After a series of moves from former Comptroller of the Currency Brian Brooks, the Office of the Comptroller of the Currency (OCC) has allowed federally regulated banks to use stablecoins to conduct payments, among other things.
Published in early January in an interpretive letter, the federal banking regulator said that national banks and federal savings associates could participate in the use of stablecoins (otherwise referred to as independent node verification networks, INVNs, or blockchain networks), which is opening up the doors for banks to discuss how they want to participate in the INVN. Since the use of INVNs comes with several fraud risks, operational risks, and compliance changes, banks will need to consider all of the avenues for implementing this.
Even though this is still in development, we’re excited that the OCC is encouraging this shift, especially since the development of Central Bank Digital Currencies (CBDC) has been extremely slow.
Here’s what you need to know about the potential introduction of stablecoins in the banking networks:
What are Stablecoins?
Based on digital ledger technology (DLT), stablecoins are an asset-backed digital currency. This digital currency operates on blockchain technology and comes with many of the benefits of blockchain, including greater flexibility, transparency, security, traceability, and increased financial efficiency.
Specifically, stablecoins may operate on the digital ledger, but they are backed by a physical asset, like gold, the U.S. dollar, or they are modified by an algorithm to remain stable. By adding a type of collateral, stablecoins present a real opportunity to be used in everyday life as a means of a hybrid fiat currency.
Stablecoins were a necessary creation because of the wide fluctuations in the blockchain. Blockchain cryptocurrencies are volatile and cannot be used for everyday transactions. Therefore, while blockchain presents a number of benefits, they still aren’t useful yet. Stablecoins are one step closer to being functional, and financial regulators like the OCC have recognized this and have green-lit the use of stablecoins in banks and financial institutions.
While stablecoins present risks, their slow adoption means that stablecoins could be used more widely. In addition to the rise of the CBDC, which the stablecoin helped create, we expect to see more digital currencies in the next ten years.
Challenges Associated with Stablecoin Transactions
While stablecoins have opened the doors to a new kind of digital currency, and a viable competitor to the CBDC, they still pose an incredible level of risk. Largely, banks and financial regulators are worried that stablecoins, which rely on digital legal technology, are vulnerable. Banks also recognize that they have limited control over identity verification since the issuer and the claim cannot be identified.
Without the ability to impose know your customer (KYC) or know your business (KYB) regulations, banks believe that stablecoins could weaken the people’s trust in financial markets. Stablecoins also do not perform like money, so financial institutions must jump through hoops in order to make it something that people would be willing to use.
In addition to identity verification, stablecoins can potentially trigger shifts to large bank deposits, impacting bank operations and monetary policy. In this way, banks may not be able to keep up with these changes, and it might pose undue risk and vulnerability on their daily operations.
Of course, with the news that banks can begin to adopt stablecoin, they are uncertainties around what the right move would be. Should banks accept the stablecoin from existing parties, or should they create their own? Creating their own stablecoins would make sense, but all of the overhead in creating a stablecoin would probably match the pace with the CBDC, which means that we wouldn’t see bank-regulated stablecoins for years.
By accepting a partnership with an existing firm, banks are risking a lot because of counterparty risk. For example, a stablecoin issuer could fail a regulatory test, or their system could go down due to less than ideal finances, operational processes, and backing associated with financial regulations or fintech hardware and security measures.
Banks wouldn’t want to risk relying on an external firm to provide payment to their clients as any hiccup would likely affect consumer payments. It is more likely that they would want to subsume these external firms into their operations, which would likely be the best mediator between creating their own stablecoins and using a third-party.
CBDCs or Stablecoins?
Financial regulators in the United States have been green-lit for both stablecoins and CBDCs. And while stablecoins have given rise to the use of CBDCs, there still exists some level of competition between the two.
Researchers believe that while there are many benefits associated with stablecoins, they still present too many uncontrollable risks or risks that may still take time to adjust to. Because of these risks and the lag time, CBDCs might be the better choice. CBDCs, which are also blockchain-based currencies (referred to as tokens), are digital currencies that are issued by banks. This could limit the amount of counterparty risk for banks, similar to creating their own stablecoins, but again limits the banks to a large amount of overhead, slow uptake, and the chance for competitors to outrank them (although banks usually survive this).
Unfortunately, banks that allow stablecoins even with the risks pose a significant advantage over others. They could reap early advantages because of cost savings and customer adoption. Right now, there are no clearinghouses for either stablecoins or CBDCs, which is potentially why CDBCs in Sweden and in Uruguay were early issuers and have successfully tested digital currencies like Sweden’s e-krona and the digital Uruguayan pesos.
What to Expect
While the OCC cleared the bank’s use of stablecoins, experts are also aware that this shift occurred before the new presidential term in January of 2021, so we are still awaiting shifts in the regulatory nature of stablecoins in banks. However, banks are now considering how stablecoins should be used. Primarily, banks will need to consider whether they want to create their own stablecoin or whether they need to use external parties, which might present additional risks.
Stablecoins are a viable competitor to CBDCs, which may increase the speed at which the CBDC regulations are developed so that digital currencies can become more widespread. So long as regulations and the administrative burden are manageable, we can begin to see stablecoins and CBDCs used more regularly.
Some scholars suggest that stablecoins will eventually come with embedded regulations, which would mitigate the risks associated with not having a clearinghouse by automating much of the data supervision, oversight, and verification. Automated regulations, like how smart contracts operate, could also improve the security around stablecoin financial transactions and improve their uptake by citizens.
While there is still some uncertainty around how banks will begin to adopt stablecoins, we can expect banks to begin to buy existing cryptocurrency firms in order to minimize the amount of overhead and startup with creating a stablecoin, but also to reduce the level of counterparty risk associated with using third-parties for a major financial transaction.