A Monetary Revolution is Taking Shape with Stablecoins

We are on the cusp of a financial revolution that has been the dream of many prominent economists for centuries. Recent financial innovations are laying the groundwork for this dream, and the U.S. political economy is shifting to support it. This revolution, if it comes to fruition, will have significant implications for global finance, economic development, and geopolitics, creating both winners and losers. The shift in question is towards 'narrow banking' built on stablecoins. To understand this concept, let's first delve into the history of financial innovation, spanning over 800 years. The current financial system is based on fractional-reserve banking, which originated in the 13th and 14th centuries with Italian money changers and bankers. They discovered that because depositors rarely demanded their money back at the same time, they could hold only a fraction of the coins needed to back their deposits. This practice was not only more profitable but also facilitated payments over long distances. However, fractional-reserve banking has a major drawback: its inherent leverage makes the system unstable. An economic downturn can cause more depositors to withdraw their savings at once, or worse, trigger rumors that the loans backing banks' deposits are about to default, leading to a 'run' on the bank. If a bank is unable to meet its depositors' demands, it collapses into bankruptcy. The failure of banks in a fractional-reserve system not only results in the loss of depositors' wealth but also severely restricts economic activity, as payment for goods and services is impaired and lending is not available for new investments. Over the centuries, as banks became more leveraged and critical to economic functioning, governments intervened to reduce the risks of banking crises. In 1668, Sweden established the first central bank, the Riksbank, to lend to other banks experiencing runs. The Bank of England followed 26 years later. While this helped solve liquidity problems, it did not prevent solvency crises. The U.S. introduced deposit insurance in 1933 to stop solvency-based bank runs, but as illustrated by numerous banking crises since, including the 2008 subprime mortgage crisis, neither deposit insurance nor bank capital regulations has solved the inherent fragility of fractional-reserve banking. Government intervention only reduced the frequency of crises and shifted their costs from depositors to taxpayers. Around the time the Roosevelt Administration introduced deposit insurance, top economists at the University of Chicago proposed an alternative solution: the Chicago Plan, or 'narrow banking'. This idea resurfaced among economists during the U.S. savings and loan crisis of the 1980s and 1990s. Narrow banking addresses the central problem of fractional-reserve banking by separating the critical functions of payments and money creation from credit creation. Many people believe that central banks create money, but in a fractional-reserve system, banks do. Central banks manage the rate at which banks manufacture money by controlling their access to reserves. The Chicago Plan splits banking functions into two: 'narrow' banks that accept deposits and facilitate payments are required to back their deposits one for one with safe instruments like T-bills or central bank reserves, effectively making them like a money market fund with a debit card. Lending is done by 'broad' or 'merchant' banks that fund themselves with equity capital or long-term bonds, making them less susceptible to runs. This segmentation of banking makes each function safe from the others. Deposit runs are eliminated because narrow banks are fully backed by high-quality assets and have access to the central bank. The safety of narrow banks removes the risk to the payments system. Because money is no longer created by credit creation, bad lending decisions at merchant banks do not affect the money supply, deposits, or payments. Conversely, neither natural fluctuations in the economy's demand for money nor concerns over loan quality affect merchant banks' lending, as it is funded with long-term debt and equity. However, the transition to narrow banking is painful and has never had the political economy to support the necessary legislation. The transition would require existing banks to either call in their loans, dramatically shrinking the money supply, or sell off their loan portfolios to buy short-term government paper, precipitating a massive credit crunch. Fractional-reserve banking is extremely profitable and generates a lot of jobs, making it difficult to change. Economists, on the other hand, are a small group with questionable employment. The American Bankers Association is one of the most powerful lobbies in Washington, D.C., and similar dynamics play out in other cities. The continuance of fractional-reserve banking is not a banking conspiracy but rather a result of good politics and cautious economics. That may no longer be the case. Both the costs of transition and the political economy have changed, particularly in the U.S. Developments in decentralized finance, or 'DeFi', and the evolution of the U.S. political economy, national interests, and financial structure have created conditions that make a shift to narrow banking in the U.S. not only feasible but increasingly likely. The critical DeFi development is the rapid growth of stablecoins. Stablecoins are decentralized 'digital dollars' or other currencies that are pegged to fiat currencies, gold, or other stores of value. They were designed to be on- and off-ramps between the traditional world of fiat money and the blockchain-based world of DeFi and cryptocurrencies. However, their use case has evolved significantly amid spectacular growth in acceptance and usage. Stablecoin annual transaction volumes have more than doubled, and users have increased by over 50% to over 30 million. The outstanding value of stablecoins has hit $250 billion. While more than 90% of stablecoin transactions still involve on/off-ramping or DeFi trading, an increasing share of transaction growth involves 'real-world' uses, such as person-to-person and business transactions in countries with unstable local currencies. The U.S. legislation defines what are acceptable high-quality, liquid assets, mandates one-for-one backing, and requires regular audits to establish compliance. Thus, Congress is creating the legal basis for entities that take deposits, are required to fully back deposits by high-quality assets, and facilitate payments in the economy. This sounds familiar - it's essentially a narrow bank. The shift towards stablecoin-based narrow banking in the United States has huge economic, geopolitical, and financial implications, creating significant winners and losers both within the U.S. and around the world.