of internet services and social media platforms would shift from advertising to microtransactions, benefiting from the emergence of efficient, integrated online payment systems. For instance, one can envision a search engine or video streaming platform supported by nearly instant micro-payments in stablecoins, instead of ad revenue and user data sales. If this transformation of internet services is achieved, it could further drive the growth of stablecoins.

In summary, the current use of stablecoins is mainly driven by cryptocurrency trading, limited peer-to-peer payments, and DeFi. Looking ahead, stablecoins may further grow by facilitating a more inclusive payment and financial system, tokenization of financial markets, and potential next-generation innovations such as Web 3.

Pegging Stability

The stability of stablecoins pegged to their reference value is a core issue. While this is not the focus of our paper, we briefly discuss this important issue here. In this section, we will first outline the sources of pegging instability of stablecoins currently backed by public reserves and discuss how to address these sources. We will then review how stablecoins may serve as a potential safe asset in the digital marketplace and provide evidence that stablecoins currently backed by public reserves may have already played this role in the cryptocurrency market.

Currently, pegging instability of stablecoins backed by public reserves takes two forms: issuer's investor redemption risk and secondary market price dislocation. The former is related to the security and robustness of the stablecoin reserves. If stablecoin holders lose confidence in the robustness of the stablecoin's backing, a panic may ensue. A run on the stablecoin poses spill-over risks to other asset classes as the stablecoin reserves are sold off or unloaded to meet redemption demands. Additionally, a run on the stablecoin may disrupt market and service smart contracts reliant on the stablecoin through interoperability, causing further distress. We believe this type of instability can be addressed through appropriate institutional and/or regulatory guardrails, such as transparent financial audits and adequate requirements for the liquidity and quality of stablecoin reserves. Recent concerns surrounding redemption risk and the degree to which it can be addressed were mentioned in Quarles (2021).

The second form of anchoring instability of stablecoins backed by public reserves stems from imbalances in supply and demand in the secondary market. Since these stablecoins trade on both centralized and decentralized exchanges, they are susceptible to demand shocks that may temporarily dislocate their peg until the stablecoin issuer adjusts the supply. In particular, as public stablecoins serve as a store of value in markets based on public blockchains, these stablecoins have seen high demand during times of distress in the crypto markets as investors rush to unwind their speculative positions into stablecoins. During these events, major public-reserve-backed stablecoins' prices often temporarily appreciate until the issuer adjusts the supply. For example, the graph depicts cryptocurrency market crashes on March 12, 2020, and May 19, 2021. The first event occurred during a period of widespread market turmoil surrounding the spread of Covid-19. The second event took place during a period of crypto market downturn associated with significant deleveraging. In both instances, as speculative cryptocurrencies like Bitcoin and Ethereum plunged by 30% to 50%, the prices of major public-reserve-backed stablecoins surged significantly.

For these extreme encryption market crisis events, stablecoins as a digital safe-haven asset appreciate, while more speculative cryptographic assets are temporarily in free fall until the stablecoin issuer can increase its supply and purchasing reserves and/or the stablecoin undergos a price pressure drop from arbitrageurs. The behavior of these public stablecoins is unique and unlike prime money market funds, which experienced significant outflows during the 2008 global financial crisis and the most severe periods of the 2020 COVID-19 pandemic.

These events demonstrate the potential of stablecoins as a digital safe haven during market crises. While discussions of financial stability risks of stablecoins backed by public reserves have largely focused on the redemption risk specific to the particular stablecoin reserve form, our analysis indicates that counter-cyclical secondary market demand for stablecoins can mitigate redemption risk during broad-based downturns. Through appropriate safeguards and regulations, stablecoins may offer stability comparable to traditional forms of secure value.

Stablecoin's Potential Impact on Credit Intermediation

If stablecoins are widely adopted throughout the financial system, they could have a significant impact on the balance sheets of financial institutions. Regulators, market participants, and scholars are particularly concerned about the potential for stablecoins to disrupt the bank-dominated credit intermediation. In this section, we analyze several scenarios in which reserve-backed stablecoins are widely adopted in the financial system. We focus on reserve-backed stablecoins rather than algorithmic stablecoins as the former are currently the largest and most closely linked to the existing banking system. Through these scenarios, we highlight how the adoption of stablecoins could critically depend on two factors: the sources of inflows into stablecoins and the composition of stablecoin reserves.

We summarize our findings. We find that, in most of the cases we consider, credit provision may not be adversely impacted. In fact, replacing physical currency (paper money) with stablecoins could potentially enable more bank-dominant credit supply. One notable exception that could lead to a significant disintermediation of credit is if stablecoins require full central bank reserves backing, which we refer to as the narrow banking framework. Under this framework, with minimization of redemption risk comes greater credit disintermediation (debanking).

Sources of Inflows

If stablecoins are widely adopted, the primary inflows are likely to come from three sources: physical currency (paper money), commercial bank deposits, and cash-equivalent securities (or money market funds). First, as a form of digital currency, stablecoins will replace a portion of circulating paper money, especially as the economy becomes more digital. In some of our scenarios, we see an increase in credit supply as users switch from physical cash to reserve-backed stablecoins, as paper money, a direct liability of the central bank, is displaced by reserve-backed stablecoins, depending on the reserve framework, credit can be created through loans or securities purchases.

Second, if households and businesses are more willing to hold stablecoins rather than traditional bank balances, stablecoins may flow out of bank deposits. Policymakers are particularly interested in this source of inflows because there is a general concern that a large-scale substitution of deposits could disrupt the credit supply of commercial banks. We show that the impact of deposit substitution on credit supply can be positive, negative, or neutral, depending on the reserve framework. Finally, stablecoins may see inflows from cash-equivalent securities (or money market funds). This may have no impact on credit supply as it would require cycling funds back into the banking system, which we will discuss in a later section.

Reserve Composition

The impact of widely adopted reserve-backed stablecoins on credit supply also depends on the composition of the stablecoin reserve. We propose three reasonable stablecoin reserve frameworks: narrow banking, two-tiered intermediation, and security holding. As shown in the figure above.

In the narrow banking framework, stablecoins need to be backed by commercial bank deposits, which are fully supported by central bank reserves. Equivalently, commercial banks could potentially issue fully backed stablecoins (or tokenized deposits) backed by central bank reserves. The narrow banking approach is roughly equivalent to a form of retail central bank digital currency, where the digital currency is a liability of the central bank, but households and firms can use it through intermediaries such as commercial banks or fintech firms. The People's Bank of China has adopted this framework in its government-supported digital currency (referred to as Digital Currency and Electronic Payment), digital yuan, or e-CNY. The proposed STABLE Act in the United States also mentions the possibility of requiring stablecoins to be backed by central bank reserves.

Although the narrow banking framework can ensure the stability of stablecoins' peg, as it is essentially a pass-through of central bank digital currency (CBDC), this reserve framework poses the greatest risk of credit disintermediation. Financial stress or periods of panic could lead to a significant amount of conventional commercial bank deposits moving into narrow banking stablecoins, which could disrupt the credit supply. While this credit disintermediation effect could be mitigated by limiting the amount of stablecoin holdings and differential reserve rates, the overall structure of the banking system's narrow approach to stablecoin reserves could undermine the stability of the banking system. Furthermore, the narrow banking approach could result in an expansion of the central bank's balance sheet to accommodate the stablecoin issuer's demand for reserve balances.

These concerns about narrow banking stablecoins reflect broader concerns about narrow banking, which the Federal Reserve has already noted. In a recently proposed regulation that would impact narrow banks (referred to officially as pass-through investment entities or PTIEs), the Federal Reserve expressed "concerns that [narrow banks] could disrupt financial intermediation in unexpected ways and may also have adverse effects on financial stability" (Regulation D: Reserve Requirements of Depository Institutions, 2019). Additionally, the Federal Reserve outlined serious concerns about reserve balance demand, stating that "[narrow banks'] demand for reserve balances could become quite large. To maintain an optimal monetary policy stance, the Federal Reserve might need to meet this demand by expanding its balance sheet and reserves supply."

Compared to the narrow banking framework, in a two-tier intermediary framework, stablecoins will be backed by commercial bank deposits used for fractional reserve banking. Similarly, commercial banks may also issue stablecoins or offer tokenized deposits for fractional reserve banking. It is important to note that this does not mean stablecoins are not fully backed. Instead, stablecoin issuers rely on commercial bank deposits as assets, and commercial banks utilize stablecoins and/or stablecoin deposits for fractional reserve banking, meaning stablecoins are ultimately supported by a combination of loans, assets, and central bank reserves. This will impact the effective rebranding of part of conventional deposits as stablecoin deposits. It is crucial that to keep the banking intermediary unchanged, the treatment of stablecoin deposits must align with that of non-stablecoin deposits in terms of statutory reserve ratios, liquidity coverage ratios, and other regulatory and self-imposed risk limits.

Lastly, stablecoin issuers may hold cash equivalents, such as Treasury securities and high-quality commercial paper, instead of keeping funds in commercial banks. These securities can be acquired directly or indirectly through money market funds. This is the primary framework adopted by stablecoins currently supported by public reserves, such as Tether, as highlighted by Federal Reserve Chairman Jerome Powell, stating that it is "just like a money market fund."

Scenario Setup

In our scenario, we will consider the impact of one or more fiat reserve-backed stablecoins gaining widespread adoption within the banking system's programmable version. The baseline balance sheet of this banking system is illustrated in the diagram. Specifically, we consider the scenario where households and businesses substitute $10 in cash, commercial bank deposits, or securities with a stablecoin, and then we conduct accounting to determine how the adoption of stablecoin would affect the balance sheets of the central bank, commercial banks, as well as households and businesses. We analyze how this impact varies based on the stablecoin's reserve framework and its sources of inflows.

It is important to note that several key assumptions were made in constructing these scenarios. Firstly, we do not know the specific form of the adopted stablecoin. Our scenarios are not intended to analyze, for example, the specific effects of widespread adoption of existing stablecoins (such as Tether). We do not distinguish whether the adopted stablecoin is an institutional tokenized deposit or a stablecoin circulating on a public blockchain, or other forms. Secondly, we only present illustrative edge cases. In reality, stablecoins can see inflows from various sources and hold multiple assets as reserves. Thirdly, these scenarios do not capture secondary chain effects or feedback loops, nor address heterogeneous impacts within the industry. Finally, we assume a 10% statutory reserve ratio for traditional commercial bank deposits.

To illustrate the complex flows between different parts of the banking system in our edge case scenario, we visualize a subset of the stablecoin inflows and reserve allocations we discussed in the diagram. Specifically, we use the chart to show commercial bank deposits (Inflow A) and cash (Inflow B) flowing into stablecoins, and how these funds are allocated in the form of commercial bank deposits to reserves (Reserve Flow A) and securities (Reserve Flow B).

In the diagram, we see how stablecoin inflows and reserve flows are interconnected. Companies and households substitute deposits (inflow A) and banknotes (inflow B) for stablecoins. The stablecoin issuer then deposits some of these funds into the commercial banking system as commercial bank deposit reserve (reserve flow A) and uses these funds to purchase securities as reserve (reserve flow B). These securities purchases also circulate funds back into the banking system, as the seller of the securities will eventually receive the proceeds of the securities sale and deposit them back into the banking system. As depicted in the diagram, these flows affect the central bank, which holds cash and central bank reserves as liabilities, and companies and households which borrow from commercial banks. While this diagram does not capture all flows between these entities, it symbolizes how the widespread adoption of stablecoins is reshuffling the intricate financial relationships within the banking system.

Scenario Analysis

Narrow Banking Framework:

As mentioned earlier, the narrow banking framework poses the greatest risk to credit provision, depending on the source of inflows. In our narrow banking scenario, as shown in the table, we find that physical cash flows into narrow banks holding stablecoin will have a neutral effect on credit supply, while commercial bank deposits will disrupt credit supply.

In Panel A (cash inflow scenario), we see stablecoin replacing cash on the households' and companies' balance sheets. The inflow of cash leads to an indirect increase in the commercial bank's balance sheet and commercial bank reserves. The central bank's balance sheet is restructured, with reserve liabilities replacing cash liabilities. The net effect is an expansion of the commercial bank's balance sheet, but with no change in credit provision. This situation assumes that banks are not subject to balance sheet size constraints. That is, narrow bank deposits and related reserve holdings are exempt from leverage ratio calculations. This leverage exemption for central bank reserve holdings has been adopted by regulatory bodies in various jurisdictions.

Panel B shows the deposit migration to stablecoin in the narrow banking scenario. Since stablecoin deposits are fully reserved on the commercial bank's balance sheet, the bank must reduce its asset holdings to accommodate the decline in non-stablecoin deposit funds. The central bank's balance sheet would then expand to accommodate the increased demand for reserve balances, without offsetting the decrease in cash liabilities. In this case, we assume the central bank would meet the increased reserve demand by purchasing securities. This lenient central bank assumption is in line with the Fed's previous ruling regarding narrow banking, as mentioned earlier, related to Regulation D: Reserve Requirements of Depository Institutions (2019). However, if the central bank determines the scale of its balance sheet, we present two alternative scenarios in Table A1 in the appendix. In the first alternative scenario, commercial banks significantly shrink their balance sheets to compensate for the shortfall in deposit funds. In the second scenario, commercial banks make up for lost deposit funds by issuing debt securities. The result is a further reduction in bank-led credit creation.

We did not envision a scenario where a narrow bank stablecoin saw a significant inflow from the securities holdings. In this case, the impact on credit reserves may be neutral. Under the same assumptions as above, the central bank would meet the increased reserve demand by (from households) purchasing securities, with the net impact on credit supply expected to be minimal. Unlike holding securities directly, the migration to stablecoin would see households holding a stablecoin backed by central bank reserves, which are in turn backed by securities. This scenario also assumes that the increased narrow bank reserve is unaffected by the leverage ratio, as described above.

Two-Tier Intermediation Framework:

For the two-tier intermediation framework shown in the table below, we find that a significant inflow into stablecoin would have a neutral to positive impact on credit supply. Panel A illustrates the scenario of cash conversion into stablecoin. As commercial banks engage in partial reserve banking through stablecoin deposits, their balance sheets expand primarily through the expansion of credit and securities holdings, representing the majority of the expansion. The central bank contracts on the net balance sheet, with reserves slightly increasing and cash liabilities significantly decreasing. Households accumulate more assets, expanding funding in bank loans. The impact on credit reserves is positive. Panel B shows a two-tier intermediation scenario with deposit substitution. The overall balance sheets and asset holdings of commercial banks and the central bank remain unchanged. The only change is in the composition of commercial bank liabilities as time deposits shift to stablecoin deposits. As mentioned earlier, this scenario assumes that the treatment of stablecoin deposits is the same as non-stablecoin deposits in terms of statutory reserve requirements, liquidity coverage ratio, and other regulatory and self-imposed risk constraints.

Securities Holding Framework:

As shown in the table below, the impact of widely adopted security-backed stablecoins is the most unpredictable. Many scenarios are possible. In Panel A, we present a scenario where a security-backed stablecoin sees an inflow of commercial bank deposits. We assume the stablecoin issuer purchases securities from commercial banks rather than households and corporate sectors. In this case, as households switch deposits to stablecoin, commercial banks compensate for the loss of deposit funding by issuing their own securities. Additionally, commercial banks may reduce their securities portfolio to offset the loss of deposit funding. If banks primarily adjust the asset side of their balance sheet by changing their securities holdings, the size of the bank loan portfolio may remain unchanged. In this scenario, due to the loss of bank reserves, the central bank's balance sheet also undergoes slight contraction.

Panel B illustrates the scenario where households convert cash-equivalent securities they hold into stablecoin. This would result in the tokenization of quasi-cash securities without directly impacting the credit supply in the banking system. We also consider another scenario (not shown) where a security-backed stablecoin experiences inflows from households and corporate sectors, while simultaneously selling securities to commercial banks. The securities sellers are households and corporate sectors, not the commercial banks as described in Panel A of table 7. The net impact on credit provision is neutral, as the commercial bank deposit balances held by households and corporates purchasing stablecoin are eventually recycled back through transferring them to other households and corporates selling securities to the stablecoin issuer. This reshuffling of securities holdings is illustrated in Figure 3 through flow A inflow and flow B reserve flow. The ultimate outcome is a balance sheet change, consistent with Panel B.

Finally, we did not describe a scenario where a secure-backed stablecoin receives inflows from physical cash. However, this could have a neutral or positive impact on credit creation. If the stablecoin issuer uses cash to purchase existing securities, and this cash ultimately does not enter the banking system, it would not affect the credit supply as it would constitute a direct exchange of cash for securities. However, if the cash used to purchase existing securities is deposited into the banking system, or if this cash is used to fund the issuance of new securities, this could potentially increase the credit supply by increasing commercial bank lending and securities purchases, or by reducing the issuance cost of securities. In summary, the possible impact is a moderate increase in credit supply.

Summary

As digital assets gain broader adoption and the use cases for programmable digital currencies become clearer, stablecoins have seen significant growth over the past year. This rapid rise has raised concerns about potential negative impacts on banking activities and the traditional financial system. In this report, we discuss the current use cases and potential growth of stablecoins, analyze historical events of unstable pegs, and explain the various scenarios of stablecoin impacts on the banking system. As stated in the introduction, this paper does not consider all potential impacts of stablecoins on financial stability, monetary policy, consumer protection, and other important unexplored issues. We focus on the balance sheet effects and credit intermediation under a set of reasonable assumptions.

We studied reserve-backed stablecoins and found that the impact of stablecoin adoption on traditional banking and credit provision may vary depending on the source of inflows and the composition of stablecoin reserves. In various scenarios, the two-tier banking system can both support stablecoin issuance and maintain traditional forms of credit creation. In contrast, a narrow bank stablecoin framework can offer the greatest stability but may come with potential costs of credit disintermediation. Finally, if a stablecoin pegged to the US dollar is believed to have sufficient collateral, then during market distress, a US dollar-pegged stablecoin can serve as a safe haven compared to other cryptocurrencies.

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