Stable/Genius: Stablecoins and Free Banking

President Trump signed the Guiding and Establishing National Innovation for U.S. Stablecoins Act (GENIUS Act) into law on July 18th, promising to “cement American dominance of global finance and crypto technology.” In his post-signing speech, the president explained, “the GENIUS Act provides banks, businesses and financial institutions, a framework for issuing crypto assets backed one for one, with real us, dollars, treasury bills and other cash equivalents, is really strengthening the dollar and giving the dollar great prominence [sic].” Trump declared that the Act “creates a clear and simple regulatory framework to establish and unleash the immense promise of dollar backed stablecoins.”

USD stablecoins have been in existence since the 2014 launches of Tether and BitUSD, but they’ve gained prominence in the last few years with an increasing number of issuers and widening acceptance. With the supportive regulatory environment of the GENIUS Act, they should surge in popularity and gain wide usage and acceptance.

I’ll briefly address the uses and ostensible benefits of stablecoins, but I want to focus on what I think is the most exciting feature, which is their potential to herald a renewal of free banking.

Why Stablecoins?

Most Americans find it extremely convenient to transfer money or make payments by tapping a debit or credit card. Indeed, in the US about 85% of payments (by number), and 96% of payments (by value) are made via these kinds of bank-to-bank transfers. Investopedia has a nice explainer on ACH—the Automated Clearing House—for those interested in the nuts and bolts of interbank payment processing.

But are there any drawbacks to using this ubiquitous bank-issued money? Plenty. Let’s start with fees: Banks charge fees ranging from a few dozen cents for debit transactions to over 3% for credit card sales. Next is timing: although most payments settle on the same day, larger payments often take days to clear, and wire transfers must be executed during business hours. Regulations requiring banks to scrutinize transactions (especially large sums) for criminal activity also drive these fees and delays.

Finally, to use a debit/credit card, check, or wire transfer, both payer and payee must be “banked.” This is not too big of a problem in the US, where only about 4% of the population, or 5.6 million households, don’t have bank accounts. Globally, however, 24% of the population is unbanked, and this proportion is higher of course in undeveloped countries with weak legal institutions. More people have smartphones than have bank accounts in these places, which means stablecoins can step up and solve the cost, timing, and network problems all at once.

Stablecoin transfers on their respective blockchains can be consummated instantly and with zero or negligible fees. Stablecoins can be transferred anonymously to anyone with a crypto account “wallet,” which does not require a bank account and is easily accessible in a competitive crypto-custody marketplace. Stablecoins, therefore, are particularly useful for foreigners who wish to transact in dollars, but lack access to US bank accounts. Stablecoins will facilitate both dollar remittances abroad, and foreign flows of capital into the US economy.

Stablecoins and Free Banking

Stablecoin issuers are essentially banks. While they don’t (for now) lend out the money they take in, they perform the money-provision and payments system roles of banks. As several commentators have noted—mostly with disapproval—this is reminiscent of the “free banking” era, in which banks were able to issue private currencies denominated in their countries’ monetary units. In historical free banking systems, most of the functional money supply was provided by private banks, in the form of banknotes (currency) and bank deposits (checking accounts). Stablecoins are “backed” by either regular bank deposits or US Treasury securities—indeed the GENIUS Act requires 100% backing of stablecoin issues with one of these forms of liquidity.

Free bank notes in the 1700s-1800s were “backed” by each bank’s specie reserves of gold and silver coins, and banks could and did issue more total liabilities (notes and deposits) than their specie reserves. This “fractional reserve” practice has led to much consternation among certain analysts, but leading scholars have found that free banking systems in Scotland, Canada, the United States and elsewhere were stable and successful. This is particularly remarkable in the US case, as state-level regulations, aimed more at governments’ fiscal goals than at monetary stability, allowed some fraud and unsound banking practices to prevail for a time in some areas. Free market skeptics wrongly uphold these “wildcat” banking episodes as emblematic of the entire system. But as Minneapolis Federal Reserve researchers Arthur Rolnick and Warren Weber noted in an overview of America’s free banking era,

(Leading monetary scholar Lawrence White provides an excellent overview of free banking theory and practice in this podcast.)

So what prevents banks from simply lending excessive amounts of banknotes into existence, causing inflation and/or destabilizing the economy? Simply the core “regulation” of free banking: enforced redemption of banknotes (and other bank liabilities), on demand, for the underlying monetary asset. Any bank that over-issues inside money will see the notes “flow back” for redemption, draining its reserves and forcing it to curtail credit—the corrective mechanism that scholars label the “law of reflux.” Competition and the market mechanism winnow the field and ensure performance and customer satisfaction. Banks that don’t keep adequate reserves nor prudently manage their loan portfolios will risk losing customers and their funds (deposits) to more soundly-managed institutions.

More than merely efficiently satisfying customers in a competitive financial services market, free banking helps achieve “monetary equilibrium” and can avoid the problems associated with both over-issue of money (inflation, boom and bust) and stringency of money (deflation, depression). This is because free banks respond to market signals to increase or curtail the issuance of bank money, providing an “elastic” money supply which can expand or contract to meet the exact needs of businesses and the public. In other words, supply of money can adjust to meet changes in demand for money, eliminating the prospect of monetary shocks and consequent macro turmoil. Moreover, with strict redemption of bank-issued forms of money, free banking obviates need for government intervention such as deposit insurance and central banking, with their attendant moral hazards. In pure free banking, market discipline rules and imposes the responsibility of due diligence and risk management on both suppliers and demanders of money and credit.

Opposition to Stablecoins

Not everyone shares President Trump and the crypto bros’ optimism about stablecoins. Objectors raise two main arguments:

1. Instability: won’t “fly-by-night” stablecoin operators be at risk of not being able to redeem stablecoins—i.e. they won’t have the underlying dollars, and if faced with a “run” on their coins they will have to shut down, leading to widespread panic and destabilizing the financial system? This view is promoted by mainstream economists such as Barry Eichengreen and Gary Gorton, who both smear stablecoins as a reiteration of the worst “wildcat” free banking episodes.
2. Nefarious activity: due to the anonymity of crypto, stablecoins enable criminal activity, money laundering, etc.

On the stability point: the free banking naysayers really need to check the literature on free banking before casually repeating bromides about wildcat banking. As noted above, free banking systems in Canada and Scotland were remarkably stable, and American free banking, despite serious flaws in regulatory structures, was more stable than mainstream scholars care to admit. The worst “wildcat” frauds were confined to a few states for a few years and only happened due to absurd regulatory loopholes that were quickly closed.

On the criminality point: yes, criminals will use stablecoins, just like criminals use cash. Law enforcement is always playing a cat and mouse game with the crooks, and stablecoins will surely add some new challenges. I’m not convinced, though, by the argument, “we can’t allow this cost-saving, brilliant new technology, because bad guys will use it to facilitate crime.” The same could be said for any innovation, from cars to phones to the internet in general.

Of course, stablecoins today are layered on top of an entrenched monetary system, with the fiat US dollar, the Federal Reserve and its helicopter drops of new base money, federal deposit insurance, and a pile of banking regulations from 4 federal and 50 state regulatory agencies. Stablecoins cannot replace all of this with a pristine free banking system. Stablecoins can, however, bring a new facet of freedom and efficiency for one of most important aspects of the financial system: the provision of money that facilitates everyday business.

In sum, stablecoins have immense potential to serve as digital banknotes for the 21st century. Stablecoins can provide full elasticity of money supply, while end-running some meddlesome, costly bank-based regulations regarding other payment media such as deposits. Stablecoins can reduce the costs and increase the benefits of the money we use daily. Stablecoins have potential for greater positive impact than the advent of credit and debit cards.