New Federal Reserve Study Is Surprisingly Upbeat on Stablecoins

Amid the Biden administration’s onslaught against cryptocurrencies, new research from the Federal Reserve surprisingly paints stablecoins in a positive light. In a new Fed paper , Stablecoins: Growth Potential and Impact on Banking, Gordon Y. Liao, a former senior economist at the Fed now at Harvard, and Fed researcher John Caramichael discuss at length the potential benefits stablecoins can bring to the U.S. economy, credit intermediation in particular.

This view starkly contrasts the administration’s posture in the report published last fall by the President’s Working Group (PWG), which cast a dire outlook and urged Congress to smother stablecoins with “appropriate federal prudential oversight on a consistent and comprehensive basis.” (Stablecoins are digital assets pegged to a stable monetary value, usually the U.S. dollar.).

To be sure, the paper focuses on how widespread stablecoin adoption would affect the Fed balance sheet and credit intermediation and doesn’t discuss other, more contentious issues—for example, monetary policy and consumer protection. Still, the researchers’ glowing outlook is welcome amid the constant hostility to crypto and promotion by some officials of knockoff government alternatives.

The contrast between the Fed research and the PWG’s position is stunning. In a 26-page report, the PWG had a single positive sentence about stablecoins while mentioning “risk” 131 times and “concern” another 20. The Fed research started by praising stablecoin programmability and composability, meaning their ability to interact with smart contracts and create new payment and financial services from scratch.

The Fed report also shows that stablecoins’ flexibility benefits not only crypto traders—their original purpose—but also a vast array of current and potential use cases, and notes stablecoins’ ability to facilitate instantaneous payment settlement globally 24/7 with low transaction fees. This is especially useful in disrupting the current archaic cross-border payment system.

Importantly, the Fed report touts stablecoins’ role in facilitating decentralized finance (DeFi) and its potential for increasing financial inclusion by lowering barriers to entry and bypassing fee-collecting institutions. The researchers also look to the future by describing stablecoins’ ability to tokenize financial markets, which could “increase liquidity, transaction speeds, and transparency while reducing counterparty risk, trading costs, and other barriers to market participation.”

Finally, the researchers describe stablecoins potential for enabling the next iteration of the Internet known colloquiarlly as Web3, which, if allowed to thrive, will keep power and value at the individual level instead of it being sucked to the top by a few dominant players.

Interestingly, in discussing stablecoins’ benefits to the overall economy, and to credit intermediation in particular, the researchers criticize the so-called narrow-bank model whereby stablecoin issuers would back their reserves on a one-to-one basis with central bank liabilities—thus appearing on the Federal Reserve’s balance sheet. This model is what the PWG urges. The Fed report states:

In most [stablecoin] scenarios we consider, credit provision would likely not be negatively affected. In fact, the replacement of physical currency (banknotes) by stablecoins could potentially allow for more bank-led credit provision. A notable exception that can lead to sizable credit disintermediation is the scenario in which stablecoins are required to be fully backed by central bank reserves, which we call the narrow bank framework. In this framework, redemption run risk is minimized at the expense of larger credit disintermediation.

Interestingly, the paper (perhaps inadvertently) warns of the dangers of adopting those alternatives known as central bank digital currencies (CBDCs), which, like narrow-bank stablecoins, would be direct liabilities of the central banking authority and assets under custody for the commercial banks that hold them. This means they could not be lent out to increase economic activity as happens with ordinary deposits in the fractional-reserve lending system. In fact, the research labels narrow-bank stablecoins and CBDCs as “roughly equivalent” while warning of the dangers these stablecoins present to credit intermediation and the larger economy.

Instead, the researchers suggest integrating stablecoins into the fractional reserve lending system by treating them as ordinary deposits, being liabilities of commercial banks with standard FDIC insurance.

As commercial banks engage in fractional-reserve banking with stablecoin deposits, their balance sheet expands with expansions in credit and security holdings accounting for most of the expansion. The central bank shrinks its balance sheet on the net, as reserves increase slightly while cash liabilities decrease significantly. Households accumulate more assets, funded by the expansion in bank loans. The effect on credit provision is positive.

With the administration’s hostile stance toward crypto from the Treasury Secretary, to the Chair of the Securities and Exchange Commission, to the IRS to its allies in Congress, the Fed research offers a glimmer of hope for crypto’s future.