Stablecoins: Old Rules, New Tech

Why Requiring 100% Cash Reserves and Fixed Prices Could Cause Problems for Stablecoins' Future

The U.S., EU, and Hong Kong have been rolling out, or have already put in place, new laws and regulations around stablecoins.

The digital currency realm is abuzz with excitement, and traditional financial markets are watching closely.

However, in terms of the fundamental logic and institutional evolution of financial markets, stablecoins represent a less advanced institutional setup.

They require mandatory full reserves and operate on a fixed-price rigid redemption. Furthermore, they are constrained by the interbank market for digital currencies, severely limiting their underlying policy autonomy and liquidity creation capacity.

Overall, it's an inferior and mediocre monetary system.

So, what does the future hold for stablecoins?

What Are Stablecoins?

Stablecoins are not a innovation created by recent regulations. Long before, major stablecoins like USDT and USDC already existed, and companies like Facebook and cryptocurrency exchanges had launched their own stablecoins.

They emerged because Bitcoin's extreme volatility led to its loss of functionality as a currency. Traders needed a stable medium to enter the cryptocurrency market for trading digital assets. Stablecoins serve as both a conduit into and out of the digital asset market and a payment method.

Why does the government need to introduce stablecoin legislation?

For the U.S., there are likely three primary goals:

1. Bring stablecoins and digital currencies under regulatory oversight;

2. Embrace new technologies, financial innovations and emerging trends, preventing the marginalization of U.S. financial dominance due to technological shifts and market transitions;

3. Bolster reserves of U.S. dollars and Treasury bonds. Currently, stablecoins hold an estimated $1.8 trillion in U.S. Treasuries—surpassing the holdings of the Japanese government.

Stablecoins, as defined in emerging regulations. Examining relevant regulations in the United States and Hong Kong, China, reveals several common features for stablecoins:

1. They are pegged to fiat currencies (USD/HKD) and are primarily used for payments and settlement.

2. They must be issued with 1:1 backing reserves of fiat currency and short-term government bonds.

3. They are subject to strict regulatory oversight and disclosure requirements, including compliance with Anti-Money Laundering (AML) rules.

4. Private companies meeting the requirements can apply to become stablecoin issuers.

5. Paying interest to stablecoin holders is prohibited.

Evidently, stablecoins represent a form of currency possessing asset-like attributes. They can be understood as stable-value currencies pegged to fiat money, issued with 100% backing reserves of fiat currency or bonds, and designed solely for payment and settlement purposes.

Stablecoins are a form of currency that follows the ancient law of demand.

The most fundamental functions of money are pricing and payment. During the era of physical currency, stable forms of money, such as gold, emerged through market competition. However, physical currency is inconvenient and inefficient.

Trade in Western Europe began expanding significantly in the 15th century. Physical currencies were flawed, proving inadequate to support rapidly growing trade. To solve this problem, private banks across Europe issued bank notes.

These notes, backed by gold reserves and operating under the gold standard system, represented a securitized form of gold. Merchants could use banknotes for remote payments and settlements, offering greater convenience and efficiency.

In the early stages, numerous private banks across Europe and the United States issued their own bank notes to function as paper currency.

However, banknotes faced stability and security issues.

At the time, it was common for banks to issue too many bank notes. During the Free Banking Era, over 8,000 banks issued currency within the United States. Some were small banks set up shop in rural areas, operating like general stores, and could disappear or go bankrupt at any moment. These banks were jokingly called "wildcat" banks.

The excessive issuance of banknotes meant banks could no longer maintain the fixed exchange ratio between their notes and gold. The resulting inflation in banknotes became severe, even triggering banking crises.

Following a financial crisis, the British government intervened in 1844 with Peel's Acts. This act ended the currency-issuing privileges of over 200 private banks in England and Wales, granting the Bank of England the exclusive right to issue pound sterling bank notes.

The Bank of England held £14 million in securities and precious metals as backing, issuing an equivalent amount of banknotes. Beyond this £14 million threshold, the Bank was required to use gold or silver as reserve assets, with silver-backed note issuance not exceeding 25% of the total.

This meant the Bank of England became the sole central bank. Other countries later followed suit, establishing their own central banks and fiat currencies.

Currency has evolved along two main paths: one toward more efficient payment and settlement systems, and the other toward maintaining a more stable value.

Greater efficiency in payments and settlements is largely fueled by technological innovation, which has transformed currency from its traditional paper form into electronic, networked, and digital formats.

Many people are drawn to stablecoins because of the global fiat currency and financial systems. Cross-border payments are inefficient and censorship is strict. In contrast, stablecoins, powered by distributed technology, deliver more efficient and private solutions for cross-border transactions.

In terms of value stability, the pursuit has always been about achieving greater stability, mainly through institutional frameworks that rein in currency value and the actions of issuers.

After the Peel's Acts came into play, governments started to take exclusive control over issuing currency, bringing in central banking systems to step in currency prices, keeping fiat money stable.

Back in the early days, the approach was to stick to the gold standard. The strictest requirement of the government was to hold 100% gold reserves to issue domestic currency, locking the price of that currency directly to the price of gold.

The Bretton Woods system, rolled out in 1944, was a gold standard and fixed exchange rate setup built around the US dollar . It tied the dollar to gold, starting with a set official rate of $35 per ounce, and required other member countries' currencies to be tied to the dollar, with exchange rate swings kept under 1%.

Now, with the introduction of stablecoin regulations, the goal is to bring in something akin to the gold standard, making sure stablecoin values stay steady.

In 2022, the collapse of USDT sparked a credit crisis for stablecoins, raising doubts about whether it had enough US dollars in reserve. The issue is that USDT's automatic trading mechanism doesn't really get how finance works, especially during liquidity crises.

Then, in 2023, the Silicon Valley Bank failed after a bank run, causing USDC to take a steep dive, since a big chunk of its assets were tied up in the bank.

These two incidents have made it clear to more people that stablecoins aren't as safe as they're made out to be, and there's a growing push to bring them under regulation.

Today's stablecoin system carries echoes of the Bretton Woods system. Stablecoins are issued with 100% backing by a base currency (USD) and maintain a fixed ratio to that currency.

However, achieving value stability is clearly tougher than boosting efficiency. Over the past 200 years, central banks have repeatedly walked away from the gold standard.

The Federal Reserve broke from the gold ratio during World War I; during the Great Depression, it announced a temporary split from gold; and in 1971, it shut down the gold exchange window, triggering the collapse of the Bretton Woods system and the end of the gold standard.

So, can we really trust the stablecoin system?

Why Stablecoins Are an Outdated System

Stablecoins represent a less advanced institutional setup, but the real issue isn't with the stablecoins themselves—it's with the regulations rolled out by the U.S. and Hong Kong for these digital assets.

I'll dive into the problems with these regulations by looking at the nature of money and how financial systems have evolved over time.

Asset reserve constraints

For a long time, adequate and reliable asset reserves have been considered the foundation for monetary credibility and price stability. During the gold standard era, economist Mises advocated for a 100% reserve requirement—arguing that banks should hold gold reserves equal to or exceeding the currency issued. Yet, not a single bank maintained such full or excess reserves even when the gold standard collapsed.

This is because there's a paradox in the 100% reserve system: no asset exists that is both abundant and reliable. Gold is scarce. By requiring a 100% gold reserve, the money supply becomes constrained by the limited availability of gold. As a result, it cannot keep pace with the growing needs of international trade and financial activities, which would inevitably lead to deflation.

Therefore, as the demand for payment and settlement grew, the money supply outpaced gold supply over the long term. The exchange ratio between currency and gold continued to decline, ultimately leading to their decoupling. This was one of the primary reasons for the collapse of the Bretton Woods system.

In fact, beginning in the 1960s, the US repeatedly devalued the dollar against gold. By 1971, traders were massively selling the dollar on black markets.

Could stablecoins face their own "Bretton Woods moment" in the future?

Stablecoins are required to hold 100% reserves in dollars or short-term U.S. Treasuries. If the stablecoin supply remains small, this system can be sustained but serves little purpose. If the stablecoin supply continues to expand, however, short-term Treasuries will become scarce, driving up their prices.

While the U.S. federal government could certainly increase Treasury issuance to suppress prices, the problem lies in current stablecoin regulations: these rules would reduce the utilization and liquidity of both dollars and Treasuries.

The issue is about prohibiting paying interest to stablecoin holders. This bans the development of stablecoin-based commercial banking, severely limiting stablecoins' money creation capacity. Consequently, both the money multiplier and overall liquidity would decline. If reserves of short-term U.S. Treasuries backing stablecoins grew to $10 trillion, it would mean $10 trillion in liquid assets locked away.

This system resembles the old compulsory reserve requirement regime, which was eventually replaced by voluntary reserves due to its inefficiency and tendency to increase bank risk.

If liquidity risks are on the horizon, the U.S. federal government might step in with additional regulations, imposing mandatory requirements on stablecoin asset composition. This would again trap us in the paradox described: reliable assets are naturally scarce, and mandatory requirements would undermine the reliability of the reserve assets themselves.

Therefore, a 100% reserve asset requirement, while appearing to be the safest institutional arrangement, actually conveys greater financial risk due to inefficient allocation.

Fixed price pegs

As the name suggests, stablecoins aim for price stability by pegging their value to a local currency. However, few countries or economies implement a fixed exchange rate system today.

The collapse of the Bretton Woods system in 1971 marked the end of the US dollar's fixed exchange rate with gold. Countries stopped holding gold reserves to back their currency issuance and abolished their own fixed exchange rate with gold.

The Latin American sovereign debt crisis of the 1980s ended fixed exchange rates against the US dollar for countries in that region. The 1997 Asian financial crisis then ended fixed exchange rate for Asian nations. Today, Hong Kong is the most successful economy in maintaining a fixed exchange rate.

In fact, the current stablecoin system closely resembles Hong Kong's linked exchange rate system. The Hong Kong Monetary Authority (HKMA) authorizes three banks to issue Hong Kong dollars. These banks deposit US dollar reserves with the HKMA and then issue Hong Kong dollars at the fixed rate of HK$7.80 to US$1, based on a Certificate of Indebtedness issued by the HKMA.

Maintained since 1983, Hong Kong's linked exchange rate system is a crucial institutional guarantee supporting its status as a global financial center. However, in recent years, the duration of this linked exchange rate system has attracted significant attention.

Why fixed prices or fixed exchange rates are hard to sustain?

Fixed prices are at odds with basic economic principles. It means they lose their ability to regulate supply and demand, and cannot warn about, release, or regulate risk. This was a key reason for the collapse of the Bretton Woods system.

On the surface, a 100% reserve system seems most likely to maintain fixed prices. However, full reserve systems contain inherent paradoxes that prevent them from supporting expanding money demand. Economies like Hong Kong that maintain fixed exchange rates are forced to rely on bigger reserves and more transactions to sustain the peg. This depends on the domestic economy maintaining persistent prosperity.

Hong Kong's ability to sustain its fixed exchange rate long-term stems from its economy growing faster than the US economy over the past 40 years. When an economy enters a recession-depression cycle, the fixed exchange rate will face challenges from selling pressure.

The constraint on policy autonomy

U.S. stablecoin regulatory legislation has significantly restricted the policy autonomy of stablecoins and shut the door on the emerging financial market for stablecoins. This outcome aligns with regulatory intent.

Two critical policies warrant attention:

• Fixed exchange rates
  Under Mundell's Impossible Trinity, a stablecoin's fixed exchange rate and free capital flow inherently strip issuers of policy autonomy. Both supply volume and interest rates become subservient to maintaining the fixed rate—mirroring the Hong Kong dollar under its linked exchange rate system.
  If stablecoin interest rates are much lower than dollar rates, it sets off arbitrage. A ton of capital would ditch stablecoins to chase the higher returns on dollars, which could end up rattling the fixed exchange rate.

• The prohibition on paying interest to stablecoin holders
  This restriction prevents stablecoins from establishing a legitimate banking system, drastically curtailing liquidity.
  Modern financial liquidity predominantly relies on commercial banks' deposit-lending mechanisms. By crushing the innovative potential of stablecoin-based finance, this rule reduces issuers to submissive central banks that "toe the line."
  If stablecoin holders were allowed to earn interest, a new financial market for stablecoins would emerge. This would substantially multiply stablecoin liquidity, but would also introduce significant redemption risks.

Under the Bretton Woods system, individuals couldn't redeem dollars for gold at the Federal Reserve, but member governments held that privilege.

Starting in the mid-1960s, persistent U.S. trade deficits flooded Europe with dollars. The French government, holding massive dollar reserves, then demanded gold from the Fed. This exposed the systematic flaw of rigid redemption.

Today's financial system is far more complex than that of the 1960s, with significantly greater credit creation capacity. If banks were allowed to create stablecoins, a classic bank run crisis would be inevitable.

Clearly, the rigid redemption guarantee by issuers and the credit creation process of commercial banks form an inherent contradiction—with the core problem lying in the rigid redemption itself, not the financial system's credit creation mechanisms. The statement "Prohibiting interest payments to stablecoin holders" denies the financial markets' liquidity creation function, which is misguided.

Today, no country or economy employs a rigid redemption system. Most rely on open market operations instead—including the Hong Kong Monetary Authority, which maintains the USD/HKD peg through open market operations.

How Will the Forms of Money and Banking Systems Evolve?

How will stablecoins evolve in the future?

The above analysis of stablecoin regulations does not dismiss their prospects. Rather, it aims to deduct stablecoin development through an institutional lens.

1. The introduction of stablecoin regulations officially recognizes the legitimacy of privately issued currencies.
   This stands as the most consequential aspect of these rules.
   Since the emergence of Peel's Act, privately issued currency has progressively been brought under state control. This ultimately established the central bank as the sole authority for issuing currency in the country.
   At the same time, legal tender became the only currency in circulation within the nation, with a monopoly and legal tender status.
   Many people never realized currency could be decentralized by nations until Bitcoin came along. But since its birth, the digital currency space has seen just as much theft, fraud, and chaotic oversupply as America's Gilded Age. This has left many disillusioned with digital and private currencies.
   The introduction of stablecoin legislation marks the state breaking its monopoly on currency issuance. Despite strict government regulations, private currency gaining legal status is still a historic event.

2. The introduction of stablecoin regulations signals government recognition of the legitimacy of on-chain payments infrastructure.
   The true value of Bitcoin lies in its creation of a distributed cross-border payment network. Compared to existing financial payment and settlement networks, on-chain payment networks offer greater efficiency, lower fees, and enhanced privacy features.

Of course, the laws will inevitably increase the transparency of on-chain payments and enhance regulatory oversight of on-chain assets and transactions, which to some extent will diminish the advantages of on-chain networks. But this does not negate its advantages.

In the past two years, some governments have been concerned that on-chain transactions are becoming the trend, so they have been rushing to put their currencies into the blockchain.

On one hand, the confirmed regulatory approval for stablecoins has markedly improved market sentiment. Access to the digital currency market will become smoother and broader, transaction costs will decrease, and market liquidity will increase. This will drive the expansion of the stablecoin market and push up the prices of digital assets.

On the other hand, growing demand for stablecoins will increase reserves of U.S. dollar or U.S. Treasury assets. This will attract more individual indirect investors to U.S. Treasuries, helping bolster their prices and creditworthiness while alleviating international pressure to reduce Treasury holdings.

In the long run, however, stablecoin development will be conditioned by existing rules. Stablecoins represent a compromise between state monopolies and market demand.

It resembles a technologically advanced machine running on an antiquated system—a monetary framework akin to the gold standard or Bretton Woods era.

Here are my personal views on specific regulations:

1. Mandatory full reserves
   This is acceptable. It highlights that stablecoins inherently represent an asset-backed instrument, contrasting with the debt-based nature of current credit currencies like the US dollar.
   Presently, stablecoins can only attract users through reliable asset backing; they lack the capacity for debt-based currency creation. However, in the future, the full-reserve requirement could be relaxed to allow space for such debt-based currency creation.

2. Fixed price peg
   This is acceptable. While attractive, it can easily disrupt price adjustment mechanisms. This could later be adjusted to a floating peg.

3. Rigid redemption
   This regulation should be removed. Stablecoin issuers should maintain the fixed or stable price through open market operations.

4. Prohibition on paying interest to holders
   This restriction should also be removed. Under regulatory oversight, the government should permit the development of stablecoin banks and emerging financial markets.

The current stablecoin system, no matter how it's adjusted, still can't match the dollar. Credit currencies like the US dollar remain the most advanced monetary system. Digital currencies excel in technological efficiency, while the dollar functions as a global zero-interest super bond that never needs to be repaid.

The Federal Reserve creates base money by purchasing US Treasuries in the bond market. The Fed's balance sheet holds vast quantities of US Treasury assets.

Some people believe that the US dollar is issued based on the reserve of Treasury bonds, but this misconception arises from not understanding that credit money is debt-based.

Traders who hold US dollars can't just walk up to the Federal Reserve and demand their money back with interest. Plus, the dollar's value is always shifting. Even so, traders all over the world are still eager to get their hands on it.

Credit currency depends entirely on credit. The trustworthiness of credit money hinges on the strength of the nation's sovereignty backing it. Right now, stablecoins just don't have the credibility to stack up against that kind of national authority.

In the future state-dominated era, private currencies will compete with fiat money. And digital assets bring three standout advantages to the table compared to fiat currencies:

• Built on distributed technology

• Function free from national borders and physical limitations

• Backed by a vast and reliable infrastructure

Tokenized real-world assets and metaverse-based assets could become the credit foundation for tomorrow's digital currencies.

What this world lacks is neither currencies nor ways for circulation—it's credit.