What makes a bank, a bank? Is it deposit-taking, credit operations, or payment facilitation? While these are all important components of traditional banking, they are just parts of a bank's master function: money creation. At its core, banking is about increasing the money supply. It's a misconception to view banks as mere intermediaries for the flow of money in the economy. Rather, banks actively participate in and drive the creation of new money.
When we think of money creation, we often imagine coins being minted or bills being printed, but these physical forms of currency represent only a small fraction of the overall money supply. In reality, the majority of money is created through the operations of private commercial banks.
When Bob deposits a lone US$1 bill in a bank, the bank can use that deposit to make loans and earn interest. Let's say that the bank uses the US$1 deposit to make a loan to Alice, who wants to buy a widget. Alice uses the US$1 loan to purchase the widget from a store, which in turn deposits the money in their own bank account. The total amount of money in circulation now is US$2. And yet, there was only a lone US$1 bill in this whole process, without the central bank having to print another bill to increase the money supply to US$2.
This is the miracle of the money multiplier. Not so different from the biblical multiplication of bread, right?
Of course, in reality, banks are subject to reserve requirements that limit the amount of loans they can make relative to their deposits. If the reserve requirement is 10%, the bank can only lend out 90 cents for every US$1 deposited. Nevertheless, this example helps to illustrate the basic principles of how money can be created through lending and deposit-taking activities, and how the banking system can expand the money supply beyond the amount of physical currency in circulation.
And so, we turn our attention to stablecoins and their issuers.
A stablecoin is a type of cryptocurrency that is designed to maintain a stable value relative to a pegged fiat currency, typically at a 1:1 ratio. For example, a stablecoin that is pegged to the US dollar at a 1:1 ratio means that each stablecoin will always be worth one US dollar. So if someone purchases 100 stablecoins, they will have the equivalent value of US$100. The goal is to create a substitute instrument that can function like fiat, but without being subject to the same restrictions and limitations as fiat. This allows stablecoins to offer advantages such as fast, cheap, and borderless transactions, while also reducing volatility and other risks associated with traditional cryptocurrencies.
How does a stablecoin actually achieve this peg?
When a stablecoin issuer sells 1 stablecoin to a purchaser in exchange for US$1, they make a contractual promise to pay the holder the value represented by the stablecoin. This guarantee is based on the promise of the stablecoin issuer that such coin is "backed by fiat". Being backed by fiat does not mean that there is a literal vault in the office of the stablecoin issuer where physical currency is kept as reserves. Being backed by fiat does not mean that you can go any time to the stablecoin issuer to convert your 1 stablecoin to US$1 kept in that vault. In reality, being backed by fiat means that the stablecoin issuer has legally promised to pay the holder the value of US$1, and should the issuer default on that promise, the stablecoin holder has a claim against the issuer's pool of assets. In short, the stablecoin is a debt instrument that creates a legal claim by the stablecoin holder against the balance sheet of the issuer. The stablecoin holder has a receivable of US$1, while the stablecoin issuer has a payable of US$1.
After the stablecoin issuer receives the US$1 fiat from the purchaser, they typically deposit it in a traditional bank as part of their reserves. This deposit creates another debt instrument, in the form of a bank deposit. The bank deposit is an asset on the part of the issuer and a liability on the part of the bank. This effectively makes the stablecoin issuer a creditor to the bank, as they are extending credit to the bank in the form of a bank deposit. The stablecoin issuer has a receivable of US$1, while the bank has a payable of US$1.
This brings us to an interesting point: stablecoin issuers are effectively engaged in something akin to deposit-taking, lending, and fractional reserve banking. By taking in debt instruments from the public (as a borrower) and extending credit to banks (as a lender), stablecoin issuers are essentially acting as commercial banks.
The stablecoin issuer could also hold its reserves in the form of other low-risk asset classes, such as money market instruments. But the same logic applies as traditional bank deposits. By holding money market instruments, such as treasury notes or treasury bills, the stablecoin issuer is effectively functioning as a lender to the issuer of these instruments.
If we go back to our earlier discussion on the mechanics of money creation, we can see that the issuance of stablecoins also creates new money in the economy. The issuer sells the stablecoin to the purchaser for US$1 fiat paid by the stablecoin purchaser, creating a liability of US$1 on the part of the issuer. The issuer, in turn, deposits US$1 in the bank, which can be further used by the bank to extend loans. This brings the money supply originally from US$ 1 to US$ 2. It's the same money multiplier effect we have seen in the Alice-and-Bob example.
Take note that we have not even talked about the stablecoin unit per se as a fiat substitute. If you count the stablecoin unit as part of money supply (it's a medium of exchange, a storage of value, and a unit of account), then the increase in money supply in this example would effectively be US$3.
While stablecoin issuers engage in activities that resemble those of commercial banks, they are not subject to the same regulatory framework as traditional banks. Stablecoin issuers do not hold banking licenses and are not subject to the same capital adequacy and liquidity requirements as commercial banks. Additionally, stablecoins are not necessarily backed by fiat currency reserves and may instead be collateralized by other assets, such as cryptocurrencies or securities. This can introduce additional risks and uncertainties for stablecoin holders.
The word "stable" in stablecoin does not necessarily mean "safe". While they may be marketed as "stable", the truth is that these crypto-assets are only stable to the extent that the issuer has promised to pay the face value of the coin equivalent to the peg and to the extent that the said issuer is able to fulfill its legal obligations. In the event that the issuer faces financial difficulties or bankruptcy, the holder of a stablecoin may only be able to recover their value to the extent that any normal creditor can recover against any other normal debtor. This means that the holder of a stablecoin is subject to enforcement costs, as well as default, bankruptcy, insolvency and liquidation risks. The holder may not be able to recover the face value of the stablecoin in full.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
