All over the world, public authorities are scrambling to address the growing adoption of crypto-assets and the use of stablecoins, whether it is by trying to suck the lifeblood out of stablecoins via proposing central bank digital currencies or via increased regulatory scrutiny. But so far, the problems that everyone is focused on are rather banal: consumer protection, various risks such as hacking, theft, liquidity, stability etc. But the elephant in the room has been completely ignored, at least to my knowledge: a profound inadequacy and incompatibility between the current monetary system based on debt and a monetary system in which stablecoins and crypto-assets become mainstream.
A few preliminary points are necessary before I go into the heart of the issues. First, it is essential to understand how our current monetary system works in order to understand why a mainstream adoption of crypto-assets and stablecoins would pose severe monetary and financial stability issues which cannot be addressed in any easy fashion. To put it in very simple terms, this is how our current debt based monetary system works:
The vast majority of the money in circulation, including the money that you see on your bank account, is someone else’s debt. In essence, for you to have that money in your bank account, someone had to go to the bank and make a loan, whether it is a private individual, a business or a government. In very simple terms, imagine an economy with only two individuals, Alice, Bob and a bank. There is no money in the economy. The bank issues a loan of 1000€ to Alice. With those 1000€, Alice can hire Bob to mount a greenhouse and plant tomatoes. Now Alice has a 1000€ debt and Bob has 1000€ on his bank account. Alice’s debt maturity is 10 months, with 100€ instalments at 0% interest rate. In order for her to be able to repay that debt, she needs to sell 100€ worth of tomatoes to Bob every month. If Bob does not spend those 1000€, then Alice will inevitably default on her debt. Therefore, it is vital that Bob spends his money.
This is why consumer spending is absolutely critical in a debt based monetary economy, because if people spend less, then inevitably, non-performing loans (or NPLs) will rise, unless governments or other entities step in to fill in the “gap” in spending.
Also worth noting from this example, what really drives the rhythm of an economy is not demand for goods and services but demand for money. The only thing that is constant is the reimbursement of the instalments of a loan. All the rest can fluctuate. People can compress plenty of expenditures, from food to clothing, but they cannot compress or delay the reimbursement of their loan (except in very rare cases, such as with the coronavirus deferred payments plans).
Finally, the whole stability of the system relies on the fact that most loans create more value in terms of goods/services or in other words, that money creation serves a productive purpose. In the example above, the 1000€ loan allowed to create 1000€ equivalent in tomatoes available on the market to buy. Debt was used to create value, to transform reality (like the raw materials of the earth) into something that other people would want to buy. The whole stability of the financial system relies on the balance between the monetary mass (or the amount of debt money created) and the amount of goods/services available to buy. If these two do not fluctuate more or less in sync, then there is a clear danger of inflation or even hyperinflation.
So how does all of this tie into the emergence of crypto-assets and stablecoins?
Let’s start with examining the emergence of crypto-assets. Imagine if tomorrow, more and more countries (following in the footsteps of El Salvador) allow for the adoption of Bitcoin as an official currency, and even extending that to many other crypto-assets. What would be the impact on the economy?
For some countries, which may suffer from having a weak currency and being dependent on the cartel of strong currencies (dollar, euro, yen, yuan, Swiss franc, English pound), then it might be positive, as it can provide for an influx of fresh money and capital to revive the economy. Besides inflation (too much money in circulation compared to available goods/services), deflation is just as bad. And in many countries, there is sometimes too little money in circulation compared to the real needs of the economy. For instance, in countries where the interest rate is very high, there is too little “fresh” new money created, and that stifles the economic growth of a developing country. Thus a fresh influx of “new” money can have a positive effect. But imagine if Bitcoin and other crypto-assets like Ethereum would be adopted worldwide? How would that interplay with the current debt based monetary systems?
To put it bluntly, it would equate to an instant multiplication of the monetary mass. How so? Again, here is a simple example:
Imagine if you have a printer at home and you print a piece of paper which says “100€” on it. Then you manage to convince a friend to trade a “real” 100€ bill for that piece of paper, saying it’s also worth 100€. After that trade, you have 100€ and your friend has your piece of paper which says “100€” on it. The next day, if you go to the store and buy stuff with your newly acquired 100€ bill, and your friend goes to a shop and also buys something with that piece of paper, the monetary mass has just been increased by 100€. In other words, there are two main types of assets in this world: money and goods/services. If goods and services can be used as if they are money or money equivalents, that completely messes up financial stability. When you buy a car, for instance, in order to buy something else, you need to first sell your car against money, and then buy something else. But in the case of crypto-assets, if they become legal tender, then you don’t need to sell your crypto-asset for money in order to buy stuff.
In other words, if tomorrow all countries decide to allow all crypto-assets as legal tender, it would mean that the monetary mass would increase instantly by about 3 trillion dollars.
And this is just the tip of the iceberg. In essence, the monetary mass would fluctuate depending on the perceived value of crypto-assets, so it could also mushroom way beyond 3 trillion, or instantly shrink in case of a crash. The current monetary and financial system is simply not at all designed to weather such fluctuations. On the contrary, stability rests on the nice and steady growth of monetary mass and economic growth, in similar proportions.
Stablecoins present similar challenges to crypto-assets: they also skew the way money circulates in the economy and affect the monetary mass. There are many types of stablecoins, but in this case, I will focus on those who are pegged to a specific currency like the euro or the dollar: Tether, USDC, True USD etc. In these cases, a third party company takes your currency and issues the equivalent in virtual currency issued on the blockchain. In the case of Tether, for instance, it is a stablecoin issued on the Ethereum blockchain as an ERC-20 token.
Again, what is important, is what is being done with your money, and how this changes the way money flows through the economy. In the case of Tether, there has been a lot of controversy about the way they handle the stability of the virtual dollar they create, as they do not hold the equivalent of the virtual dollars they emit in cash or cash equivalents. In essence, if they took your 100$ bill, stashed it under a mattress, and issued a 100$ virtual equivalent, that wouldn’t pose any problems (actually, if they had to hold your money in cash, it would create a very big problem, since there isn’t nearly enough physical cash in circulation, but that’s another question altogether). But what they do, is use your dollars to buy various assets which they consider or claim to be equivalent to cash. Some speculate that Tether actually invests in bonds and various other investments (such as the Chinese real estate bond market). In that case, again, it completely skews the way money circulates in the economy. This is the way I interpret it, if I were to compare it to existing assets:
Imagine if you bought an ETF which would claim to emulate the value of the euro. When you buy such as ETF, normally, you cannot use it to buy your groceries. In the case of stablecoins, if they become a valid means of payment, then it would be as if you could pay your groceries with your ETF.
But imagine if on top of that, the people managing the ETF invest your euros in various financial products, bonds etc. Then, again, the money circulates twice in the economy: once when you buy groceries with your stablecoin/ETF, and another time when it is used to be invested in bonds or other financial instruments.
Stablecoins pose some obvious financial stability risks, if it becomes public knowledge that the value of the assets a stablecoin issuer holds is clearly inferior to the amount of stablecoins issued. But it also poses problems with regards to how money flows through the economy and monetary creation, as I explained above.
Central bank digital currencies
The emergence of CBDCs is rather incomprehensible for several reasons:
Their “added value” compared to stablecoins is questionable: even if there are disadvantages and risks with privately issued stablecoins like Tether, the advantages are immense. First, anyone can open a stablecoin account, since many stablecoins are issued on a public blockchain (such as Ethereum). This means that you can send a payment to literally everyone across the entire world. You want to pay in dollars or euro in a third world country which has an unstable national currency (think Lebanon, Turkey, Venezuela and more)? No problem! Any merchant just needs to have a smartphone, download an app like Argent (https://www.argent.xyz/), and you can pay them via QR code in a matter of minutes (waiting for the confirmation of the transaction) and soon, seconds (once Ethereum 2.0 becomes fully operational). At that point, why bother travelling with cash? Why bother converting your currency to the national currency? All of the current exchange services would become obsolete, especially if all national currencies are converted, by private third parties, into a stablecoin issued on a public blockchain. In that case, anyone could convert any currency into any other currency inside an app like Argent. CBDCs, on the other hand, would likely be subject to many restrictions, attempts at control, limitations etc. You would probably not be able to send CBDCs issued by the European Central Bank to Venezuela or Lebanon, to a person there, as a remittance service, or as a payment, or for any other reason. You would also most probably have to go through KYC/AML verifications to open a CBDC account, contrary to stablecoins issued on public blockchains, which only require you to download an app, freely available on the Internet.
Their very existence presents a threat to private banks. In essence, paying with a CBDC wouldn’t be more or less convenient than paying with your banks’ card or sending money via your banking app. But the liability associated with your CBDC would be completely different. Whereas the money on your bank account is debt money, and is therefore subject to counterparty risk, cash or CBDCs are not subject to such a counterparty risk. The money available on peoples bank accounts is a liability that the bank holds, and which has to be balanced by an asset of equivalent value such as the value of the loans they have sold, bonds, cash or other equivalent assets. This means that should a bank’s assets be wiped out, the money on people’s bank accounts would be under severe risk. Only cash is a liability only to the Central Bank, and is an asset which has no other counterparty risk. When a bank holds your money in their bank account, they cannot lend it or invest it on your behalf if you do not agree to it. And once you have invested your money, it is no longer available to you.
Central bank digital currencies could affect monetary policy and money supply. Since it would be much less risky for a person to hold CBDC, as it would be as “risk free” as cash, there would be little sense for anyone to still want to have a bank account. The only alternative would be for banks to propose a CBDC account, and citizens not being able to open an account with the central bank directly. However, in that situation, all money on individual’s bank accounts would be equivalent to cash, and we would move to a “full reserve” monetary system. This would greatly affect the money creation/destruction cycle through debt. The current system’s stability rests on the seamless and continuous creation and destruction of money. If consumption goes down, then defaults will inevitably rise.
With a move to “hard” currency, it is unclear how money will be created/destroyed. How would CBDCs be issued? If the central bank converts a person’s 1000€ to CBDC, would the central bank then hold the original 1000€ (as debt money)? But that poses a great many questions in terms of monetary policy and money creation: if they are issued by sending money from your bank account to the central bank, then would your central bank also take on the counterparty risk associated to the debt money you have sent it? How would this conversion work? Would the 1000€ in CBDC also be destroyed if money is repaid in this currency rather than in a regular bank’s currency?
In any case, CBDCs would put a tremendous amount of pressure on the financial system since no one would see a reason to hold “bank money”, which has many risks associated to it, if there is a digital alternative which can function in the same way. The central banks have tentatively tried to solve this by putting “caps” on how much CBDC an individual could own (for instance, a maximum of 3000€, and introducing negative interest rates if you hold more). But these caps would defy the purpose of a CBDC, and would make it a less attractive alternative to private digital currencies (such as stablecoins).
A way forward
In my opinion, there is no way we can put the stablecoins and crypto-assets toothpaste back into the tube, and any and all regulatory attempts at stifling this emergence would simply favor the emergence and adoption, by the wider public, of decentralized alternatives, such as using DAI (a stablecoin issued via an open source protocol running on the Ethereum blockchain, and impossible to “stop” or regulate).
The only solution, in my mind, is to completely rethink our current monetary system to enable it to stomach the emergence of crypto-assets and stablecoins. It would be too long to explain in details how this should be done, but here are some pointers:
The main problem is price stability. Right now, existing national currencies, especially the strong currencies mentioned above, are used to measure the value of all existing goods/services, including crypto-assets. The value of Bitcoin is still measured in euro or in dollars. If the euro or the dollar’s value starts to fluctuate due to hyperinflation, that would completely collapse the financial system, because in order for economic exchanges to happen, you need a stable frame of reference, a “stable measuring stick” on the basis of which you can transact. If the dollar and the euro’s value would fluctuate widely, then how would you measure the value of Bitcoin? In the number of loafs of bread you can buy with it?
One emerging alternative, which I see as transitory, is to use hard assets like gold and silver as a temporary trading pair to assess the value of crypto-assets, and which is why many countries are stocking up on gold (Russia, China) to hedge against the combined threat of the emergence of crypto-assets and the devaluation of many currencies via inflation. Since gold is rather rare, and only 2% extra gold is mined per year (give or take), it does represent a form of stable and neutral measuring stick. But that would also mean that growth would be capped to 2% or you would have distortions in the form of inflation/deflation. The whole purpose of a debt based system is that money supply could fluctuate to accommodate to the rate of growth, by emitting more or less debt to match growth potential.
The more viable solution would be to convert all existing money in the economy into a “hard” currency based on the Relative Theory of Money (https://en.trm.creationmonetaire.info/). In my view, this is the only monetary theory which would enable the current financial system to stomach the emergence of crypto-assets, without creating deep distortions.
If you want to learn more about how this transition could take place, and put the emergence of crypto-assets and the current strains experienced by the financial system into a broader perspective, then feel free to read a paper I have written on this, which explores these questions into much more detail: https://www.academia.edu/44084783/Mirroring_biology