Zhou Xiaochuan: A Multidimensional Perspective on Stablecoins

Currently, some discussions about stablecoins are only from a single perspective. To deduce the operation and future prospects of stablecoins, a multi-dimensional and multi-perspective examination is necessary. If we hope to promote the development of digital payment systems and achieve healthy growth, we must also pay attention to multiple dimensions of performance and balance.

1. Central Bank Perspective: Preventing Excessive Currency Issuance and High Leverage Amplification

Stablecoin issuers will want to incur minimal costs while obtaining the maximum scale of stablecoin issuance and application.

They might wonder, why can central banks print money, and can't I? Nowadays, they can also have the function of printing money through stablecoins, but due to a lack of deep understanding and responsibility regarding monetary policy, macroeconomic regulation, and public infrastructure functions, they may lack sufficient self-discipline, potentially leading to uncontrolled issuance, high leverage, and instability. Whether a stablecoin is stable or not is not self-proclaimed; there needs to be a judgment mechanism.

Currently, there are at least two concerns from central banks.

First is "excessive currency issuance," meaning that issuers issue stablecoins without real 100% reserves, which is over-issuance;

Second is the emergence of high leverage amplification, meaning that the operation after issuance will produce a multiplier effect of currency derivation.

In this regard, the U.S. "GENIUS Act" and Hong Kong's "Stablecoin Regulation" have already paid attention, but there is still a significant lack of control.

First, it should be clear who the custodian of the issuance reserves is. In practice, there are cases where custodians do not fulfill their duties, and there have been many such cases in the past. In 2019, Facebook initially planned to self-custody the issuance reserves of Libra, which allowed for strong autonomy and the ability to retain the income from the custodial assets. However, reserve custody must be a reliable custody, ideally by the central bank or a custodian recognized and regulated by the central bank; otherwise, it is not very reliable.

Second, how to measure and manage the amplification effect during the operation of stablecoins? Even if the issuer places 100% reserves, stablecoins will still exhibit a multiplier effect in subsequent operational stages (such as deposits, loans, collateral, transactions, and revaluation), and the potential amount to be addressed in a run could be several times the issuance reserves.

On the surface, relevant regulations may prevent amplification, but a deeper observation of the laws of currency issuance and operation reveals that existing rules are far from sufficient to cope with derivation and amplification.

We can refer to the example of three commercial institutions in Hong Kong issuing Hong Kong dollar banknotes: the issuance mechanism of the three note-issuing banks in Hong Kong is that for every 7.8 Hong Kong dollars issued, they need to pay 1 U.S. dollar as reserves to the Hong Kong Monetary Authority, while also obtaining a liability certificate.

Based on the M0 of Hong Kong dollars, the economic and financial system generates M1 and M2 through derivation and multiplier effects. In the case of a run, it will target not only M0 but also M1 or M2. Even if the base currency M0 has a 100% reserve backing, it cannot rely on M0 reserves to cope with a run and maintain currency stability.

There are three known typical channels for the amplification effect of stablecoins: first is the deposit-loan channel; second is the collateral financing channel; third is the asset market trading channel (which can additionally purchase or revalue issuance reserve assets). Therefore, regulators need to statistically measure the actual circulation of issued stablecoins; otherwise, the potential scale of redemption risk cannot be determined The amplification multiplier effect of stablecoins will also provide opportunities for fraud and market manipulation.

II. Financial Service Model Dimension: The Real Demand for Decentralization and Tokenization

Assuming that the future ecosystem is characterized by large-scale decentralization of financial activities and large-scale tokenization of assets and trading tools, stablecoins will be very useful. First, stablecoins can adapt to the development of decentralized finance (DeFi); second, tokenization is a necessary foundation for the operation of DeFi.

What needs to be explored is why or to what extent we will move towards decentralization and tokenization?

From the supply side, blockchain and distributed ledger technology (DLT) indeed provide characteristics for decentralized operations; but from the demand perspective, how much demand is there for decentralization as a new operating system? Will most financial services transition to this new system?

Looking at it calmly, not all financial services are suitable for decentralization, and there are not many financial services that can achieve significant efficiency improvements through decentralization. The real demand for tokenization as a technological foundation also needs to be estimated calmly.

From the perspective of upgrading and transforming the hopeful payment system (especially cross-border payments), the retail payment systems in China and several Asian countries have made successful progress based on mobile phones, using QR codes and near-field communication (NFC) as merchant interface applications, which are still account-based. Currently, the digital currency developed in China is also account-based, extending and iterating the existing financial system. In addition, some rapid payment systems in Asian countries that connect cross-border have not chosen the route of decentralization and tokenization.

As of now, centralized account systems still demonstrate good applicability. There is insufficient theoretical basis to replace account-based payment systems with comprehensive tokenization.

The Bank for International Settlements (BIS) has proposed a centralized ledger architecture—Unified Ledger—that tokenizes bank deposits and other financial services, where central bank digital currencies (CBDCs) can play an important role within a centralized framework, combining centralization and tokenization. It needs to be questioned that not all types of financial assets are suitable for tokenization, nor are all financial service links suitable for decentralization, requiring specific analysis and comparison for each item.

III. Payment System Perspective: Technical Path and Compliance Challenges

There are two major concerns regarding the upgrade of payment systems: one is payment efficiency, and the other is compliance.

Improving payment efficiency is considered one of the potential advantages of stablecoins. In the current process of digitalizing payment systems, there are roughly two paths to enhance efficiency. The first path is to continue being account-based, optimizing and innovating based on IT and internet technology. The second path is a new payment system based on blockchain technology and cryptocurrencies.

From the current development of payment systems in China and Southeast Asia, the main progress achieved so far is still based on internet and IT technology, including the development of third-party payment platforms, advancements in central bank digital currencies (CBDCs), reliance on NFC hard wallets, and interconnection of rapid payment systems. These advancements have significantly improved payment efficiency and convenience The technical route itself is not the only criterion; the comparison of payment efficiency must also place a high emphasis on security and compliance, including Know Your Customer (KYC), identity verification, account management, Anti-Money Laundering (AML), Counter Financing of Terrorism (CFT), anti-gambling, anti-drug trafficking, and other compliance requirements. Some believe that since stablecoins are based on blockchain, they do not involve account opening. This is not accurate. Even when using "soft wallets," user identity verification is required, and the account opening process must be followed to meet compliance requirements. Currently, stablecoin payment services have significant deficiencies in KYC and compliance.

4. Market Trading Dimension: Market Manipulation and Investor Protection

From the perspective of financial markets and asset market trading, the most pressing issue to guard against is market manipulation, especially price manipulation, which necessitates the establishment of sufficient transparency and effective regulation.

In fact, this phenomenon of manipulation already exists, with several related cases having occurred. Some of these price manipulation behaviors have clear fraudulent characteristics. However, under the improved current institutional framework, whether it is the U.S. "Genius Act," relevant regulations in Hong Kong, or regulatory provisions in Singapore, these issues have not yet been satisfactorily addressed.

A new phenomenon is the mixed use of hybrid coins or multiple currencies, which involves using various currencies for transactions or payments within a single system, where not all combinations are true stablecoins, nor is there necessarily a consistent and recognized standard for stablecoins.

In the current asset market, especially in virtual asset exchanges, many trading objects can be paid for with stablecoins, non-stable other cryptocurrencies, or even completely unstable currencies. This arrangement provides opportunities for market manipulation and has become one of the regulatory focal points.

It is noteworthy that some market promoters have mentioned that through stablecoins and Real World Assets (RWA) and other technical means, the shares of asset transactions can be divided into very small portions, thereby achieving broader investor participation, claiming that this model has attracted a large number of students under 18 to participate in trading.

Although some believe this helps cultivate youth participation in the capital market and contributes to the future prosperity of the capital market, whether this practice is truly beneficial from the perspective of investor protection remains to be seen.

In the past, there has been an emphasis on the adaptability and qualification requirements of investors; however, there is currently insufficient basis to determine whether minors are suitable for participating in asset market trading. If market manipulation behaviors cannot be effectively prevented, attracting unqualified investors into the market will significantly increase risks.

5. Micro-Behavior Dimension: Motivations of Participants

The issuing institutions of stablecoins are generally commercial entities aiming for profit, and many entities involved in stablecoin-related payment services and asset trading businesses are also commercial institutions, which must have their commercial motivations.

However, stablecoins and payment systems include some functions or aspects with infrastructure and inclusive attributes, which should not be guided by the logic of maximizing corporate self-interest in micro-behavior but should embody the spirit of public service. There should be a clear distinction regarding which areas are suitable for market-oriented entities and which belong to infrastructure nature It is necessary to analyze the motivations and behavior patterns of various participants in stablecoins from a micro perspective.

What considerations do people have when using stablecoins for payment? Why are payees willing to accept stablecoins? What motivations do the issuing institutions of stablecoins have? What kind of trading scenarios do private exchanges pursue?

Currently, Hong Kong has issued licenses to 11 virtual asset trading platforms. What trading entities and trading varieties do these licensed institutions focus on? How do they profit?

Although many believe that stablecoins will reshape the payment system, objectively speaking, there is not much room for cost reduction in the current payment system, especially in the retail payment sector. In China, the existing retail payment system, including third-party payment platforms, central bank digital currency (CBDC), soft and hard wallets, clearing infrastructure, etc., has not adopted a decentralized and tokenized approach. After years of development, it has become very efficient and low-cost, making it very limited for any new entrants to reduce costs and profit in this field.

Looking at the United States, there may still be some room for cost reduction and profit in the retail payment system due to the long-term reliance on the credit card payment system, where merchants typically bear a 2% price discount, thus having the motivation to try new, lower-cost payment systems. This also indicates that, from the perspectives of payers and payees, the situations vary across different countries and regions.

Cross-border payments and remittances are often highlighted areas when discussing the application scenarios of stablecoins. To delve deeper into this issue, it is first necessary to break down the reasons for the high costs of current cross-border payments and specifically identify which links lead to high fees.

It is important to note that some claims about traditional cross-border payment systems being "very expensive" in a technical sense may be exaggerated.

In fact, many cost factors are not technical but involve foreign exchange controls, which are related to various institutional issues such as balance of payments, exchange rates, and currency sovereignty. Another part of the cost comes from compliance costs such as KYC and AML, which cannot be avoided even when using stablecoins.

Additionally, part of the cost comes from cross-border foreign exchange business as a licensed "rent." In summary, the attractiveness of stablecoins in cross-border payments is not as great as imagined. Of course, this should be considered separately for scenarios where the local currency has been mishandled and there is a need to introduce dollarization.

From the perspective of stablecoin issuers, if they perceive insufficient attractiveness in domestic and cross-border payments, the most likely focus of application will be in asset market transactions, particularly virtual asset trading. Certain assets in this market have strong speculative attributes, making them prone to price inflation through speculation, thus attracting stablecoin issuance. Moreover, some virtual assets can serve as qualified or semi-qualified reserves for stablecoin issuance.

From the current micro behavior perspective, it is necessary to be wary of the risk of stablecoins being excessively used for asset speculation, as a deviation in direction may lead to fraud and instability in the financial system.

Furthermore, the behavior of the stablecoin-related industry utilizing the popularity of stablecoins to increase their company's valuation is also worth noting. Some companies may use this to "raise funds" through the capital market or realize capital appreciation for cashing out, while the stablecoin business itself, its profitability, and sustainability are not their primary focus This is detrimental to the healthy development of the entire financial system and may accumulate systemic risks.

6. Circulation Path Dimension: The Circular Mechanism from Issuance to Redemption

The circulation path of stablecoins involves the entire cycle from issuance to market circulation in specific scenarios and redemption.

Taking the issuance of banknotes by the People's Bank of China as an example, the printed banknotes are first stored in a specific issuance warehouse. Whether and when these banknotes enter the market depends on whether commercial banks have cash demand. Commercial banks will only withdraw cash from the People's Bank of China's issuance warehouse when their customers have net demand or exhibit a lending gap. After withdrawal, it incurs an occupancy cost for the commercial banks, so when they have excess inventory, they will return cash to the warehouse. This indicates that the circulation of currency does not occur automatically.

Similarly, stablecoin issuers obtain relevant licenses and pay reserves, but this does not equate to the issuance of stablecoins. If there is insufficient demand scenario, stablecoins may not enter effective circulation, meaning they could obtain an issuance license but fail to issue. Theoretically, the circulation path should be networked, often with several major lines of high traffic. If the main line for payment is not smooth, the main channel for stablecoins to enter circulation will overly rely on speculation of virtual assets, leading to concerns about health.

In addition, whether stablecoins are used as temporary payment mediums at the time of transaction or as value preservation tools for a certain period will affect the amount of stablecoins remaining in the market after issuance. If they are used only for transactions and held as little as possible, the role of stablecoins is weaker, and the issuance volume is lower, which involves circulation paths, holding motives and behaviors, and supporting systems. This is not something that can be automatically conferred by an issuance license.

In summary, in the face of the new phenomenon of stablecoins, scholars, researchers, and practitioners need to observe and analyze their functions and realization paths from multiple dimensions, avoiding the use of imprecise concepts, data, and one-dimensional thinking. By comprehensively discerning various important dimensions, one can better grasp market trends.

China Financial Forty Forum, original title: "Zhou Xiaochuan: A Multi-Dimensional Perspective on Stablecoins"

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