EDITOR NOTE: As with physical cash, digital currencies are not immune to the risks of fractional reserve banking. A convenient system of digital transactions, stablecoins are just as, if not even more, vulnerable to bank runs. Think of a cybersecurity breach, or any event that can cause holders to doubt the stability of the coin’s sponsor, and you have a potential bank run on your hands, to which financial institutions will have to begin liquidating assets to absorb their losses. Rather than enhancing or bolstering the efficiency of the banking system, stablecoins can amplify the opposite, giving the system and its holders yet another worrisome layer of fragility. In the US, the OCC has granted banks the authority to custody stablecoins this week, and proclamation SIL20449 aims to have digital wallets created for all Americans by January 1st, 2021. Are we rushing into a financial slaughterhouse?
The European Central Bank (ECB) is worried that a stablecoin version of a bank run could endanger financial stability.
Bank runs occur when people worried about a bank’s stability start withdrawing deposits, convincing more and more customers to withdraw funds in a panic as well—actually endangering the bank’s stability.
In a Sept. 22 report, the ECB suggested that “fragilities within the stablecoin arrangement itself, and its links to the financial system, may give rise to financial stability risks.”
Specifically, it said stablecoins are vulnerable to so-called liquidity “runs” if consumers fear that the token may lose its value. In such instances, the stablecoin may stop functioning normally and its redemption may not be possible in the usual way.
Such runs could take place as a reaction to hacks against the systems, wallet thefts, or even simple consumer doubt concerning the value of the stablecoin, the ECB added.
In a large, widely used stablecoin, such instances could have far-reaching consequences, according to the ECB:
“Runs could also occur in the case of an arrangement that guarantees redeemability at face value—if the stablecoin sponsor is perceived as lacking sufficient loss-absorbing capacity. In these events, the liquidation of assets to cover redemptions could have negative contagion effects on the financial system.”
Which is to say that a stablecoin run could spread far beyond the world of cryptocurrency.
And widely used stablecoins are likely coming. As Modern Consensus reported yesterday, ECB President Christine Lagarde recently suggested that its central bank digital currency—the digital euro— will leave room for privately issued stablecoins such as Facebook’s Libra.
Changes are coming to the stablecoin space
The ECB report follows a July call by the Financial Action Task Force (FATF) to clamp down on “so-called stablecoins.” The institution claimed because those assets’ “propensity for mass adoption makes them more vulnerable to be used by criminals and terrorists.”
FATF’s concern over stablecoins and their adoption should be seen as particularly alarming to industry insiders as the organization sets the standards of anti-money laundering and counter-terrorist financing regulation. The organization believes that stablecoins should follow the same standards that are being used to stop criminals from using other virtual assets.
While the FATF has only 37 members, over 200 countries follow its guidelines as a failure to do so can result in the country being cut out from the global financial system. Because of this, major changes should be expected in the stablecoin industry.
Read more on Modern Consensus