Stablecoin Paradox
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Stablecoin Paradox
Stablecoins have facilitated the development of decentralized finance, but they themselves run counter to decentralization.
Navigating Web3 tides with focused insightsBy: Eswar Prasad, Professor of Economics at Cornell University
Translated by: Eric, Foresight News
The early revolutionaries of cryptocurrency aimed to break the monopoly of central banks and large commercial lenders over financial intermediation. The grand vision behind Bitcoin—the first crypto asset—and its underlying blockchain technology was to bypass intermediaries and directly connect transacting parties.
This technology was meant to democratize finance, giving everyone, rich or poor, easy access to a wide range of banking and financial services. Emerging financial institutions would use this technology to offer competitive financial products—such as customized savings, credit, and risk management solutions—without the need to build costly physical branches. The goal was to sweep away the old financial institutions that lost public trust during the global financial crisis and establish a new financial order. In this decentralized new world of finance, competition and innovation would flourish, benefiting both consumers and businesses.
But the revolution was quickly subverted. Decentralized crypto assets like Bitcoin, which are created and managed by computer algorithms, have proven impractical as mediums of exchange. Their values fluctuate wildly, and they cannot process large volumes of transactions at low cost, making them unsuitable for everyday use and preventing them from achieving their intended purpose. Instead, Bitcoin and other crypto assets ultimately became what they were never supposed to be—speculative financial assets.
Stablecoins emerged to fill this gap, serving as more reliable mediums of exchange. They use the same blockchain technology as Bitcoin but maintain stable value by being pegged one-to-one to reserves of central bank currencies or government bonds.
Stablecoins have advanced decentralized finance (DeFi), yet they themselves run counter to decentralization. Rather than relying on decentralized trust mediated by computer code, they depend on trust in the issuing entity. Their governance is not decentralized either; users do not determine rules through open consensus. Instead, the stablecoin issuer decides who can use and how to use the currency. Stablecoin transactions, like those of Bitcoin, are recorded on digital ledgers maintained by decentralized networks of computer nodes. But unlike Bitcoin, these transactions are validated by the stablecoin issuer, not by computer algorithms.
Payment Channels
Perhaps an even greater promise lies ahead. Stablecoins could still serve as gateways for people across income levels to access digital payments and DeFi, weakening the long-standing privileges of traditional commercial banks and, in some ways, narrowing the gap between wealthy and poorer nations. Even small countries could benefit by gaining easier access to the global financial system and reducing frictions in payment systems.
Stablecoins do lower payment costs and reduce friction, especially in cross-border transactions. Economic migrants can now send remittances home more easily and affordably than ever before. Importers and exporters can settle foreign transactions instantly, without waiting days.
However, beyond payments, DeFi has largely devolved into a stage for financial engineering, spawning many complex products whose value beyond speculation is questionable. DeFi activities have done little to improve the lives of poor households and may even harm inexperienced retail investors lured by high returns while overlooking risks.
Regulatory Shifts
Can recent U.S. legislation allowing various companies to issue their own stablecoins promote competition and curb less reputable issuers? In 2019, Meta attempted to launch its own stablecoin, Libra (later renamed Diem). However, strong opposition from financial regulators led to the project’s cancellation. Regulators feared such stablecoins might undermine the effectiveness of central bank money.
With a shift in Washington’s regulatory environment and a new administration friendly toward cryptocurrencies taking office, the door has opened for private stablecoin issuers. Stablecoins issued by major U.S. corporations like Amazon and Meta, backed by strong balance sheets, could dominate and displace other issuers. Issuing stablecoins would strengthen these firms, leading to increased market concentration rather than enhanced competition.
Large commercial banks are also adopting new technologies to improve operational efficiency and expand their reach. For example, converting bank deposits into digital tokens enables trading on blockchains. It is foreseeable that major banks may one day issue their own stablecoins. All of this would erode the advantages of smaller banks—such as regional and community lending institutions—and consolidate the power of large banks.
International Dominance
Stablecoins may also reinforce existing structures in the international monetary system. Dollar-backed stablecoins have the highest demand and are used most widely around the globe. They could ultimately enhance the dollar’s dominance in global payments indirectly and weaken potential competitors. For instance, Circle, the issuer of the second-most popular stablecoin USDC, sees very low demand for its other stablecoins pegged to major currencies like the euro and yen.
Even major central banks feel uneasy. Concerns that dollar-backed stablecoins could dominate cross-border payments have prompted the European Central Bank to develop a digital euro. Payment systems within the eurozone remain fragmented. While it is possible to transfer funds from a Greek bank account to one in Germany, using funds from a bank account in one eurozone country to pay in another remains inconvenient.
Stablecoins pose an existential threat to the currencies of small economies. In some developing countries, people may trust stablecoins issued by well-known companies like Amazon and Meta more than their local currencies, which suffer from high inflation and exchange rate volatility. Even in economies with reliable central banks and sound macroeconomic management, individuals may find it hard to resist the appeal of stablecoins—convenient for both domestic and international payments and linked in value to major global currencies.
Inefficiencies of Traditional Payment Systems
Why have stablecoins attracted so much attention so quickly? One reason is that high costs, slow processing speeds, complex procedures, and other inefficiencies continue to plague domestic and international payment systems in many countries. Some nations are considering issuing their own stablecoins to prevent their currencies from being marginalized by dollar-backed stablecoins. But such efforts are unlikely to succeed. They would be better off first fixing their domestic payment systems and cooperating with others to reduce frictions in international payments.
Stablecoins appear safe but harbor significant risks. One is that they could facilitate illegal financial activities, making anti-money laundering and counter-terrorism financing efforts more difficult. Another is that they create privately managed, siloed payment systems, threatening the integrity of the overall payment infrastructure.
Solutions
The solution seems obvious: effective regulation can reduce risks, allow space for financial innovation, and ensure fair competition by curbing excessive economic concentration among a few firms. The internet knows no borders, so national-level regulation of stablecoins is far less effective than cooperative, multilateral approaches involving multiple countries.
Unfortunately, in today’s environment of weak international cooperation—where countries actively defend and advance their own interests—such outcomes are unlikely. Even major economies like the United States and the eurozone regulate cryptocurrencies independently. Even under more coordinated frameworks, smaller economies would struggle to participate in decision-making. Countries with weak financial systems and limited regulatory capacity, which rely heavily on robust oversight, may be forced to accept rules imposed by larger powers that scarcely consider their own interests.
Stablecoins serve to expose widespread inefficiencies in existing financial systems and demonstrate how innovative technologies could address them. Yet, they may also lead to greater concentration of power. This could give rise to a new financial order—not the one envisioned by cryptocurrency pioneers, filled with innovation, competition, and fairer distribution of financial power—but one marked by even greater instability.
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