Stable coins and the cost of high grade money

22 June 2022

Stable coins are being increasingly integrated into the financial mainstream. The U.K. Treasury recently launched an open consultation reaffirming that stable coins are basically similar to other contractual monetary arrangements. Stable coins if done right could become high-grade monies of choice in particular where central bank money is not readily available or too expensive. Different stable coin denominations could also offer new possibilities to conduct international payments. There are already some solutions, but they maintain too close a dependence on existing systems. As central bank money in the U.K. alone is estimated to cost about GBP12 billion to hold, one third of the U.K. largest high street banks’ annual profits, the quest, made more urgent by rising rates, for finding alternative high-grade monies is on.

Stable coins are typically seen as high-risk instruments. Yet, they constitute in principle though not de jure obligations similar to bank deposits and money market fund units. They normally convey a commitment, though many actual arrangements are unclear, to convert a stable coin at par and on demand into a national currency and maintain an asset backing portfolio serving to meet obligations arising from coin redemptions. Stable coins, unlike many other crypto assets therefore constitute monetary liabilities. Regulation needs to ensure, similar to bank and money market fund regulations and be aligned therewith, that stable coins are being managed such that convertibility can be assured most of the time. Stable coins could therefore constitute high grade monies.

Money does not equal money. Central bank money is normally the highest-grade money in any currency area. It consists of bank notes held by the non-bank public and reserves held by commercial banks. Commercial banks hold reserves to meet immediate payment needs. Reserves are used to settle transactions with finality in large value payment systems typically real-time gross settlement (RTGS) systems. Other monies, normally issued by banks in the form of bank deposits, exhibit credit and other risks and therefore normally do not offer settlement finality.

Central banks have issued unprecedented amounts of reserves, being the outcome especially of outright purchases of securities as part of central banks’ quantitative easing strategies. Before the global economic and financial crisis, in January-May 2007, the Bank of England had GBP18 billion of reserves outstanding, about 0.3 percent of total commercial banks’ liabilities or less than 1 percent of GDP. In January-May 2022, there are GBP961 billion in reserves or 11 percent of commercial banks’ liabilities or about 44 percent of GDP (Bank of England).

Reserves are costly. Since commercial banks acquire reserves de facto in exchange of high-grade securities to the Bank of England, the cost of carrying reserves is the difference between the average yield of a high-grade security and the Bank’s policy rate or Bank rate. At end-May, the average yield of the U.K. government nominal spot curve was 2.2 percent. With Bank rate at 1.0 percent, the rate at which reserves are being remunerated, the opportunity cost of holding reserves or the current seigniorage revenue of the Bank, is estimated to be around GBP12 billion per year. With instruments other than U.K government bonds being accepted by the Bank, the opportunity costs of holding reserves are likely to be considerably higher. Rising rates accompanied by a steepening of the yield curve will make it costlier still.

Banks seem to have had good reasons to maintain large holdings signalling strong liquidity preferences, low risk tolerance, lack of alternative resources deployment, changed banks’ business models, market fragmentation, accommodation of low long-term rates. Also, the fear of relying on money markets for liquidity management and in particular regulation through the liquidity coverage ratio may all have contributed to large reserve holdings. But actual levels of reserves seem too high to justify possible liquidity and other market concerns.

Stable coins could serve two functions similar to reserves: As settlement medium and liquidity buffer. They could be constructed similar to reserves. Commercial banks would deposit high-grade securities in a backing portfolio with an investment vehicle that would issue digital coins, denominated in the currency of the underlying securities, strictly in proportion to securities being deposited. Because eligible assets for the stable coins could be those eligible for the Bank’s market operations, the quality of the stable coin would be similar though not identical to reserves. As the assets in the stable coins’ backing portfolio are interest rate sensitive, stable coins would always be responsive to prevailing monetary policy impulses and should not per se give rise to financial stability concerns.

Commercial banks would be able to have access to the coins at any time irrespective of access to the RTGS system and Bank of England’s facilities. It would allow on instant demand settlement thereby minimising assets being encumbered by the need to meet future settlements. Where foreign currency denominated high grade securities can be used, stable coins could also be issued in different currency denominations to facilitate cross-border payments in high grade monies that is not being offered today. The coins, assuming they are being issued on distributed ledger technology-based platforms, would enable instant settlement and programmability to complement existing payments functions.

Stable coins with adequate regulation could become the more efficient high grade settlement medium. The objective of high-grade stable coins needs to be to serve outside existing platforms to advance towards a more diversified and resilient payments infrastructure. With GBP12 billion on the table, the push into stable coins is set to become irresistible.

Economics Advisory, June 2022