Stablecoins are on the rise, and so is interest in tokenization. How might these changes impact the stability of the broader financial system?

That question was at the center of the second Conference on Stablecoins and Tokenization, a virtual event recently hosted by the Federal Reserve Banks of Boston and New York.

In his welcoming remarks, New York Fed Director of Research Kartik Athreya said that over recent years, there has been a “meteoric” rise of blockchain markets, including stablecoins.* Blockchain technology is also a starting point for the tokenization of a broader set of traditional financial assets.

Athreya added that it’s important for the research community to understand these innovations and their impact on the financial system. He said they are critical to assessing financial stability risks and also relate to the provision of payment services – a key Federal Reserve responsibility.

“(This conference) will improve our ability to fulfill our responsibilities with respect to the roles we have in the payment system and our monetary policy mandate,” Athreya said.

How might rapid stablecoin adoption impact the financial system?

Cristoph Bertsch, a senior economist at Sveriges Riksbank (the central bank of Sweden), started the conference by presenting his paper, “Stablecoins: Adoption and Fragility.” Bertsch wrote that stablecoins serve as a critical link between the crypto industry and traditional financial markets. But they could also pose broader financial stability risks because they are prone to instability.

Using a theoretical model, Bertsch showed that regulators’ concerns about “excessive” adoption of stablecoins are justified – particularly when new stablecoin adopters increase the “flightiness” of the investor pool. That’s when new users are more likely to react to uncertainty by moving their money out of stablecoins and into investments they feel are safer. These “runs” can cause instability that could potentially impact other markets.

Keynote: The financial system’s “architecture” is quickly evolving

Keynote speaker Franklin Allen, a professor of Finance and Economics at Imperial College London, presented a paper called, “Monetary Innovation and Financial Architecture." Allen co-authored it with his Imperial College London colleague Ansgar Walther.

Allen said that more than 23,000 cryptocurrencies now exist. At the same time, he said the “architecture” of the broader financial system is also changing rapidly with the growth of nonbank financial intermediaries, including stablecoin issuers. For example, Allen noted that some researchers estimate nonbank financial intermediaries now make up more than 50% of the financial system.

“If we have these monetary innovations, how do they affect this financial architecture, and how does that play into stability?” Allen asked.

Allen and Walther used a theoretical model to analyze how monetary services and the financial system’s architecture interact. They found that public sector monetary innovations could shift activity from banks to nonbanks. They argued that could reduce banks’ debt, leading to fewer bank failures and increased financial stability. But they said the impacts of monetary innovations by the private sector were more “ambiguous” and could reduce stability.

“We’ve done a very simple (version) of this model, but the kind of trade-offs we have here are going to be important,” Allen said.

Authors compare the potential financial stability implications of new “money-like products”

Patrick McCabe, a deputy associate director at the Federal Reserve Board, and JP Perez-Sangimino, a senior financial policy analyst at the Board, presented the paper, “New Activities, Familiar Risks? Potential Financial Stability Implications of New Money-Like Products.” Their co-authors are Nathan Swem, a principal economist at the Board, and Kenechukwu Anadu, a vice president at the Boston Fed and a conference co-organizer.

The paper introduces a framework for examining the vulnerabilities of three new “money-like products:” stablecoins, tokenized money market funds, and money market fund ETFs, or exchange-traded funds.

A money market fund, or MMF, is a type of mutual fund that typically aims to maintain a stable or near-stable per-share price of $1. When an asset is tokenized, a digital representation of it is created on a blockchain. Money market fund ETFs are a type of investment fund that can be traded throughout the day on stock exchanges.

The paper’s framework builds on well-documented fragilities in money market funds, and it compares stablecoins to two other investment types: “tokenized” money market funds and money market fund ETFs. These fragilities include:

• Liquidity transformation
• Money-like assets
• Threshold effects
• Contagion effects
• Reactive investors

McCabe and Perez-Sangimino noted that these fragilities are present to varying degrees in each product analyzed. As the products evolve, so will their potential benefits and effects on financial stability, they said.

Can tokenization reduce settlement risks?

New York Fed economist Michael Lee presented “Optimal Design of Tokenized Markets,” a paper he coauthored with Antoine Martin, vice chair of the governing board of Swiss National Bank, an economist at Swiss National Bank, and Robert Townsend, an economics professor at MIT.

The paper emphasizes that in a tokenized market, “settlement” – a transaction’s final point of completion – is instantaneous. This represents a fundamental shift in the way markets operate by dramatically reducing the risk that a transaction won’t be completed. But Lee said tokenization can exacerbate other problems. For instance, it requires a trader to reveal private information that’s not required in a traditional environment, and which the buyer can exploit.

Lee said that tokenization has real advantages over traditional markets only if it’s possible to guarantee settlement protocols are compatible with whatever trading mechanisms are being used. He also discussed potential contract designs that could mitigate issues, and he offered guidance about how to redesign the relevant financial architecture.

Papers and presentations shared during the conference

The conference included seven paper presentations and a keynote address, each of which are available on bostonfed.org. Their titles are listed below:

• “Stablecoins: Adoption and Fragility,” presented by Cristoph Bertsch (Sveriges Riksbank)
• “On the Programmability and Uniformity of Digital Currencies,” presented by Cyril Monnet (University of Bern)
• “Monetary Innovation and Financial Architecture,” presented by Franklin Allen (Imperial College London)
• “New Activities, Familiar Risks? Potential Financial Stability Implications of New Money-Like Products,” presented by Patrick McCabe and JP Perez-Sangimino (Federal Reserve Board)
• “Strategic Money and Credit Ledgers,” presented by Jonathan Payne (Princeton)
• “Information and Market Power in DeFi Intermediation,” presented by Maryam Farboodi (MIT)
• “Optimal Design of Tokenized Markets,” presented by Michael Lee (New York Fed)
• “Risk-based Capital for Stable Value Tokens,” presented by Gordon Liao (Circle)

*The presenters each emphasized that the views they expressed at the conference were their own and did not necessarily represent those of their employers.