Stablecoins Survived ‘Crypto Winter’, But That Doesn’t Make Them Secure

Amid the harsh conditions of this year’s “crypto winter,” one category of blockchain currency has fared better than others: stablecoins, which are pegged to an existing currency like the US dollar or euro. As its counterparts stumbled, the largest stablecoin, Tether, briefly broke free of the dollar but managed to hang on. “They weathered the storm,” says Yale SOM’s Gary Gorton.

But that doesn’t mean the coast is clear. In several recent posts, Gorton highlights the systemic risks posed by stablecoins when comparing them to private currencies of the past. Those historical analogs ultimately created more problems than they solved and failed to improve the money issued by governments. The same problems, Gorton argues, are true for stablecoins today.

In a paper co-authored with Sharon Y. Ross of the US Treasury and Chase B. Ross of the Federal Reserve Board of Governors (both Yale SOM alumni), Gorton shows that stablecoins follow similar patterns. to the privately issued bank notes of the “”free banking” era in United States history.

During this period, from 1837 to 1863, banks could issue their own money, apparently backed by government bonds. The challenge was that merchants from one region were understandably wary of another region’s banknotes, resulting in a complex system in which currency became less valuable as the distance from its issuer increased. Lax regulation also made these private notes vulnerable to bank runs. Eventually, to control the chaos, the federal government stepped in and became the exclusive issuer of a uniform national currency.

For Gorton, the complex technology behind stablecoins has blinded us to a simple truth: They are no different from the private currencies of the free banking era. “That was the last time there was privately produced money in circulation,” he says. “And stablecoins are also privately produced money in circulation.”

In the paper, Gorton and his co-authors find that private notes and stablecoins follow similar trajectories. The researchers created a variable called D that captures the “money” of a currency: qualities including its price, how easy it is to use in practice, and the likelihood that another party will accept it without question. Overtime, D it decreased for private notes, meaning they became more money-like. The researchers found that the same thing is happening with stablecoins, although it is still early days.

Decrease in D, they argue, stem in part from technological change. In the case of private banknotes, “it was mainly due to the railway, which allowed the notes to be returned to issuing banks faster,” explains Gorton, leading to less uncertainty about whether they could be successfully redeemed at face value. In the case of stablecoins, improved graphics processing units have made it faster to mine Etherium and convert it to, for example, Tether, resulting in higher efficiency.

Reputation build also reduces D, the researchers point out. In the era of free banking, newer bank notes traded at a discount to those of established banks in a given region, a testament to the role of trust and track record in monetary systems. To build its reputation and demonstrate stability, Tether has started issuing regular reports on its reserves. These kinds of disclosures are likely to make stablecoins more reputable and therefore more like money.

But just because stablecoins become more money-like doesn’t mean they improve government-issued currency, write Gorton and Jeffrey Zhang of the University of Michigan Law School in another recent post. They argue that, time and time again, and in many countries, a government monopoly on money issuance has been shown to provide the necessary financial stability and allow the necessary control over the money supply.

“We’ve been through all of this before, and I think the answer should be the same. Every country on Earth decided that the state should have a monopoly on creating a circulating currency.”

Looking at the financial history of countries such as England, Canada, the US, and Sweden, Gorton and Zhang show why monopolies are a better strategy than allowing private currencies to compete with government currencies. Many countries adopted the strategy of coexistence, until a major financial trauma convinced them to take drastic measures. In 19th-century Sweden, for example, the central bank twice had to bail out private banks after their currencies collapsed.

Unfortunately, in Gorton’s view, the US appears to be headed once again toward a strategy of coexistence. Congress has introduced legislation that would require more transparency from stablecoin issuers, indicating that they have tacitly accepted the presence of private currency in the US financial system and are choosing to regulate rather than ban it.

He sees it as a mistake, especially since it is possible to eliminate the risks of private money while enjoying the advantages of digital currency. Central banks could issue their own digital currency, with “potentially huge benefits for cross-border trade,” Gorton and Zhang write in a third paper. Today, moving money between jurisdictions is slow and expensive. A global digital currency system could reduce those frictions, something crypto advocates have long argued. Gorton and Zhang simply think that central banks, not private banks or corporations, should be in charge of the system.

“We’ve been through all of this before, and I think the answer should be the same,” says Gorton. “Every country on Earth decided that the state should have a monopoly on creating a currency in circulation.” The technology has changed, but the underlying problems are the same: “It’s no different now.”

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