[Insight & Opinion] Doubts Raised by Stablecoins

Kim Kyung-soo, Professor Emeritus at Sungkyunkwan University

The money we need to repay by the due date is prepared in the form of a reliable store of value, such as deposits, that is, safe assets. Safe assets are mostly used as means of settlement in transactions. Moreover, in the modern financial system where wholesale finance targeting financial companies, governments, and large corporations is dominant, safe assets are also used as collateral, serving as a cornerstone.

To be considered a safe asset, there must be no doubt about its face value, but surprisingly, there are not many types. Government bonds are representative safe assets because they are debts of governments with taxing authority. Cash is also a safe asset but has the weakness of being difficult to store and cannot be reused as collateral in repurchase agreements.

Although not as good as government bonds, bank deposits are also safe assets. Due to the nature of banking, which raises short-term deposits and operates long-term, there is maturity mismatch and credit risk, but strict regulations on asset management, protection by the central bank as the lender of last resort, and deposit insurance systems provide safety.

The global financial crisis fundamentally stemmed from a shortage of safe assets. The increased liquidity (credit) during the great easing period raised the demand for safe assets, but their supply was insufficient. Emerging countries, including China, accumulated US Treasury bonds as foreign exchange reserves.

At that time, when safe assets were lacking, the private sector manufactured alternatives. These were collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs) based on mortgage-backed securities and asset-backed securities. The global financial crisis occurred when investors’ doubts about these AAA-rated securities triggered a sell-off.

Stablecoins are the safe assets in the cryptocurrency world. They emerged because the high price volatility of cryptocurrencies made it difficult to perform transaction and store-of-value functions. According to The Economist, the market value of coins reaches $170 billion.

Stablecoins are like bank deposits. Just as banks prepare for deposit withdrawals, the issuers of coins also prepare for redemptions, mainly in two ways. One is that the issuer holds highly liquid and highly creditworthy assets like a bank. However, stablecoins do not have public protection mechanisms like bank deposits. Instead, they sometimes issue regular audit reports for transparency.

The other method is to automatically adjust the supply and demand of coins based on algorithms. In this case, another coin supports the stablecoin; examples include the delisted Terra and Luna. The reason for the collapse of these coins can be found in the nature of cryptocurrency value.

Cryptocurrency value comes from digital technology that enables regulatory arbitrage. Banking, which only authorized parties can conduct, has artificial entry barriers. These barriers allow banks to establish monopolistic systems and engage in rent-seeking behaviors. High cross-border remittance fees are one example. However, cryptocurrencies can be freely sent and received anytime and anywhere once connected to the internet, making them a useful means to evade economic regulations.

On the other hand, banks are subject to strict regulations by supervisory authorities to maintain credibility. This sound regulation and institutional support, which do not exist for cryptocurrencies, build trust in bank deposits as safe assets.

When liquidity overflowed under ultra-low interest rates, no one doubted safe assets, and cryptocurrencies soared. However, the excessive liquidity created conditions that bred future financial instability. Despite high inflationary pressures, the Federal Reserve’s delayed response signaled a sharp interest rate hike, causing safe assets to be doubted again. This time, the suspicion began with algorithm-based stablecoins.