As the world of decentralized finance (Defi) continues to grow, there is in our opinion much demand for a stable, transparent and less volatile digital currency fit for use in blockchain-based applications with near–real–time, peer-to-peer global settlement that can be used as a medium of exchange. However, most currently available cryptocurrencies are far too volatile for such purpose and there are in our opinion also concerns with upcoming central bank digital currencies (CBDC’s) which are state-sponsored and therefore defeat the principal object of decentralized cryptocurrencies. Most CBDC’s may also not be based on the distributed Ledger technology of blockchain or even be available for retail use. Another concern is that they might be too slow to materialize.
Stablecoins come in many varieties. Calvin • Farel’s upcoming stablecoins ‘Seed’ for example will be backed by the commodity gold as we at Calvin • Farel believe that the only ones likely to function as a medium of exchange in the foreseeable future are the ones which are tangible, transparent and backed by a valuable, tradeable underlying which the issuer holding those backed underlying as audited reserves. Issuers after to redeem their tokens on demand must be able to liquidate their reserves constantly to ensure to meet this pledge in near-real-time. The tokens, like Calvin • Farel’s upcoming gold backed ‘Seed’ which does not pay interest, are usable as digital money in blockchain applications and trades in them can be settled on a near-real-time, peer-to-peer basis. In addition to being a medium of exchange, they serve as collaterals in decentralized finance (Defi).
Issuers of stablecoins which are fiat currency pegged have thrived while nominal interest rates have been near zero. With high positive interest rates, the opportunity costs of holding zero-interest paying stablecoins increases and the issuers of such fiat-currency pegged tokens will in our opinion lose a lot of its current business.
With significantly negative rates – as slightly seen in for example Switzerland or Germany in the recent past -, the value of safe reserves declines but the tokens are still redeemable at par. In such a market scenario issuers might face insolvency and must invest in riskier reserves for a chance to survive. If stablecoins are no longer fully backed by safe and liquid assets and are widely used, this could once again create financial stability risks.
Let’s assume that issuers of fiat currency pegged cryptocurrencies could pass on their interest earnings – or cost if rates are negative – on reserves to the token holders on a one-on-one basis. That would mean if interest rates are high, fiat currency pegged stablecoins are theoretically a competitive liquid store of value. If interest rates are significantly negative, the issuers’ liabilities shrink along with their reserve; the issuer therefore remains solvent. Fiat currency pegged stablecoins could then be sustainable in all interest rate environments.
But there is another problem for fiat currency pegged stablecoins. Though, at least for the EU with the Regulation of Markets in crypto-assets (Mica) that is expected to come into force in 2024-2025. This new, upcoming law bans the paying of interest on money tokens. That in our opinion will force issuers to adopt to a business model that is only sustainable with near-zero interest rates. We at Calvin • Farel don’t see any sensible reason for such a ban – apart from competition – but such regulation will force fiat currency pegged stablecoins and their issuers to evolve quickly based on current global inflation figures and therefore rising interest rates. Shares in a regulated retail money market fund, issued as security tokens on a public blockchain under the applicable securities legislation, might just be one alternative. Tokenized deposits offered by commercial banks are another possibility. Banks would administer deposits on a distributed database rather than their own. In legal and economic terms, these are identical to conventional deposits; they do not fall under Mica and therefore can pay interest.
Given current government debt levels which have risen tremendously over the past two decades, we at Calvin • Farel don’t have much trust in government backed fiat currencies. This is one of the reasons why Calvin • Farel’s upcoming stablecoin ‘Seed’ is gold backed instead of fiat currency pegged. Tokenizing deposits on the other hand would enable peer-to-peer settlement and would make commercial bank money usable in blockchain applications without impacting the broader financial system. Tokenizing commercial bank deposits might also have other advantages over alternative stablecoins. They could for example fall under existing deposit insurance schemes and may qualify as legal tender in some jurisdictions like bitcoin in El Salvador.
Finally, banks have access to the central bank as lender of last resort, widening the scope of assets that the token holders’ funds could be invested in while maintaining sufficient liquidity. If interest rates deviate significantly from zero – which is quite possible -, we at Calvin • Farel believe that larger fiat currency pegged stablecoin issuers are likely to apply for banking licenses to benefit from the regulatory advantages. None of this in our opinion will obviously solve the distrust in governments by the public but existing banks will most probably introduce tokenized deposits in the upcoming years in order to be able to complete.