Bank of Canada publishes paper on Stablecoins, highlights risks to financial stability

Bank of Canada plans to adopt CBDC asks for inputs

The market for fiat-referenced crypto assets, commonly known as stablecoins, has expanded rapidly in recent years alongside the growth of the crypto asset ecosystem. In fact, the market capitalization of stablecoins increased by more than 30 times since the beginning of 2020.

Recently a paper was published by the Bank of Canada titled “Stablecoins and Their Risks to Financial Stability”. Stablecoins have emerged as a form of “risk-free” asset in the crypto ecosystem and have witnessed tremendous growth in recent years.

Currently, stablecoins are mainly used to facilitate trading, borrowing and lending of other cryptoassets, but they also hold the potential to compete as a broader medium of exchange for goods and services. Even though the size of the market remains small, stablecoins will likely become more widely adopted across geographic areas and demographic groups, along with the digitalization trend of the global economy.

The paper highlights, price stabilization mechanisms and use cases. The use cases are cryptoasset trading, decentralized finance, crypto banking and payments. Further, it unscores that the design and use of stablecoins could give rise to various risks in the financial system, particularly if the regulation of stablecoin issuers alone propels the growth of DeFi,which could exacerbate vulnerabilities in the overall sector if not appropriately regulated.

In addition to this the paper underlines that regulatory responses should therefore take a holistic view of the ecosystem to mitigate these risks. Just like bank deposits, stablecoins are vulnerable to confidence runs. A run on a major stablecoin could result in losses for token holders and disruptions for stablecoin-based services and could affect the broader financial system.

The researchers mentioned that the risk of runs on stablecoins can be mitigated by regulations to ensure that reserve assets are invested only in highly liquid and risk-free instruments or that it otherwise employs features of the safety net that currently exists for commercial bank deposits.

In addition to the risks associated with the stablecoin instrument itself, regulators should also consider how the use of stablecoins may facilitate the buildup of vulnerabilities through leverage and liquidity maturity transformation in DeFi and crypto banking.

When these activities resemble deposit-taking and fractional reserve banking, or significant rehypothecation of collateral is taking place, they should be regulated in accordance with the principal of “same risks, same regulation” as advocated by the Financial Stability Board.

The use of stablecoins may also present new risks associated with the digital infrastructures and custodians they rely on. Failures of these infrastructures and custodians could affect the availability of payments or financial services based on stablecoins and should thus be subject to the same standards of operational resilience as other financial market infrastructures and payment services.

Finally, under a possible scenario where stablecoins prove to be a more efficient and low-cost payment instrument than existing alternatives, there could be wide-ranging implications for the supply of credit, the banking sector and monetary policy. These effects will largely depend on the regulatory framework developed for stablecoins and on the response of incumbent financial institutions.

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