Discussion Post: Taming Wildcat Stablecoins

CTA:In these threads, we attempt to further the discussion of a key problem in this category and evolve our understanding of the domain space where research work has not yet answered the specific problem or question being considered. These posts are living documents, and it is our hope that the community will continue to contribute to their structure and content.

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Background

  • Stablecoins: “are a digital form of privately produced money where each coin is supposed to be backed one-for-one with ‘safe’ assets. ‘Depositors’ buy stablecoins and, for each dollar deposited with the issuer, they receive that number of stablecoins in exchange.” (Gorton & Zhang, 2021)
  • Important properties of money: “the three most commonly stated ones being a store of value, a unit of account, and a medium of exchange.” (Mankiw, 1997; Desan, 2014)
  • The no-questions-asked (“NQA”) principle: “requires the money be accepted at par in a transaction without due diligence on its value.” (Holmström, 2015)
  • Convenience yield: “A convenience yield is the benefit or premium associated with holding an underlying product or physical good, rather than the associated derivative security or contract.” (Smith, 2021)
  • Bank run: “A bank run occurs when many customers withdraw all their money simultaneously from their deposit accounts with a banking institution for fear that the institution is, or might become, insolvent.” (CFI, n.d.)
  • Demand deposit: “A demand deposit account (DDA) is a bank account from which deposited funds can be withdrawn at any time, without advance notice.” (Chen, 2021)
  • Saving deposit: “A savings account is an interest-bearing deposit account held at a bank or other financial institution.” (Kagan, 2021)
  • Free Banking Era in the United States:“The closest analogy to stablecoins is found in the Free Banking Era, when entry into banking was relatively easy and banks could issue their own banknotes. Starting in 1837, some states changed the way that bank charters were granted. These states allowed free banking—that is, anyone could open a bank. However, there were rules. Banks had to back their note issuance one-for-one with state bonds that were deposited with the state treasurers (the banks received the coupons from these bonds). Each state specified the exact bonds that were eligible to back notes. But, the private bank notes, whether issued by chartered banks or free banks, did not trade at par away from the issuing bank. The market was an ‘efficient market’ in the sense of financial economics, but varying discounts made actual transactions (and legal contracting) very difficult. It was not economically efficient.” (Gorton & Zhang, 2021)
  • National Banking Era in the United States: “The National Bank Act was passed in 1863, establishing national banks in the United States. These banks could issue national bank notes, but they had to be backed with U.S. Treasury bonds deposited with the U.S. Treasury. Subsequent legislation imposed a prohibitively high tax on bank notes other than national bank notes. In other words, the era of privately issued bank notes was over. For the first time in U.S. history, there was a uniform currency that satisfied the NQA principle.” (Gorton & Zhang, 2021)
  • Section 2(c) of the Bank Holding Company Act of 1956: defines a bank as any institution “which (1) accepts deposits that the depositor has a legal right to withdraw on demand, and (2) engages in the business of making commercial loans.” (Gorton & Zhang, 2021)
  • Legal Tender Act in 1862: "authorized the creation of paper money not redeemable in specie (‘greenbacks’). " (Gorton & Zhang, 2021)
  • Section 21 of the Glass-Steagall Act: “prohibited entities [that were] not banks from taking deposits. Section 21(a) of the Glass-Steagall Act is still on the books today.” (Gorton & Zhang, 2021)
  • Title VIII of the Dodd-Frank Act: “In Title I of the Dodd-Frank Act, Congress created the Financial Stability Oversight Council (‘FSOC’) to combat the risk of systemic nonbank financial companies…The FSOC could designate stablecoin issuance as a systemic payment activity under Title VIII of the Dodd-Frank Act. The statute states: The purpose of this subchapter is to mitigate systemic risk in the financial system and promote financial stability by— (1) authorizing the Board of Governors to promote uniform standards for the— (A) management of risks by systemically important financial market utilities; and (B) conduct of systemically important payment, clearing, and settlement activities by financial institutions; (2) providing the Board of Governors an enhanced role in the supervision of risk management standards for systemically important financial market utilities; (3) strengthening the liquidity of systemically important financial market utilities; and (4) providing the Board of Governors an enhanced role in the supervision of risk management standards for systemically important payment, clearing, and settlement activities by financial institutions.” (Gorton & Zhang, 2021)
  • 12 C.F.R. § 5.20(e) by Office of the Comptroller of the Currency (“OCC”): “In 2003, the OCC promulgated a rule that set forth its authority to grant a bank charter to any entity engaged in at least one of the three core banking functions: receiving deposits, paying checks, or lending money.” (Gorton & Zhang, 2021)
  • The Federal Deposit Insurance Corporation (FDIC): “The Federal Deposit Insurance Corporation (FDIC) is an independent federal agency insuring deposits in U.S. banks and thrifts in the event of bank failures. The FDIC was created in 1933 to maintain public confidence and encourage stability in the financial system through the promotion of sound banking practices.” (Gorton & Zhang, 2021)
  • Money market funds: “A money market fund is a mutual fund that invests solely in cash and cash equivalent securities, which are also called money market instruments. These vehicles are very liquid short-term investments with high credit quality.” (Gorton & Zhang, 2021)
  • Systemic risk: “Systemic risk is the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy.” (Gorton & Zhang, 2021)

Key Problem / Topic Area

  • Are stablecoins issuers violating laws that regulate banks or currencies issuing such as the National Bank Act of 1863?
  • How do policy makers address the systemic risks created by stablecoins?
  • What is the best design for central bank digital currencies (CBDCs)?

Specific Question or Problem Statement

  • Are Stablecoins “Money”?
  • Are Stablecoins “Demand Deposits”?
  • Are Stablecoin Issuers legally “Banks”?
  • Could a stablecoin issuer become a bank in practice?
  • Should the sovereign have a monopoly on money issuance?
  • What is the best design for central bank digital currencies?
    Gorton & Zhang’s this article points out that there are two ways to design central bank digital currencies:(1) as a digital currency token and (2) in the form of a deposit account with the central bank. (2021) Which one is better? Or is there any choice better than these?

Approach / Methodology

  • In order to understand the legal framework governing stablecoins, Gorton & Zhang’s article makes a historical review of money market funds, which were deemed not to be deposit-taking institutions. (2021)
  • In order to propose how stablecoin issuers could be regulated, Gorton & Zhang’s article goes back further in time to the 19th Century and describes the Free Banking Era, the consequences of porous regulation, and the eventual demise of the system via the National Bank Act. (2021)

Conclusions / Key Takeaways

  • Gorton & Zhang’s article argues that for a stablecoin to be “Money” in addition to being a store of value, a unit of account, and a medium of exchange, a stablecoin must also satisfy the requirements of the NQA principle. Currently, stablecoins can’t satisfy the NQA principle. Thus, stablecoins are not money. (Gorton & Zhang, 2021)
  • Gorton & Zhang’s article argues that because holders of stablecoins are not the owners of the stablecoin issuer, many stablecoins could be considered deposits. Thus, stablecoin holders are essentially creditors of their own depositories. However, some stablecoin issuers like Tether could be treated like money market funds because their contractual relationship with stablecoin holders is equity, instead of debt. If the redemption process for stablecoins were unencumbered, then that would mean stablecoin issuers were accepting demand deposits. (Gorton & Zhang, 2021)
  • Gorton & Zhang’s article argues that stablecoin issuers are not “Banks”. According to the Competitive Equality Banking Act of 1987, an institution is considered a bank for the purposes of the Bank Holding Company Act if it is either (1) an FDIC-insured institution or (2) an institution that accepts demand deposits and makes commercial loans. Stablecoin issuers are not FDIC-insured institutions. Given the narrow scope of the term “commercial loan” applied by the Supreme Court’s decision in FRS vs. Dimension Financial Corp. (474 U.S. 361), stablecoin issuers would not be considered to provide commercial loans. Thus, stablecoin issuers would not be considered banks under the Bank Holding Company Act. (Gorton & Zhang, 2021)
  • Gorton & Zhang’s article argues that a stablecoin issuer cannot be a bank in practice. Reserve Banks can decide which institutions receive master accounts regardless of whether the institution has a charter from the OCC or from a state like Wyoming or Nebraska. Thus, in a practical sense, stablecoin issuers cannot become banks simply by receiving a charter from the OCC or from a state banking authority. (Gorton & Zhang, 2021)

CTA: Future Work / RFP

Following Nobel laureate Paul Krugman’s tweet “This, by Gorton and Zhang, is very good: stablecoins are just a modern version of free banking, in which private banks issued their own notes supposedly backed by specie. That system was crisis-ridden, and the same will be true no.”

  • As the SEC Chair Gary Gensler said, “We already have an existing stablecoin market worth $113 billion.” (Gensler, 2021) Do stablecoins constitute a revival of the free banking era? Is that really a problem? If so, how can we manage it?
  • Is there any way to encourage the global wild stablecoins to fit into the NQA principle legal frameworks?

In order to facilitate the fine development of stablecoins, it is important for those who are expecting its future to think about these questions.

  • Gorton & Zhang’s article points out that “there are three main takeaways from our historical experience. First, the use of private bank notes was a failure because they did not satisfy the NQA principle. Second, the U.S. government took control of the monetary system under the National Bank Act. Third, runs on demand deposits only ended with deposit insurance in 1934. In this context, the researchers suggest that the government has a couple of options: (1) transform stablecoins into the equivalent of public money by (a) requiring stablecoins to be issued through FDICinsured banks or (b) requiring stablecoins to be backed one-for-one with Treasuries or reserves at the central bank; or (2) introduce a central bank digital currency and tax private stablecoins out of existence.” (Gorton & Zhang, 2021)
  • Gorton & Zhang’s article is in favor of the design that a central bank digital currency would be issued as a digital currency token. It allows the central bank to avoid the operational tasks of opening accounts and administering payments for users, as private sector intermediaries would continue to perform retail payment services. It can also avoid the consequence of designing central bank digital currencies in the form of a deposit account with the central bank that the Federal Reserve would be engaging in fiscal policy with all the political ramifications that would entail and jeopardize its independence. (Gorton & Zhang, 2021)
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Why does the researcher suggest the government transform stablecoins into money? Is it necessary to do so to meet the NQA?

It’s also curious to me why the government should be playing a role in enforcing the nature of stable coins at all. How does he or she justify the government’s role?

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I think the researchers mean that if stablecoins can’t satisfy NQA, then it can’t be deemed as money. Being money may result in many concerning regulations. On the other hand, stablecoins are issued by private sectors, they are not backed by the national treasury, so traders who use particular stablecoin may need to take another step to check if that stablecoin is well back so that their interests could be safe. This additional step will produce a lot of costs in an entire society. Maybe these are why the researchers regard NQA matter in the discussion of stablecoin’s nature.

The researchers suggest the government issue digital fiat currencies which money backed up by the national treasury, so-called CBDC, that are issued by central banks and are different from stablecoins which are issued by private sectors. I think some fiat currencies may not satisfy NQA because their countries are in huge debt or at war what will diminish their back, and people still need to check their value. So I think fiat currencies or CBDC might not definitely satisfy NQA.

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George Selgin from the CATO Institute argues that the comparison with the US’s wildcat banking years is flawed — it had nothing to do with consumers. “If it had,” he said, “there’d be no need for a punitive 10 percent tax to force state banks to quit issuing their own notes.” (from Sebastian Sinclair at CoinDesk). Who would really be benefiting from forcing stablecoins to adhere to NQA standards?

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It reminds me of a mystery story I have heard about Die Rothschild Familie. Though I’m not sure if it is true and if this topic has anything to do with them. On the other hand, I believe levying on issuing notes would be beneficial to the government. Think about the battle of currencies between countries can tell.

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Yeah, I agree it is undeniable that the United States has benefited from a strong currency (especially now), I think the quotation above is aimed more at the idea that the federal government is benefiting at the expense of the people it serves… which is a constant struggle in American history (states rights vs. federal). It’ll be very interesting to see what happens with El Salvador and to see who comes out ahead.

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Recently, SEC’s Chairman Gary Gensler mentioned the wildcat banking era of 1837-63 in the U.S. when he talked about cryptocurrencies (Kiernan, SEC’s Gensler doesn’t see cryptocurrencies lasting long, Wall Street Journal, 2021). It looks like that the regulation on cryptocurrencies will become harsh.

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Coming to this subject as a naive reader, I have to ask why anyone would issue a private Stablecoin in the first place. Unless you’re trying to profit disreputably by facilitating money laundering or otherwise acting as a “shadow banking system,” what could be the source of the utility?

What Gorton and Zhang say is: “Stablecoins are a new form of private money that can add value in cross-border transactions for firms and banks.” I.e., Stablecoins can serve as a common denominator for countries using different currencies.

This seems a modest but valid role for Stablecoins. It does NOT require them to “be like money” or to satisfy the NQA principle across an entire society.

At the other extreme, we have 1) Facebook—a company that has always shown the naked ambition to become or replace society—deciding to conduct its business within an FDIC-insured bank and thus make its Diem coin ultimately indistinguishable from the US dollar…

Or 2) the issuer of another prominent Stablecoin, Tether, found to be less than honest about the backing of their virtual currency, with the apparent motive NOT of “adding honest value” to a transaction but playing digital three-card-Monty and moving “the value” around so quickly that no consumer can say for sure where it really is at any given moment.

I agree that the interests of the Feds may at times be in conflict with the interests of the States, but if the sovereign can’t dictate the terms of the money supply, there’s no basis for being the sovereign.

So my naive question is: Beyond the function of “adding value in cross-border transactions,” what is the utility of issuing and using Stablecoins in the first place?

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The easiest answer to this question that is a “legitimate” usage would be to facilitate wholesale purchasing giving “club” members the power to purchase things wholesale while building the organization’s buying power without directly making purchases at any given time. Effectively, creating a private stable coin amounts to a “treasury” that the community or organization can decide how they want to allocate the funds. Some use the pool as a means to provide liquidity to the stablecoin, while others use the funds to facilitate businesses operating by covering the costs and then reimbursing the pool with the profits from the business.

The problem with framing the argument against Tether or any other stablecoin is ultimately the Federal Reserve has succumbed to the same problems and thus it undermines the notion that Tether’s fraud potential is somehow any different than the fraud potential the currently exists in fractional-reserve banking.

Ultimately, the main utility is pooling funds to give the capacity to direct the reserve. That is a desirable outcome for any organization. Stablecoins make that easier. On the other hand a floating token then provides another avenue for “speculation”, whereas stablecoins are much harder to arbitrage themselves on speculative trading.

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@Larry_Bates Regarding “the notion that Tether’s fraud potential is somehow any different than the fraud potential that currently exists in fractional-reserve banking,” I would love to understand this better via some specific examples and/or suggestions for further reading.

Again, I was referring to Tether’s initial claim that 75% of its tokens were backed by “cash and cash equivalents,” a claim later found to be fraudulent. Is it fair to say that the Fed has “succumbed to the same problems”?

On your point that “the main utility [of Stablecoins] is pooling funds to give the capacity to direct the reserve,” my (admittedly) naive question still stands: “Why not just do that with dollars?” How exactly do “Stablecoins make that easier”?

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So, I think it’s reversed: Tether succumbed to the same problem the Federal Reserve has had over multiple decades. Fractional reserve banking has shown to be a problem multiple times in the Federal Reserve’s distribution of funds to national banks. In other words, Tether just followed the same practices of the Federal Reserve, not the other way around.

“Why wouldn’t people just use US Dollars?”

Considering Americans only make up a small percentage of the global population, establishing the US Dollar as the global reserve currency is clearly a means of maintaining US dollar dominance, effectively giving the US government (Federal Reserve) a lot of influence over global monetary policy.

Getting away from a USD peg legitimately strips influence over the global economy from the US government. That alone is a reason for an organization not interested in the US government’s goals to not hedge their capital in USD.

Assume users of stablecoins are not necessarily American, and the motivations become much more clear.

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@Larry_Bates When I described myself as “admittedly naive,” I probably should have said “willfully naive” — i.e., for the purposes of getting down to first principles.

I completely get your point about “legitimately [stripping] influence over the global economy from the US government.” That certainly sounds like a bigger-sounding issue than “pooling funds to serve the interests of a group.”

If I were answering my own question about “Why not use US dollars?”, I’d probably home in on the issue of decentralization.

Do you have any specific posts or summaries, etc. that focus on decentralization specifically, and that we could use to generate deeper discussion of this key issue?

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While the language of “pooling funds to serve the interests of a group” sounds overly reductive and seemingly insignificant, what is a government beyond “pooling funds to serve the interests of a group”?

Effectively, every government operates at that level with a varying degree of influence by a varying minority/majority of the group on how the funds are allocated. I try to use language that applies at the macro/micro level so that it is more likely to be “correct” in alignment with reality than trying to use extremely scenario-specific language.

I will point to the “Prize-Linked Savings Pools” post as to why it is a good idea to diversify the number of pools in which people are contributing to retain value as not to cause a central point of economic failure. Effectively, diversifying the currencies in which a person is saving while pooling savings to create market liquidity mechanisms seem to be an element of stablecoins that make it easier for someone to create an interest-bearing mechanism beyond the poor yield associated with a simple USD savings account.

In other words, the yield mechanisms associated with USD specifically are not as good of a prospect for higher return rates than using a stablecoin-based PLS account. When you get into the post, you start to see the outsized returns on those types of accounts compared to traditional USD savings accounts. There is nothing political about it. It is provably more profitable to use a PLS stablecoin account than to use a traditional USD savings account.

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@Larry_Bates Thanks for your reply and the explanation of your use of “macro/micro” language.

Yes, I see your point more clearly now.

BTW, in following your link to PLS accounts, I came upon a succinct thread on “Why Web 3 matters” (recommended by the co-founder of PoolTogether) that quickly captured (for me, anyway) the importance of decentralization.

It’s also succinctly answers my (deliberately naive) question: “Why not just do that [pool funds] with dollars?”

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As the Financial Stability Board (FSB) (2021) observed in Regulation, Supervision and Oversight of “Global Stablecoin” Arrangements: Progress Report on the implementation of the FSB High-Level Recommendations, “At present, stablecoins are being used primarily as bridge between traditional fiat currencies and other crypto-assets, which in turn are primarily held and traded for speculative purposes” (p.1)
Stablecoins still playing the role of haven in the cryptocurrencies world currently. As the largest capitalization stablecoin, it will be a tragedy if Tether breaks out confidence risk. Thus, the Zeke Faux’ investigation that @jmcgirk posted in the comment of On the Economic Design of Stablecoins aroused concerns again.
While I don’t argue that we must tame these wildcats by over-tax to diminish them, moderate regulations are required. FSB’s recommendation and implementation of jurisdictions are notable.
Recently, Bank for International Settlements (BIS) released Application of the Principles for Financial Market Infrastructures to Stablecoin Arrangements (2021). According to its considerations for determining the systemic importance of a Stablecoin Arrangement (SA), Tether may be considered as systemic important at least because of its size and being used in cross-border payments. If so, being a SA, Tether has a much longer way to go to meet the requirements BIS set, including providing clear and direct lines of responsibility and accountability, developing appropriate risk-management frameworks, aligning technical settlement and legal finality, providing the transparency and remedy policies of settlement gaps, and the most related to the discussion in On the Economic Design of Stablecoins, “no credit or liquidity risk”, which requires transparency of its reserve to the public as the first step. When we are discussing what’s the truth behind its reserve sources and it’s still buzzing, it’s quite far from the needed confidence degree of a systemic important financial infrastructure.

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I thought I’d bring this thread to life given the recent depegging of TerraUSD and the plunge in the value of Luna (which has since recovered). Feel free to add your thoughts in here. You can watch the community discuss this issue in real time – Governance & Proposals - Terra Research Forum

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This seems to be the most active thread - [Proposal] Help UST Pegging. Increase estimated minting capacity to $1200M - Governance & Proposals - Terra Research Forum also check out Do Kwan’s thread for some interesting and valuable context - https://twitter.com/stablekwon/status/1524331171189956609 @Astrid_CH it would be really interesting to get your input.

Another interesting thread - the attack on the UST system: https://mobile.twitter.com/OnChainWizard/status/1524123935570382851

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This piece on algorithmic stablecoins in Wired claims that the “clever architecture” of UST/Terra “did not and could not work.”

And of course the whole debacle gives regulators an opportunity to rush in.

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Vitalik Buterin sent a couple of tweets yesterday expressing strong support for “coordinated sympathy and relief for the average UST smallholder.” “The obvious precedent is FDIC insurance (up to $250k per person),” he said. “IMO things like this are good hybrid formulas.”

Vitalik was responding to a tweet thread where the poster made an analogy to the Madoff ponzi restitution which also prioritized making the average investor whole, not the wealthiest.

SCRF Community: Do you agree or disagree with this idea?

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I think there is insurance available for some crypto deposits, so it’s certainly feasible. One of the things that makes the crypto ecosystem so exciting and dynamic, however, is the lack of regulation and I worry that restitution and other external authorities looking in would eventually hurt the hothouse environment that’s creating all of the innovation in crypto. Still, I wouldn’t mind a little bit of safety!

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