If stablecoins are money, they should be backed by reserves

The growth of stablecoins could reduce the supply of safe collateral available to markets

Stablecoins are sometimes dismissed as the poor relations of the cryptocurrency family. While free-floating cryptocurrencies such as bitcoin and ethereum have soared in value, stablecoins are more like government money market funds that are anchored to a par value.

This is by design. Stablecoins are designed to be a medium of exchange, rather than a speculative asset, and are typically pegged to an established currency. But, despite their promise of stability, they may pose a bigger challenge for policymakers than their freewheeling crypto-cousins.

The market for stablecoins backed by high-quality liquid assets is expected to quadruple again this year – from about $30 billion at present. To maintain a stable value, US dollar stablecoins must be backed with a riskless asset, such as short-term US Treasury obligations. This introduces into the economy a privately established dollar-denominated currency that is not backed by reserves at the US Federal Reserve. Their appearance on the scene requires a rethink of the basics of monetary policy – a rethink so fundamental that it is useful to go back to the foundations of monetary policy, and rework from there.

The traditional understanding of monetary policy is based on the idea that the money supply is influenced by the Fed’s open market operations. Most money is bank account money – deposits at banks – after all. As taught in every undergraduate economics course, because the Fed requires that deposits be partially backed by central bank reserves, the money supply is a multiple of those reserves. So, when the Fed carries out open market operations, trading its reserves for Treasuries, it changes the amount of reserves available to banks and thus alters the money supply.

In this model, US Treasury bonds, while safe and interest-bearing, cannot be used to back bank accounts. The emergence of stablecoins changes that fundamental dynamic. The money supply no longer needs to be backed by reserves only – Treasuries work just as well. As a result, the central bank’s ability to influence the money supply through open market operations will be reduced as stablecoins become important.

A question of liquidity

Reserves will continue to be in demand in the banking system. The crucial difference between reserves and safe collateral such as US Treasuries is not their safety (both are safe) but their liquidity. For some purposes – specifically, the instantaneous transmission of money over large value payments systems –reserves are useful, and Treasuries are not. This is directly of concern to banks only, since they are the only ones with access to those systems. (Banks must also hold a certain amount of reserves to satisfy regulatory requirements and supervisory expectations.) However, this need for reserves does potentially have knock-on effects, as the bank must be able to provide payment services to any customer with a demand deposit. To the extent that the rest of the economy depends on banks to make payments for them, the banking system will need reserve balances.

To maintain a stable value, US dollar stablecoins must be backed with a riskless asset, such as short-term US Treasury obligations

But, if the stablecoin business grows sizably, the demand for Treasuries will grow as well. The Fed has no means of directly meeting this demand through standard monetary policy. Additional government borrowing will increase the supply of Treasuries, but an alternative would be to allow – or even encourage – stablecoin issuers to use reserves as backing rather than Treasuries. To do so, the Fed could in effect turn the stablecoin issuers into banks and allow them to have reserve accounts. Stablecoin issuers would be likely to favour direct access to reserves through Fed master account and access to central bank payment rails, as this would be less expensive than siloing caches of Treasuries or obtaining reserves through a correspondent bank.

Giving stablecoin issuers access to the payments system could be beneficial in another way, too. Treasuries are in demand as collateral for a variety of purposes, not just for backing stablecoins. In the Covid-era, continuing quantitative easing by central banks around the world will reduce the supply of safe collateral, such US Treasuries, German bunds, or Japanese government bonds available to the markets. To the extent that there is a shortage of Treasuries, allowing stablecoin issuers access to reserves would relieve the problem, and give policymakers greater control over the money supply.¹ It has the added advantage of allowing a more flexible adjustment in the amount of backing the stablecoin issuers have, should circumstances warrant. After all, the need for flexibility in the supply of money was one of the original justifications for the creation of the Federal Reserve.

The views expressed are those of the authors and should not be attributed to the IMF, its executive board, or its management.

Charles Kahn is professor emeritus, University of Illinois. Manmohan Singh is the author of Collateral Markets and Financial Plumbing, and a senior economist at the IMF

¹ For this the effective supply of Treasuries is a relevant metric as it encompasses both nominal supply and reuse of Treasuries (Singh 2011, IMF paper 256; Infante and Saravay, 2020, Fed Reserve paper 103).