Stablecoin: A currency revolution in the making

Author: Marvin Barth Source: Coindesk Compiled by: Shaw Golden Finance

We may be on the verge of a revolution in the field of monetary finance, which has been the dream of many renowned economists for centuries. Financial innovation is laying the groundwork for this dream, while the political and economic environment in the United States is also changing to support this revolution. If this revolution proceeds smoothly, it will have a significant impact on global finance, economic development, and geopolitics, creating numerous winners and losers. The shift I am referring to is the "narrow banking" built on the foundation of stablecoins.

The Origin of the Partial Reserve Banking System

Our current financial system is built on the concept of a fractional reserve banking system. In the 13th and 14th centuries, Italian moneylenders and bankers began to realize that since depositors (rarely) demanded withdrawals at the same time, they only needed to hold a fraction of the gold coins required for deposits as reserves. This not only increased profits but also facilitated long-distance payments: a member of the Medici family in Florence could avoid transporting gold coins on dangerous roads by simply writing a letter to his agent in Venice, instructing him to deduct from one account and deposit into another.

Although fractional reserve banking can be highly profitable and efficient under normal circumstances, it also has drawbacks. Its inherent leverage makes the system unstable. An economic downturn can lead to more depositors withdrawing their funds simultaneously, triggering rumors about impending defaults on loans backed by bank deposits, which can result in bank runs. Banks that cannot meet the withdrawal demands of depositors eventually go bankrupt. However, under a fractional reserve system, the losses from bank failures are not just the wealth of the depositors. Since banks can both generate credit and facilitate payments, when a bank fails, economic activity is severely restricted, as payments for goods and services are affected and new investment projects cannot secure loans.

The government is trying to solve its problems

For centuries, as banks became increasingly leveraged, their importance to economic operations also grew, prompting government intervention to mitigate the risk of banking crises. In 1668, Sweden chartered the first central bank—Sweden's Riksbank—providing loans to other banks facing runs. Twenty-six years later, the Bank of England was established. While this helped address liquidity issues (the problem faced by banks that are fundamentally sound but cash-strapped), it did not prevent solvency crises (the crises faced by banks with bad loans). In 1933, the United States created a deposit insurance system aimed at curbing bank runs triggered by solvency issues. However, as evidenced by many subsequent banking crises, including the 2008 U.S. subprime mortgage crisis, deposit insurance and bank capital regulation have not resolved the inherent vulnerabilities of the fractional reserve banking system. Government intervention merely reduced the frequency of crises and shifted their costs from depositors to taxpayers.

Economists conceive better solutions

Around the time when the Roosevelt administration introduced the deposit insurance system in the United States, some top economists at the University of Chicago were devising a different solution: the so-called "Chicago Plan," also known as "narrow banking." During the savings and loan crisis in the United States in the 1980s and 1990s, this idea gained renewed attention among economists.

The narrow banking system addresses the core issues of the fractional reserve banking system by separating the key functions of payment and money creation from the function of credit creation. Many believe that central banks create money, but under the fractional reserve system, this is not the case: commercial banks are the true creators of money. Central banks manage the rate at which banks create money by regulating the channels through which banks obtain reserves. However, when banks lend, they magically generate corresponding deposits in the process, thus achieving money creation. This system and its disorderly deconstruction process link money growth to credit growth and associate it with payment activities through the network effects of banks.

Dividing the Bank in Two

The "Chicago Plan" separates banking functions by decoupling the key functions of money creation and payment from credit activities. "Narrow" banks are responsible for accepting deposits and providing payment services, and they must back deposits with sufficient support at a one-to-one ratio using safe instruments such as government bonds or central bank reserves. These types of banks can be imagined as a money market fund with debit cards. Loan business is conducted by "broad" or "commercial" banks, which finance themselves through equity capital or long-term bonds, thereby not facing the risk of a bank run.

This segmentation of banking services allows various functions to operate independently without interference. Since narrow banks are entirely supported by high-quality assets (as well as central bank channels), they avoid the risk of bank runs. Narrow banks facilitate payments, and their security eliminates risks in the payment system. As money is no longer created by credit, the decision-making regarding non-performing loans by commercial banks does not affect the money supply, deposits, or payments. Instead, natural fluctuations in economic demand for money (booms or recessions) and concerns about loan quality do not impact commercial banks' lending, as their funding comes from long-term debt and equity.

Why this excellent solution was not adopted

You might be asking yourself now: "If the narrow banking system is so wonderful, why haven't we implemented it today?" The answer has two aspects: the transition process is painful, and there has never been a political and economic environment supportive of legislative change.

Due to the requirement that deposits at narrow banks must be 100% backed by treasury bonds or central bank reserves, the transition to narrow banking will require existing banks to either call in loans, significantly reducing the money supply; or, if they can find non-bank buyers, sell their loan portfolios to purchase short-term government bonds. Both of these actions would lead to a large-scale credit contraction, while the transformation to narrow banking would cause liquidity shortages and payment issues.

In terms of political economy, the fractional reserve banking system is highly profitable and creates a large number of jobs. In contrast, economists are just a small group of people, their own work also being questionable. In Washington D.C., anyone will tell you that the American Bankers Association (ABA) is one of the most influential lobbying groups in the area. The same play is being performed in London, Brussels, Zurich, Tokyo, and other places, just with different actors. Therefore, the continuation of the fractional reserve banking system is not a bank conspiracy, but simply because it is politically feasible and economically prudent.

Financial Innovation Meets Political Changes

This situation may no longer persist. Both the costs of transformation and the political and economic environment have changed, especially in the United States. The development of decentralized finance (also known as "DeFi" or "cryptocurrency") and the synchronized evolution of U.S. political economy, national interests, and financial structure have created conditions that make the transition of the U.S. towards a narrow banking system not only feasible but, in my view, increasingly likely.

Let’s start with the key development in decentralized finance (DeFi): the rapid growth of stablecoins. Stablecoins are decentralized "digital dollars" (or euros, yen, etc.). Unlike central bank digital currencies (CBDCs), which are centrally issued, cleared, and settled by central banks, stablecoins are privately created "digital tokens" (electronic records). Like cryptocurrencies, ownership and transactions are stored and settled on a distributed ledger using blockchain technology. The immutability of blockchain combined with a universally replicated ledger allows trust to be established between parties who do not know each other, without government guarantees.

The difference between stablecoins and cryptocurrencies lies in the fact that they are pegged to fiat currencies, gold, or other stores of value that are more "stable" than Bitcoin or other cryptocurrencies. Stablecoins are designed to bridge the traditional fiat currency world with the blockchain-based DeFi and cryptocurrency world, providing a stable "on-chain" unit of account to facilitate DeFi transactions. However, with significant growth in acceptance and usage, the use cases for stablecoins have also changed dramatically. As of March, the annual trading volume of stablecoins reached $35 trillion, more than doubling from the previous year; the number of users grew by over 50%, exceeding 30 million; and the circulating market cap of stablecoins has reached $250 billion.

Over 90% of stablecoin transactions still involve fiat on-ramps or DeFi trading, but an increasing number of transactions are growing due to "real-world" use. In countries with unstable local currencies such as Argentina, Nigeria, and Venezuela, peer-to-peer and business transactions have been a major source of growth, but one of the largest sources of growth is the increasing volume of remittances from migrant workers globally, which is estimated to account for over a quarter of the total.

With the help of Congress

As the Trump administration and the U.S. Congress begin to institutionalize stablecoins, stablecoins are being increasingly accepted and developed as an alternative payment system.

How do stablecoins maintain their value relative to specific currencies like the US dollar? In theory, each stablecoin is pegged one-to-one with the currency it is anchored to. However, this is not always the case in practice. The US legislature defines what constitutes an acceptable high-quality liquid asset ( HQLA ), requiring a one-to-one peg and regular audits to ensure compliance. Therefore, Congress is creating a legal framework for the following entities: ( 1 ) accepting deposits; ( 2 ) must be fully backed by HQLA for the deposits; and ( 3 ) facilitating economic payments.

Familiarity

Does this sound familiar? Isn't that "narrow banking"?

There are some missing parts in this. Notably, neither the "GENIUS Act" nor the "STABLE Act" grants stablecoin issuers access to the Federal Reserve, nor does it define stablecoins as taxable currency. The lack of access for stablecoins to the Federal Reserve may reflect a necessary caution to avoid undermining the fractional reserve banking system too quickly with direct competitors, and it may also reflect the lobbying efforts of the American Bankers Association (ABA) to protect the monopoly position of banks. However, there are some intriguing signs that the protection of banks may be temporary and only sufficient to transition to a narrow banking model: among the HQLA approved for stablecoin issuers in both acts, it includes reserves at the Federal Reserve that currently only banks can use.

Change in Political Winds

Trump's campaign team turned to cryptocurrency last year, and the push for the normalization of stablecoins in both houses of Congress reflects a profound shift in the political economy and national interest perspective in the United States. Since the global financial crisis, the populist anger towards banks and their relationship with Washington has not subsided for either party. The Federal Reserve's quantitative easing policy and recent inflation policy missteps have further fueled the anger of populists. This, like the FOMO sentiment, is part of the cryptocurrency phenomenon.

But cryptocurrencies have also created immense new wealth and business opportunities, giving rise to a well-funded competitor in the American Bankers Association (ABA). Even institutional asset management companies have now diverged from their traditional banking allies, coveting the opportunities in the DeFi space. The combination of public support and economic strength is for the first time creating a political and economic environment that supports narrow banking.

In addition, the United States currently has pressing national interests in the development of stablecoins. Firstly, in the context of China (and other U.S. competitors) increasingly seeking to replace American payment systems like SWIFT with their own payment systems, an independent third-party payment system that can prevent countries from being "trapped" in the Chinese payment system is highly appealing. Another national interest, which U.S. Treasury Secretary Scott Bessent has repeatedly mentioned, is that a systematic shift towards stablecoin-based narrow banking will create "one of the largest buyers of U.S. Treasury bonds."

New Financial Architecture

The financial structure of the United States is now more favorable for achieving non-disruptive transformation than at any time in history, even compared to other countries, giving it a competitive edge. Although the U.S. has historically relied less on banks for credit due to greater utilization of the corporate bond market and securitized mortgages than other major economies, the development of so-called "shadow" banking over the past two decades has further deepened its reliance on credit. U.S. bank credit accounts for just over one-third of the total credit to the private non-financial sector. The remainder is provided by the bond market and the shadow sector, which are essentially the broad banks or commercial banks envisioned by the Chicago Plan.

The shift in the United States towards narrow banking based on stablecoins will have a huge impact on the economy, geopolitics, and finance. This will create significant winners and losers both domestically in the U.S. and globally.