Topic question In pursuit of a global currency is stablecoin the answer

Topic question:
In pursuit of a global currency: is stablecoin the answer?

Course

Financial Markets BAFI3182

Assignment

Assignment 3 – Research paper

Student’s name

Phan Thai Binh

Student ID

s3804785

Lecturer

Mr. James Murphy

Class time

Friday 11.30am

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Table of contents

1. Abstract........................................................................................................................................3
2. Introduction.................................................................................................................................3
3. Literature Review.........................................................................................................................4
3.1. What are stablecoins?......................................................................................................................4
3.1.1. Definition...................................................................................................................................4
3.1.2. Types of stablecoins...................................................................................................................4
3.2. Contemporary problems in the global payment system...................................................................7
3.2.1. Shortcomings of fiat money.......................................................................................................7
3.2.2. Shortcomings of the cross-border payment system...................................................................7
3.2.3. Shortcomings of the first-generation cryptocurrencies..............................................................8
3.3. How stablecoins can address these problems..................................................................................8
3.3.1. Acting as a true currency...........................................................................................................9
3.3.2. Promoting financial inclusion and currencies resilience............................................................9
3.3.3. Allowing regulations and governance......................................................................................10
3.4. Economic issues raised by stablecoins............................................................................................10
3.4.1. Illicit financial acts and cyber risks...........................................................................................11
3.4.2. Risk of a bank run....................................................................................................................11
3.4.3. Spillover effects and monetary sovereignty undermining........................................................11
3.4.4. Changes in bank business model.............................................................................................12
3.5. Central banks and officials’ views towards stablecoins...................................................................12

4. Conclusion..................................................................................................................................13
5. Limitations.................................................................................................................................13
6. References.................................................................................................................................14

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1. Abstract
This paper aims to examine the potential of stablecoins as a global payment instrument and

their possible impacts on the financial markets. As a literature review, my research concentrates
mainly on evaluating the findings of different authors in the field of stablecoins and analyzing
how these findings correlate with each other. Ultimately, this paper seeks to apply some
financial markets theories to the way stablecoins operate and financial actors behave. This study
encompasses the discussions of existing issues in the financial sector, the advantages of
stablecoins and economic problems ensuing them. It also includes the analysis of four main
types of stablecoins and authorities’ opinions on these digital assets. Finally, no data is included
since this paper is conceptual.

2. Introduction
With the advent of blockchain technology, the financial market is witnessing the emergence of
assets that operate on the digital platform – cryptocurrencies. Among the apparent benefits,
there still exist an array of pitfalls hidden beneath these assets’ shells that can wreak havoc on
global financial stability. A notable example would be the price crash of Bitcoin in 2018 which
caused a lot of investors to incur serious losses. In light of this extreme volatility of cryptoassets,
stablecoins appear to be the solution with their ability to stabilize their value over time. Various
studies have found that a global stablecoin not only can complement the first breed of
cryptocurrencies but also improve the global payment system and currencies ecosystem.
However, does the concept of a stable global currency sound too perfect that it can only exist in
a utopia? Bearing that wonder in mind, I have decided to choose stablecoins as the topic of my
literature review, which begs the question: In pursuit of a global currency, is stablecoin the
answer?

In Part 3.1, I will examine the concept as well as the pros and cons of four distinct breeds of
stablecoins. Next, I will shed light on some contemporary shortcomings inherent in the global
payment system that stablecoins aim to address, specifically the weaknesses of the fiat
currencies, cross-border payment system and the first-generation of cryptocurrencies (Part 3.2).
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After that, in Part 3.3, I will elaborate on the strong features of stablecoins that can help uproot
the aforementioned problems. This part will boil down to stablecoins’ capability of being a true
currency, advancing financial inclusion and currencies flexibility as well as how they can
incorporate regulations into their system. Then, the main focus of Part 3.4 is on the notable
economic risks that stem from stablecoins. These include illegal financial activities, cyberattacks, the classic bank run, concerns regarding the spillover effects along with monetary
sovereignty disruption, and the situation where stablecoins subdue the role of the banking
sector. Subsequently, Part 3.5 will present the opinions of global financial authorities on this
type of digital asset. Finally, I will recapitulate the main points of this paper and illustrate some
limitations existing in this study.

3. Literature Review
3.1. What are stablecoins?
3.1.1. Definition
To be able to fully analyze stablecoins, it is of great essence to first comprehend their concepts.
According to Dell’Erba (2019), stablecoins are cryptocurrencies whose value remains stable
against a target benchmark, or as Chohan (2019) puts it, a new generation of cryptocurrencies.
Brainard (2019) extended the definition and added stablecoins’ working principles to limit
volatility – by pegging these coins to an asset or a group of assets and by algorithmic
mechanisms.

3.1.2. Types of stablecoins
With the differences in the operational principles and level of decentralization, stablecoins are
generally divided into four types: fiat-collateralized stablecoins, off-chain collateralized
stablecoins, on-chain collateralized stablecoins, and

non-collateralized or

algorithmic

stablecoins.

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3.1.2.1. Fiat-collateralized stablecoins
As the name has stated, fiat-collateralized stablecoins are cryptocurrencies that use fiat money
as collateral. The most famous coin of this type is Tether which is tied with the ratio 1:1 to USD.
Using real fiat money like USD to back, this type of stablecoins requires a central entity to
secure the collateral funds and ensure that these funds are redeemable (Bullmann, Klemm &
Pinna 2019). In their paper, Demirag, Seyedehmahsa, and Clark (2019) found that fiat-backed
stablecoins hold the same price and volatility in their value as the collateral fiat currencies. In
another study on stablecoins, Kuznetsov (2019) asserted that while fiat-backed stablecoins hold
some advantages for its simplicity and stability, they also have a downside as this type of
stablecoins needs a certain amount of trust towards the central body to be able to operate. This
is consistent with the findings of Berentsen and Schär (2019). These authors elaborated more
on the disadvantages of fiat-backed stablecoins by adding concerns about the profitability of the
issuer. To achieve high stability, assets in the reserves need to be liquid, and since liquid assets
usually get low returns, the stablecoins issuer would gain poor profits (Berentsen & Schär 2019).

3.1.2.2. Off-chain collateralized stablecoins
Off-chain collateralized stablecoins are cryptocurrencies whose value is pegged to physical
assets like commodities or real estates. For example, Digix Gold Token (DGX) is a stablecoin
using gold as collateral. Similar to fiat-collateralized stablecoins, this breed of stablecoins
involves a custodian who ensures that the collateral reserves are kept safely at a specific place
(Bullmann, Klemm & Pinna 2019). These authors also found that due to mild volatility in the
price of these assets, many off-chain backed stablecoins are obliged to be over-collateralized
and there happens a process called compulsory redemption when the value of the collateral
falls below the over-collateralization minimum level required. To be specific, a user’s collateral
would be liquidated if he does not top up the amount of collateral to the minimum level when
receiving the margin call (Bullmann, Klemm & Pinna 2019). In his study, Kuznetsov (2019)

pointed out that this type of stablecoins is beneficial for their stability and real assets backbone
but also bears some disadvantages stemming from audit costs, transparency, and trust issue for
the central body.
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3.1.2.3. On-chain collateralized stablecoins
On-chain collateralized stablecoins are cryptocurrencies that are backed up by other
cryptocurrencies. A popular example would be MakerDAO, whose value is backed by Ether.
Because the collateral is also digital assets, the whole system of these stablecoins runs
completely on a blockchain and thus are absolutely decentralized (Bullmann, Klemm & Pinna
2019). Demirag, Seyedehmahsa, and Clark (2019) supported this point by asserting that the
exchange rates of the backing cryptocurrencies are constantly updated by a smart contract
called an oracle, not a real custodian. The collateralization ratio required by these stablecoins
stands as high as 150% (Bullmann, Klemm & Pinna 2019), which stems from the fact that many
cryptocurrencies are highly correlated with significant volatility (Yi, Xu, and Wang 2018) . Due to
the unstable nature of the collateral assets, Kuznetsov (2019) believed that on-chain backed
stablecoins would not be a useful tool for payments.

3.1.2.4. Non-collateralized stablecoins (Algorithmic stablecoins)
Non-collateralized stablecoins are cryptocurrencies that use stabilizing algorithms to limit
volatility and do not need any assets to back up. The most well-known and potential stablecoins
of this kind are Basis and NuBits. In his research, Dell’Erba (2019) demonstrated the working
principles of non-backed stablecoins: when the cryptocurrency price falls below a certain level,
the smart contract will issue and sell bonds to users, in exchange for the coins which will be
burned and destroyed so as to reduce the coins supply and vice versa. Therefore, in a sense of
managing the money supply, the smart contract appears to play a role of a real central bank as it
controls the volume of money in circulation (D’Monte 2019). This discovery falls in line with the
study of Lee (2018) who pointed out the similarities between the smart contract and a central
bank. In his paper, Kuznetsov (2019) argued that although algorithmic stablecoins are extremely

stable and not affected by counterparty risks, this class of stablecoins is difficult to be launched
due to complex technology.

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3.2. Contemporary problems in the global payment system
3.2.1. Shortcomings of fiat money
The ecosystem of fiat currencies, while seems to run on a smooth course with discrete
monetary sovereignty of each government, has been proved to contain some drawbacks. Firstly,
according to the findings of Kuznetsov (2019), the price of fiat currencies is not backed up by
any real assets with intrinsic value but rather depends on the economy in the issuer country,
hence tends to fluctuate on a daily basis due to news and public opinions. This is certainly true
in the forex market. Theoretically, movements in exchange rates of currencies hinge on supply
and demand of the currencies, which in turn depend on the speculation and confidence of
investors in the emitting countries. Secondly, Rey (2015) found that due to the global spread of
the US dollars, any economic swings of the US economy would lead to a spillover effect and
exert a multiplier impact on the rest of the world. This notion is consistent with the study of
Carney (2019), in which this author emphasized the unhealthy dependence of the global
economy on the USD and stated that the depreciation of USD could result in tighter credit
conditions, especially in emerging economies.

3.2.2. Shortcomings of the cross-border payment system
Payments carried out between countries play an important role in both international trade and
domestic context. As stated in the paper conducted by G7 Working Group on Stablecoins, three
factors are to be blamed for a slow and costly cross-border payment. Firstly, since a huge
proportion of the world population lack access to financial services, the current payment system
is not efficient in facilitating worldwide transactions (Cœuré et al. 2019). Secondly, these
authors stated that the AML/CFT (Anti Money Laundering and Counter Financing of Terrorism)
program requires safety measures at multiple steps in the transaction, thus significantly driving

up the cost of international payments. Lastly, incertitude about contractual obligations
emanating from different legal frameworks across jurisdictions have added a lot of frictions to
the efficiency and slow down the contemporary cross-border payment system (Cœuré et al.
2019).

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3.2.3. Shortcomings of the first-generation cryptocurrencies
The first wave of cryptocurrencies emerged in 2009 when Bitcoin was issued by Satoshi
Nakamoto, followed by an array of cryptoassets like Litecoin or Ethereum. In spite of many
advantages offered by the blockchain technology, this first-generation of cryptocurrencies still
hold some noticeable drawbacks that limit their potential to become a method of global
payment. The first disadvantage of these cryptocurrencies lies in their high volatility. According
to Berentsen and Schär (2019), as these coins’ value depends completely on market
expectations about its future movements, their price usually fluctuates startlingly and becomes
a target for market manipulation. Because of such instability, Klages-Mundt and Minca (2019)
and Abraham (2019) in their paper asserted that this first breed of digital assets is often used by
speculators to take advantage of the volatile market rather than a means of payments.
Secondly, these cryptocurrencies have raised serious concerns regarding governance and
regulations (Cœuré et al. 2019). In his study, Conesa (2019) corroborated this statement by
arguing that since the system does not have a central entity, a possible attack vector is stealing
the private key of the owner to fake the transactions without being inspected by any authority.
Ultimately, Brainard (2019) considered this lack of transparency and a governing body to be a
major reason for high barriers to the adoption of this first-generation cryptoassets as an
instrument for payment.

3.3. How stablecoins can address these problems
In light of the aforementioned issues, stablecoins have been shown to hold a profusion of
advantages that can help alleviate these problems and increase their potential to become a

global means of payment.
3.3.1. Acting as a true currency
First of all, Dell’Erba (2019) asserted that stablecoins have the ability to perform the essential
functions of a currency: a store of value, a medium of exchange and a unit of account. This
author elaborated on this point and stated that the price stability of stablecoins can subdue the
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amount speculations, hence fitting their utility as a means of exchange and store of value. In
their paper, Clark, Demirag, and Moosavi (2019) consolidated this idea with their finding that
stablecoins are more evolved than the first breed of cryptocurrencies in a sense that they are
able to play a role of a true currency, whereas the likes of Bitcoin can hardly stand a chance with
their extreme volatility.

3.3.2. Promoting financial inclusion and currencies resilience
Secondly, stablecoins are believed to have the prospect of advancing financial inclusion. This
new wave of cryptoassets will likely grant access to financial services for the portion of the
population that currently lacks connection to the payment system when being launched on a
global scale (Natarajan et al. 2017, cited in Kuznetsov 2019). In their paper, Bullmann, Klemm,
and Pinna (2019) also asserted that due to the simplicity and stability, stablecoins can be used
for retail payments in developing countries where confidence in the domestic payment system
is low. Furthermore, stablecoins hold a large potential to become a solution for people living in
a country with high inflation because they can secure and elevate consumers’ purchasing power
(Bilal, cited in Kuznetsov 2019).

Additionally, stablecoins can increase the flexibility of the currency ecosystem. Abraham (2019)
found that fiat-backed stablecoins can provide a gateway to popular currencies such as USD or
EUR for developing regions, thus facilitating international trade and commerce. In his study,
Dell’Erba (2019) complemented this point and stated that at the same time, stablecoins can also
reduce global dependence on the US dollar since they can serve as the perfect replacement of

the USD for their limited volatility.

3.3.3. Allowing regulations and governance
Another innovation that stablecoins can bring about is their openness to governance and
regulations. Lee (2019) showed that there is a growing desire of crypto companies to
incorporate regulations into their operations as an attempt to adopt safety protocols like KYC

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(Know Your Customer) or AML (Anti Money Laundering). Owing to the stability, financial
institutions and banks would be more likely to authorize and integrate stablecoins into their
traditional system, hence raise the opportunity to exercise regulations on this type of
cryptocurrency (Bowater 2019).

A different approach of stablecoins to allow governance is to fuse the responsibility of private
sectors and banks into their operations. In their paper, Adrian and Mancini-Griffoli (2019)
comprehensively explained one hybrid solution is to peg fiat-backed stablecoins to the
currencies in central bank reserves, and the epitome of this mechanism is when The People’s
Bank of China demanded AliPay and WeChat Pay to back their coins with banks assets. Since the
reserve is safely secured by the central bank, this approach can promote transparency and ease
of transactions (Adrian & Mancini-Griffoli 2019). Proponents of this method are Copeland
(2019) and former IMF chairman Christine Lagarde (Dell’Erba 2019), who believed that statebacked stablecoins have a large potential to become an authentic digital currency, especially on
a domestic level where they can gain trust from customers with the involvement of the central
bank.

So in short, it is obvious that stablecoins take the best features of traditional currencies and
cryptocurrencies, specifically the stability and trustworthiness from fiat money and the ease of
circulation from cryptoassets.

3.4. Economic issues raised by stablecoins
Although stablecoins hold a great prospect to address the existing issues in the financial market,
many researchers have raised a red flag and found that this type of cryptocurrency can give rise
to various economic pitfalls if not controlled properly.
3.4.1. Illicit financial acts and cyber risks
According to Cœuré et al. (2019) and Bullmann, Klemm, and Pinna (2019), the decentralized
peer-to-peer network on blockchain of stablecoins poses a lot of risks for cyber-attacks and

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illegal acts. This finding falls in line with those of Woensel, Kritikos, and Fanni (2019) who took a
specific example of Libra – the stablecoin of Facebook – and pointed out that Libra operates on
mobile network, information technology system and data flows, which are all susceptible to
cyber-attacks and fake transactions in money laundering. Additionally, Cœuré et al. (2019)
argued that stablecoins can promote tax evasions and illegal goods trading. This author
explained that because the transactions through blockchains are rendered anonymous and thus
hampering the detection of shady activities, stablecoins can potentially create room for the
aforementioned illicit schemes.
3.4.2. Risk of a bank run
Stablecoins have been proved to be extremely prone to a bank run behavior. The working group
on stablecoins of G7 stated in their study that since a global stablecoin is built on trust of users,
any incident that tarnishes this coin’s reputation can strongly discourage people to hold that
stablecoin as asset, hence resulting in a bank run and imposing downward pressure on the value
of the coin (Cœuré et al. 2019). This finding is also consistent with the research of Chohan
(2019) and Kuznetsov (2019), who demonstrated a range of factors contributing to bank run
activity in stablecoins, including the robust rise of other currencies in the case of NuBits crash in
2016.
3.4.3. Spillover effects and monetary sovereignty undermining
Regarding the worldwide operating scale of a global stablecoin, The Federal Reserve System

(2019) asserted that if an excessive number of participants in the financial market places their
assets in stablecoins, it is reasonably foreseeable that a defect in the operations may result in
single points of failure and amplify the damages to the whole system. This idea is supported by
the study of Brainard (2019). This author argued that the spillover effects can be intensified if
banks and traditional financial institutions refrain from adopting stablecoins into their system
and providing liquidity when needed to help stabilize the market. Furthermore, Cœuré et al.
(2019) found that stablecoins might debilitate the power to implement monetary policies of a
government and disrupt the domestic financial market if a huge proportion of residents in that
country switch from domestic currencies to stablecoins to secure their assets.

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3.4.4. Changes in bank business model
Another economic impact that a global stablecoin can bring about is that its existence can alter
the role of banks in the financial market. According to Brainard (2019), stablecoins with their
stability and flexibility might induce customers and investors to shift their deposits from bank
reserves to digital wallets. This author also added that this transition will squeeze banks’
funding and hence dampening their ability to make loans to make money. In another study,
Cœuré et al. (2019) strengthened this argument by stating that with this shortage of funds,
banks would have to raise money from more costly and riskier sources or, in extreme cases, be
forced to shut down business, which leads to the situation of disintermediation. From my
perspective, this is not necessarily a bad thing but steps need to be taken to prepare the
financial sector for such change and prevent any abrupt disruption in the market.

3.5. Central banks and officials’ views towards stablecoins
Taken into consideration the advantages as well as economic risks that stablecoins can create,
financial authorities around the world have expressed their cautiousness, and at the same time,
their willingness to embrace such a leap of development.

The G7 Working Group on Stablecoins, which represents the voice of seven leading countries,
has stated that although being expected to address the challenges in the financial sector,
stablecoins still pose a lot of serious economic, legal and regulatory risks that need to be
identified (Cœuré et al. 2019). The central bank of the US conveyed the same perspective. The
Fed believed that while stablecoins are capable of improving global financial services, it is of
great essence for this nascent type of cryptocurrency to satisfy all legal and economic standards
before going into circulation (Federal Reserve System 2019). Ultimately, the G7 asserted that no
stablecoin should be launched until all the risks are carefully and sufficiently addressed (Cœuré
et al. 2019).

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4. Conclusion
In conclusion, stablecoins hold a large potential to address the long-standing issues in the
financial markets but strict oversight of such projects is of great essence. With various
mechanisms to stabilize their prices, stablecoins can serve as a true currency and reduce global
dependence on the US dollar. They can also provide financial access to the population that lacks
connection to the payment system and open the door to regulations, which renders them more
beneficial than both fiat money and the first wave of cryptocurrencies. However, stablecoins
raise many economic risks that need to be addressed. Operating on the blockchain technology
which allows anonymity, stablecoins can easily become the target for cyber-attacks and illicit
financial acts such as money laundering or trading of prohibited goods. They can also debilitate
the role of banks by cutting their sources of fundings, hence promoting disintermediation. In
regards to stablecoins, leading financial authorities are remaining alert but open to any
innovation that can help improve the financial sector. Particularly, the G7 emphasized the
importance of careful preparations prior to the launch of any stablecoin.

5. Limitations
There is a limitation that restrains the scope of my paper. Since stablecoin is a nascent topic that

has just drawn mass attentions only after the announcement of Libra by Facebook, there have
not been many authorities looking into it. This paper thus only includes the voice of the leading
countries in the Group of Seven. Consequently, there is a lack of opinions of financial regulators
in developing countries, where stablecoins are envisioned to exert the most influence on. This
limitation may therefore diminish the worldwide perspective on stablecoins of this literature
review.

6. References
Abraham, R 2019, ‘Stablecoin: The new kid on the block(chain)’, The Economic Times, 17 May,
viewed 20 December 2019, < />13


Adrian, T & Mancini-Griffoli, T 2019, ‘From Stablecoins to Central Bank Digital Currencies’, IMF
Blog, 26 September, viewed 20 December 2019, < />
Berentsen, A & Schär, F 2019, ‘Stablecoins: The quest for a low-volatility cryptocurrency’, in
Fatas A, The Economics of Fintech and Digital Currencies, CEPR Press, London, pp. 65-71.

Bowater, J 2019, ‘Stablecoins - An Elegant Solution For Crypto Chaos’, City AM, 4 February,
viewed 21 December 2019, < />
Brainard, L 2019, ‘Digital Currencies, Stablecoins, and the Evolving Payments Landscape’, Speech
at The Future of Money in the Digital Age, Peterson Institute for International Economics and
Princeton University’s Bendheim Center for Finance, Washington, D.C.

Bullmann, D, Klemm, J & Pinna, A 2019, ‘In search for stability in crypto-assets: are stablecoins
the solution?’, European Union: Occasional Paper Series, no. 230.

Carney, M 2019, ‘The Growing Challenges for Monetary Policy in the current International
Monetary and Financial System’, Speech at Jackson Hole Economic Policy Symposium 2019,
Federal Reserve Bank of Kansas City.

Chohan, U 2019, ‘Are Stable Coins Stable?’, Discussion Paper Series: Notes on the 21 st Century.
Clark, J, Demirag, D & Moosavi, S 2019, ‘SoK: Demystifying Stablecoins’, SSRN,
< />
Conesa, C 2019, ‘Bitcoin: A Solution for Payment Systems or a Solution in Search of a Problem?’,
Banco de Espana Ocassional Paper, no. 1901.

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Copeland, R 2019, ‘A Global Stablecoin: Revolutionary Reserve Asset or Reinventing the
Wheel?’, SSRN, < />
D’Monte, L 2019, ‘Stablecoins gain traction amid volatility in bitcoins’, Live Mint, 4 June, viewed
22 December 2019, < />
Dell’Erba, M 2019, ‘Stablecoins In Cryptoeconomics. From Initial Coin Offerings (Icos) To Central
Bank Digital Currencies (CBDCs)’, New York University Journal of Legislation and Public Policy,
forthcoming.

G7 Working Group on Stablecoins 2019, Investigating the impact of global stablecoins, G7
Working Group on Stablecoins.

Klages-Mundt, A & Minca, A 2019, ‘(In)Stability for the Blockchain: Deleveraging Spirals and
Stablecoin Attacks’, IDEAS Working Paper Series from RePEc.

Kuznetsov, Y 2019, ‘Adaptation of stablecoins as the reserve currency’, Review of Business and
Economics Studies, vol. 7, no. 1, pp. 57-61.

Lee, P 2018, ‘Are stablecoins the reinvention of money?’, Euro Money, 6 November, viewed 21
December 2019, < />Rey, H 2015, ‘Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy
Independence’, NBER Working Paper, no. 21162.

The Federal Reserve System 2019, Financial Stability Report on November 2019, The Federal
Reserve System, Washington, D.C.

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Woensel, L, Kritikos, M & Fanni, R 2019, ‘What if Libra disrupted the financial system?’,
European Parliamentary Research Service Paper.

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