July 14, 2020

Market News

How stablecoins can provide more financial stability

In recent years, investors have increasingly come across the concept of financial stability. In particular, with the proposed launch of Libra, the Bank for International Settlements, the US Federal Reserve and the Fincial Stability Board have raised public concerns about Libra's impact on financial stability. This shows that there is concern on the part of the monetary policy bodies about the global stablecoins , which have enormous potential in terms of their reach. But are stablecoins really a threat to financial stability?

That is behind financial stability

What is the concept of financial stability? Is it a solidly financed state budget? Perhaps there is also talk of healthy consumer behavior and the associated inflation? The definition of financial stability is comparatively difficult. Nonetheless, most people find an example of financial instability – the financial crisis in 2008.

However, in 2009 the G20 governments launched the Financial Stability Board (FSB), which is organized by the Bank for International Settlements (BIS). The FSB's stated aim is to monitor the global financial system and coordinate the national financial authorities. The FSB's official definition is to address vulnerabilities affecting financial systems in the interests of global financial stability. In this way, the Financial Stability Board is to ensure that a systemic financial crisis like the one in 2008 no longer occurs.

But is it likely that we will experience another bank-caused crisis? In any case, the explanations for the occurrence of the financial crisis are simple and always amount to the following factors:

  • Exaggerated greed
  • Immoral action
  • Excessive risk taking

Financial system risk definitions

The next step was to define numerous definitions of the so-called financial system risks. A possible definition was provided by the Canadian Supreme Court in 2011, for example:

"Risks that trigger a domino effect, ie the risk of a solvency of a market participant, impairs the ability of other market participants to fulfill their legal obligations, thereby creating a chain of negative economic consequences that pervades an entire financial system." – Supreme Court ruling Canada

Something easier it has Gert Wehinger in "Lessons from the financial market turmoil: Challenges ahead for the finance industry and policy makers" defined . According to Wehinger, financial system risks can be defined as follows:

"The potential for substantial volatility in asset prices, corporate liquidity, bankruptcies and loss of efficiency caused by economic shocks." – Gert Wehinger

The definition may seem obvious at first glance, but reasons for the shocks or risks mentioned are not defined. The specific case of the financial crisis shows that the sudden fall in the price of debt-financed assets caused the subprime mortgages – and thus also the secured securities – to lose massive value.

Principle of supply and demand

Finally, the question arises as to why the prices of subprime-backed securities could drop so quickly. The answer to this is simple, because the price of each asset depends on the interplay between supply and demand. However, it was almost impossible for investors to analyze the securities in detail. In contrast, the mortgage founders had no financial incentive to analyze the loans.

As a result, the subprime securities received an AAA rating with the best credit rating. With the increasing insolvency of borrowers, the market collapsed – banks had to write off bad loans.

If we want to rule out corresponding, systemic risks, then we need healthy pricing mechanisms. Market participants play a key role here, as they do not rely on rating agencies when allocating capital, but instead use more rational decision criteria. Nonetheless, these institutions need a cost-effective vehicle to quickly allocate capital and maintain balance. At this point we want to take a closer look at the stablecoins.

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The purpose of stablecoins

Now we come back to the starting point of this article: the reports of the FSB , the BIS and the Federal Reserve (FED) . All institutions see stablecoins like Libra as an attempt to reduce the volatility of other Krytpo assets. However, this assessment does not correspond to the actual meaning of a stablecoin.

Rather, stablecoins should address the inefficiencies of the classic financial system. By providing highly liquid cryptocurrencies, which basically have the properties of fiat money, the disadvantages of the financial system can be offset. A closer look also shows that this has little to do with the price stabilization of other cryptocurrencies.

In addition, stablecoins are not in direct competition with other crypto assets, but facilitate access to these new assets. To put it bluntly, there would be no stablecoins if our financial system were not so expensive, slow and marginalizing.

As a result, stablecoins such as Libra do not pose a systemic threat even with large-scale adaptation. The stablecoins are more of a modern vehicle for carrying out transactions and not an investment. You are also hedged with another asset, such as a fiat currency. However, trading the stablecoin does not affect the corresponding countervalue. For this reason, pricing for a global stablecoin is also very robust and strong price fluctuations are almost non-existent.

Pricing at stablecoins

The initial issue of stablecoins takes place on the primary market. Here the token is issued at the defined rate. Subsequently, trading can take place on the secondary markets. We can once again observe the interplay of supply and demand on the secondary markets. However, it turns out that the price moves very closely around the bound price. If there are deviations, these are used by Abitrage dealers and there is a new definition of the market balance.

In addition, from a stablecoin issuer's perspective, the business model is comparatively simple. While financial intermediaries are always dependent on new business to generate profits, stablecoins issuers earn fees by managing the tokens. Accordingly, we see no market participants here who have to take risky bets in order to achieve a return. Instead, the protection of the deposited security reserves, which were collected during the primary investment, is already sufficient to act in a profit-oriented manner.

Regulation of stablecoins to ensure the stability of the financial system

This is how stablecoins promote financial stability

The reports of the FED, BIS and FSB state that we should not only pay attention to the potential efficiency gains, but also that the risks to financial stability are an important factor. However, the reports are comparatively one-sided and the potential of stablecoins to promote financial stability is not mentioned.

However, above all, the political decision-makers should consider the same potential when it comes to evaluating global stablecoins. In this way, institutional investors can quickly allocate assets using global Stabelcoins. This could result in faster pricing, which in turn is a natural counterpoint to financial instability.

From the perspective of the FED, BIS and FSB, however, the established financial institutions also play a role if we look at financial stability. With the introduction of alternative means of payment, which completely dispense with intermediaries, the yields of banks and payment service providers could also fall further. Thus, the profitability is in the focus of the supervisory bodies, but the stability of the financial institutions is not synonymous with the stability of the financial system in a broader sense.

So it cannot be assumed that balance sheet profits on the part of the banks are synonymous with financial stability. Instead, we should value society's interest higher and accept an alternative asset class than this.

Conclusion: stablecoins can improve financial stability

In their statement on the potential danger posed by the Libra Coin, the FSB, BIS and FED warned that the coin was a potential risk to global financial stability. However, a closer look at the term financial stability shows that this is actually a healthy balance between supply and demand. In addition, extreme excessive movements – as in 2008 in the mortgage business – should be avoided.

However, there are also advantages of stablecoins, which were not taken into account in the present reports. Examples include the lower costs compared to traditional banking or better access to cryptocurrencies, even for people without a bank account. In addition, stablecoins guarantee faster processing in payment transactions thanks to the underlying distributed ledger technology and are therefore suitable on an international level.