SK Lee · Follow
7 min read · Jul 24, 2024
The financial landscape is evolving rapidly, with stablecoins emerging as a critical component in the intersection of decentralized finance (DeFi) and traditional finance (TradFi). In this context, the Hong Kong Monetary Authority (HKMA) has recently welcomed three entities into its Stablecoin Issuer Sandbox. Both Hong Kong and Singapore have clarified their regulatory frameworks for stablecoin issuance, underscoring the importance of stablecoins in driving Web3 policy directions and the necessity of proper regulation to ensure public confidence and financial stability. Here we will focus on the implications of stablecoins on the money supply, a crucial aspect of their broader economic impact.
Stablecoins are digital currencies designed to maintain a stable value by being backed by fiat currencies such as USD or EUR. As cryptocurrencies, they are compatible with public blockchains, facilitating seamless transfers. This fiat backing ensures that stablecoins maintain a relatively constant value, thereby minimizing the volatility typically associated with other cryptocurrencies. However, the issuance of stablecoins can significantly impact the overall money supply, particularly when the reserve funds are deposited in banks.
The money supply in an economy is measured in several ways, primarily using the aggregates M1, M2, and M3:
- M1: This includes the most liquid forms of money, such as physical currency (coins and notes), demand deposits, and other assets that can be quickly converted to cash.
- M2: This includes all of M1 plus near-money, which are less liquid but can still be quickly converted to cash. These include savings deposits, money market securities, and other time deposits.
- M3: This includes all of M2 plus large time deposits, institutional money market funds, and other larger liquid assets. M3 is the broadest measure of the money supply.
When a stablecoin issuer wants to issue 1 million stablecoins, each pegged to 1 USD, the issuer must back these stablecoins with an equivalent amount of fiat currency, i.e., 1 million USD. This fiat currency is then deposited into a reserve account at a bank. This reserve account is essentially a deposit, which banks can use (for example, in lending) subject to regulatory requirements for liquidity and capital adequacy. Banks typically lend out a portion of their deposits to generate income. This process is governed by reserve requirements and other regulatory constraints. Simply speaking, if the reserve requirement is 10%, the bank can lend out 900,000 USD of the 1 million USD deposit, keeping 100,000 USD in reserve.
When stablecoins are issued, they enter circulation and are used for transactions, effectively increasing the money supply. For instance, if a stablecoin issuer releases 1 million stablecoins, these now circulate within the economy, providing a new medium of exchange that adds to the existing money supply.
M1 (Most Liquid Assets): The issuance of stablecoins directly increases M1 because they are highly liquid and can be used for everyday transactions. For example, if 1 million stablecoins are issued, M1 increases by 1 million USD since these stablecoins function similarly to physical currency and demand deposits. This immediate increase in M1 could lead to higher spending and transaction volumes in the economy, potentially stimulating economic activity. However, it may be argued that the 1 million was actually from bank savings accounts by users to whom the stablecoins are issued, that impact should be in M2 instead.
M2 (M1 + Near-Money): If individuals and businesses move money from savings deposits (part of M2) to purchase stablecoins, M2 is affected. However, since stablecoins are still part of M1, the overall money supply (M2) increases. For example, if 500,000 USD is moved from savings accounts to buy stablecoins, M2 initially decreases by 500,000 USD, but M1 increases by 1 million USD, leading to a net increase in M2 by 500,000 USD. This shift can affect savings rates and the availability of funds for long-term investments, potentially influencing interest rates and economic growth. However, it may be possible that 1 million USD is moved from a savings account to buy 1 million USD stablecoins, then there will be no change to the overall M2. What should be taken into consideration is that there may be possibly new funds entering into the jurisdiction in which the stablecoin is being issued, and may increase the overall domestic money supply.
M3 (M2 + Larger Liquid Assets): The broadest measure of money supply, M3, encompasses all that is included in M1 and M2. Additionally, stablecoin-related activities can influence large time deposits and institutional funds. For instance, if institutional investors begin holding substantial amounts of stablecoins within their portfolios, M3 could see significant increases. An increase in M3 indicates higher overall liquidity in the economy, which can affect long-term interest rates and investment activities. However, since stablecoins can be utilized in DeFi, the spending may actually occur outside the jurisdiction, meaning the domestic M1 may not increase proportionally with the issuance of stablecoins. The cryptocurrency nature of stablecoins adds complexity to assessing their impact on the domestic money supply.
The bank holding the stablecoin reserves can lend out a significant portion of these reserves. With a reserve requirement of 10%, for example, the bank can lend out 900,000 USD, further increasing the money supply. This process essentially creates new money, as the lent-out funds are re-deposited and re-lent within the banking system.
Bank lending activities have a multiplier effect on the money supply. The initial deposit leads to a series of loans and deposits, amplifying the overall impact. For instance, the 900,000 USD lent out can be re-deposited and lead to further lending, significantly expanding the money supply beyond the initial amount of stablecoins issued.
There can also be a risk of double counting, where both the stablecoins and the lent-out fiat reserves are considered part of the money supply, inflating perceived liquidity. This can cause inflationary pressures if not properly managed.
Stablecoins are borderless and can be used globally in DeFi and public blockchain ecosystems, extending their impact beyond local economies. This global circulation facilitates international transactions without traditional banking systems, enhancing global liquidity and trade efficiency but complicating the tracking and regulation of money flows.
Large-scale issuance of stablecoins backed by a single fiat currency, such as USD, can affect foreign exchange markets. Increased demand for the backing currency can appreciate its value, impacting international trade balances and monetary policies. For example, if many stablecoins are issued and backed by USD, the demand for USD rises, potentially strengthening the dollar and affecting US export competitiveness.
The decentralized nature of stablecoins can lead to regulatory arbitrage, where issuers and users exploit differences in regulations across jurisdictions. This complicates efforts by individual countries to manage their money supply and enforce financial regulations, as issuers might choose jurisdictions with lax regulations, making effective regulation and monitoring challenging for countries with stricter controls.
An inflated money supply can lead to inflation, reducing the purchasing power of the currency. Central banks may struggle to control the money supply and maintain economic stability, especially if stablecoins fall outside their regulatory scope. The additional liquidity from stablecoins can increase demand for goods and services, driving up prices and eroding the value of money.
Traditional monetary policy tools, such as interest rates and open market operations, may become less effective. Central banks need to consider the liquidity provided by stablecoins when setting policy. If stablecoins become a significant part of the money supply, central banks might find it challenging to influence economic conditions through traditional mechanisms, necessitating new approaches to monetary policy.
The issuance of stablecoins presents complex challenges for money supply management, both domestically and globally. Governments and regulators must implement robust frameworks to ensure that stablecoins do not inadvertently destabilize the economy. By maintaining stringent oversight, transparent reserve management, and effective coordination with monetary policies, the potential risks associated with stablecoin issuance can be mitigated. The borderless nature of stablecoins further underscores the need for international cooperation and regulation to manage their impact effectively.
