Stablecoins in search of a nominal anchor

A key development in the crypto universe is the rise of decentralised finance, or
“DeFi”. DeFi offers financial service and products, but with the declared objective of
refashioning the financial system by cutting out the middlemen and thereby
lowering costs.6
To this end, DeFi applications publicly record pseudo-anonymous
transactions in cryptocurrencies on permissionless blockchains. “Decentralised
applications” (dApps) featuring smart contracts allow transactions to be automated.
To reach consensus, validators are incentivised through rewards.
While the DeFi ecosystem is evolving rapidly, the main types of financial activity
continue to be those already available in traditional finance, such as lending,
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trading and insurance.7
Lending platforms let users lend out their stablecoins with
interest to borrowers that post other cryptocurrencies as collateral. 

Decentralised
exchanges (DEXs) represent marketplaces where transactions occur directly between
cryptocurrency or stablecoin traders, with prices determined via algorithms. On
DeFi insurance platforms, users can insure themselves against eg the mishandling
of private keys, exchange hacks or smart contract failures. As activities almost
exclusively involve exchanging one stablecoin or cryptocurrency for another, and
do not finance productive investments in the real economy, the system is mostly
self-referential.
Stablecoins play a key role in the DeFi ecosystem. These are so-called because
they are usually pegged to a numeraire, such as the US dollar, but can also target
the price of other currencies or assets (eg gold). In this sense, they often import the
credibility provided by the unit of account issued by the central bank. Their main
use case is to overcome the high price volatility and low liquidity of unbacked
cryptocurrencies, like Bitcoin. Their use also avoids frequent conversion between
cryptocurrencies and bank deposits in sovereign currency, which is usually
associated with significant fees. Because stablecoins are used to support a wide
range of DeFi activities, turnover in stablecoins generally dwarfs that of other
cryptocurrencies.

 The two main types of stablecoin are asset-backed and algorithmic. Asset-backed
stablecoins, such as Tether, USD Coin and Binance USD, are typically managed by a
centralised intermediary who invests the underlying collateral and coordinates the
coins’ redemption and creation. Assets can be held in government bonds, short-term
corporate debt or bank deposits, or in other cryptocurrencies. In contrast, algorithmic
stablecoins, such as TerraUSD before its implosion, rely on complex algorithms that
automatically rebalance supply to maintain their value relative to the target currency
or asset. To avoid reliance on fiat currency, they often do so by providing users with
an arbitrage opportunity relative to another cryptocurrency.
Despite their name, stablecoins – in particular, algorithmic ones – are less
stable than their issuers claim. In May 2022, TerraUSD entered a death spiral, as its
value dropped from $1 to just a few cents over the course of a few days (see Box A).
In the aftermath, other algorithmic stablecoins came under pressure. But so did
some asset-backed stablecoins, which have seen large-scale redemptions, temporarily
losing their peg in the wake of the shock. Redemptions were more pronounced
among stablecoins whose issuers did not disclose the composition of reserve assets
in detail, presumably reflecting investors’ worries that such issuers might not be
able to guarantee conversion at par.
Indeed, commentators have warned for some time that there is an inherent
conflict of interest in stablecoins, with an incentive for issuers to invest in riskier
assets. Economic history is littered with attempts at private money that failed,

 leading to losses for investors and the real economy. The robustness of stablecoin
stabilisation mechanisms depends crucially on the quality and transparency of their
reserve assets, which are often woefully lacking.8
Yet even if stablecoins were to remain stable to some extent, they lack the
qualities necessary to underpin the future monetary system. They must import their
credibility from sovereign fiat currencies, but they benefit neither from the
regulatory requirements and protections of bank deposits and e-money, nor from
the central bank as a lender of last resort. In addition, they tie up liquidity and can
fragment the monetary system, thus undermining the singleness of the currency.9
As
stablecoins are barely used to pay for real-world goods and services, but underpin
the largely self-referential DeFi ecosystem, some have questioned whether
stablecoins should be banned.10 As will be discussed below, there is more promise in
sounder representations of central bank money and liabilities of regulated issuers