Stablecoin issuer institutions can be designed and interjected into the financial system as creators of financial stability. And one might find this to be the simplest way to indeed create this stability. What follows briefly explains how this might transpire.

First we need to understand the instability that is inherent in the banking system.

Banking system instability challenges

The main challenges inherent in the banking model are reasonably well understood — and somewhat generally accepted. Here a few are listed in headline format. Reality may be more complicated than the simplifications offered by these headlines, but this approach is taken to illustrate that emotions around these issues run very hot — particularly around crisis times.

  1. “Heads, the bank wins — tails, the taxpayers lose.” If the banking sector gets bailed out (depositors insurance and central bank interventions), there is a management incentive to swing for the fences. And if the bank is big enough there truly is no other government choice but to bail out the bank — the reverberation in the financial system of a large bank going bankrupt would simply cause too much chaos. It is noteworthy that probably no banking disaster has been resolved via only depositor insurance — other tools and interventions have been necessary also — which suggests that depositor insurance isn’t truly a practical resolution tool.
  2. Systemic risk event minefields. The banking sector, invariably, builds up systemic risk pathways that create a “minefield” of potential crisis-creating events. Events that the world rarely knows about or suspects before it’s too late.
  3. Incompatible jobs: resilient utility versus efficient financial risk taker. Safeguarding deposits, ensuring liquidity to depositors on demand, and enabling the payment system is essentially the job of providing a resilient money utility — much like any water, energy or electricity provider. The other job — efficiently leveraging short-term deposits and taking on risks (illiquidity, credit, interest, FX, derivatives, etc.) for profit — is incompatible with the demand for resilience in performing the utility job.

We have had all kinds of solutions proposed ever since the Great Depression in the 1930s (e.g. the Chicago plan). The gist of the more radical proposals made across the ages is developing a separation between the deposit-taking franchise and the risk-taking franchise to safeguard the continued status of the depositors, yet still have a full risk-taking bank system to service the economy. Perhaps in the form of a restrictive banking license for the deposit-taking franchisees and a more liberal one for the non-deposit-taking — even more liberal than today’s. The thinking around this particular separation idea can more broadly be found under the concept of narrow banking.

Another suggestion has been to take away depositor insurance and any implicit or explicit guarantee of bank bailout, as these are essentially market-distorting factors, and make it clear that “you and your bank are on your own”. Depositors’ demand for safeguards and guaranteed available liquidity would lead the banking system to bifurcate into safe and risk-taking banks.

One of the key arguments against these changes is that the bank business of transforming short-term deposits into long-term credit and financing (the maturity transformation) is vital for financing the economy, and so disconnecting the two franchises would hamper both access to and pricing of long-term capital. The counter-argument might be that the wholesale funding market can develop rapidly and can adequately be made to replace any funding loss from less access to leveraged traditional deposits.

Post a financial crisis, very broadly, what appears to transpire is that the already large banking rule book becomes even larger, and in it, asset risk charges are increased to motivate risk reduction and ensure a similar crisis is unlikely to repeat. The banking sector consequently sheds risk from its balance sheets, which then slowly reappear in new formats outside of the core banking system. However, the non-bank sector is tightly coupled with the banking system, and systemic risk in the combined bank/non-bank system starts to rebuild. And at some point, a certain event triggers yet another unexpected financial crisis.

This ever larger rule book of banking ensures substantive and growing homogeneity in the conduct of banking in the sector, which again may be part of the answer to why systemic risk seems always to build up.

This only scratches the surface on banking challenges, and the opinions and arguments for and against them and their solutions. However, it has hopefully shown the reader how deep the financial system debate goes, and that there is general acknowledgement of challenges and substantive interest in finding improvements to this core of the financial system.

This means when thinking about blockchain technology we shouldn’t just think about how blockchain technology can improve efficiency in the system, but also how the technology can allow us to improve the architecture of the financial system for a better stability and resilience outcome.

Market-led changes and Token Financial Institutions

The financial regulators and governments across the world are well aware of both the above challenges inherent in the financial system, and probably starting to be aware that by pointing the fierce trinity of venture capital, entrepreneurs and blockchain technology towards these challenges, financial system efficiency, stability and resilience improvements can be forged.

The path for how this is to come about would be via some policy of market-led financial market change and innovation. This means the trinity forces above are going to be allowed to compete directly with traditional market actors and solutions on a fair basis, under the expectation that this competition will lead to a better outcome for the world.

This would, in practice, mean the financial regulator would need to continually open up key regulated parts of the financial system to new actor definitions that have new restrictions, oversight and allowances, which would also continually be monitored and revised. For simplicity we coin this class of new regulated blockchain financial services actors Token Financial Institutions (“tFI”).

In the EU, MiCAR is defining conditions for the first, infant, types of tFIs that are allowed to issue e-money tokens on the blockchain. Similarly, the EU DLT Pilot regime allows other tFIs to form with different purposes.

For a productive give-and-take to emerge between tFIs, financial regulators and the incumbent financial industry, the key must be not to veer from the path towards improving financial architecture, resilience, stability and efficiency. For the emerging tFI industry to play a role in determining this path, industry associations and work groups must form with adequate capacity and skill to act as such. These should be further encouraged by industry players as well as regulators and policy makers.

tFI stablecoin issuer development path

For further clarity, a potential path for how the tFI for stablecoin issuers could evolve can be considered.

Ground zero to a tFI stablecoin issuer is the EU MiCA framework. All the basic safeguards are included in the framework, and it demands the tFI to produce what should reasonably be considered a high-quality stablecoin, and thus allow the general industry to start building out useful applications in payments and settlement with the issued e-money token accepted as “money” for all practical purposes.

Where does regulation go from here? A few simple avenues of development could be considered in respect of their ability to increase stability and resilience.

  1. HQLA portfolio management requirements. High-quality liquid assets encompass a reasonably large set of different assets with different risks — from commercial paper to government funds to repos — and so a requirement of careful portfolio construction for relevant diversification and periodic stress tests would be a perfectly reasonable condition to set for tFI stablecoin issuers, particularly when the portfolio could reach into the many billions. The fact that S&P, Moody’s and Fitch perform extensive ratings of money market funds illustrates clearly the need for this. Now, of course, nobody prevents any current MiCA-regulated stablecoin issuers from doing so, but adding regulatory requirements and oversight would add to the overall quality in our view.
  2. Central Bank liquidity facility access. Somewhat related to the above point, it would seem advantageous for the financial system’s stability if tFI stablecoin issuers had access to a Central Bank liquidity facility — i.e. the ability to deposit appropriate HQLA collateral in exchange for central bank liquidity at reasonable wholesale conditions. Such a change, perhaps, might be the simplest and most powerful way to increase the quality of the stablecoin delivered by a tFI. In real terms as well as in sentiment — and increase adoption speed.
  3. Depositor insurance or redemption insurance plan? One could consider including tFI stablecoin issuers into a depositor insurance variant — a redemption-value insurance plan. For reasons set out previously, the depositor insurance concept is ultimately broken; it is not recommendable.
  4. Credit institution counterparty risk minimisation via tokenization. In this first iteration of the MiCA stablecoin, it is tightly connected with credit institutions, as cash and custody of assets must sit with credit institutions. This counterparty risk can only be addressed via diversification (i.e. multiple credit institutions used for cash and custody) and selecting assets that are less credit-institution exposed (i.e. more government bonds and perhaps less certificates of deposits, and using non-credit-institution affiliated asset managers). As both securities and stablecoins now come in tokenized formats, there is some further distancing from credit institutions possible: cash can be substituted for other EMT currencies and held in a secure digital custody solution, and HQLA assets can be tokenized securities and also held in a secure digital custody solution. This clearly reduces reliance on credit institutions and, in fact, very likely increases the speed and reduces the cost of asset reallocations, issuance and redemption. It appears a very positive option to go further down this path, as it does ensure tFI stablecoin issuers become a more independent part of the overall financial system, rather than being a clear affiliate at risk of selected credit-institution counterparties. This will lead to more market-led changes in the financial system architecture, when the tFI stablecoin issuers are not ultimately beholden to credit institutions. It also allows the tFI stablecoins to more easily aim to exceed the money quality of credit-institution-issued stablecoins and tokenized deposits.
  5. Technical risk. tFI stablecoins are ideally for safe, real-time, 24/7/365 transactions on public chains. This means tFI stablecoin issuers will be deploying smart contracts and tokens, and likely some back-end system to orchestrate and connect with banks and other (today) necessary institutions. Ensuring a very high security standard in this system is vital for the tFI. For this reason it seems reasonable to consider whether a MiCAR v2 should have at least some minimum technical requirements. Of course no one is preventing any current tFI issuer from taking these steps independently of any regulation, but including minimum requirements in a MiCAR v1.1 — and oversight measures — would increase the quality of the tFI-issued on-chain currency.
  6. Transparency. Given the utility-type nature of what a tFI stablecoin issuer does, it might make good sense to require a utility-type level of real-time transparency in the operations and financial status.

The tCI, money creation and heterogeneity

One could imagine a new form of tFI in MiCAR v2 — namely a Token Credit Institution (tCI) — an entity that can indeed issue credit and so in fact be part of the money creation mechanics of the markets. So far a tFI stablecoin issuer under MiCAR does not create any money into the financial system — it just converts off-chain to on-chain currency. Being able to “mint” loans and credit tokens — on collateral or on cash-flow evaluation, and form a regulated tokenised stablecoin hereupon — would be a game-changing feature. Markets would have a chance to form on the credit issued in token format in a more granular format than what is seen today, and the money created from the credit can simply move with the customer in token format also.

For instance, this mechanism would be able to cover potential timing gaps, in a strongly regulated format, between off-chain and on-chain financial actions (for example, redemption of a fund instrument off-chain might take, say, two days. If a credit is issued hereupon instantly upon the redemption request, a tCI would be able to mint a regulated stablecoin — as a credit on the redemption — in real time upon redemption request rather than waiting for off-chain clearing).

As described here, the tCI is essentially a bank, and there is no need to create another framework for that — it is already there — but that would be missing out on how tCIs might be designed to act as a precursor for general changes in the banking industry. The tCI could be preloaded with a more restrictive capital, risk or credit scope framework than a traditional bank framework. From a systemic crisis perspective it would be an improvement to get further heterogeneity into the banking-or-banking-like sector, which the tCI, with a differently skewed business model and regulatory framework, could be.

A tCI-type framework would allow stablecoins to increase in quality, open the door further for financial markets on-chain, and very likely give the incumbent banking sector a run for their money in terms of use of blockchain technology and how to work with clients in a “token world” — it would be very healthy competition.

Bank deposit tokens?

These types of money are bound to start to emerge, as their quality is instantly understood across all parties on the surface. One assumes that traditional (or new) clearing mechanics would emerge for bank-to-bank transfers (i.e. I send my bank deposit token to you, and you can — we imagine — change it to your bank’s bank deposit; maybe it is even automatic via some central bank settlement mechanics) and perhaps general public trading in bank deposit tokens becomes available. And will these pay interest? And are they, if generally traded, a certificate of deposit? Could they be time deposits or other structured deposit types? One can imagine a whole raft of different types of deposit tokens could emerge.

However, the overarching challenge here is that this is, more or less, a simple perpetuation of the current banking model wrapped in a new technology. It doesn’t seem to create any real architectural changes to the financial system.

So, while one might easily think this token product will emerge, one would believe that stablecoins issued by a tFI provider (or tCI) under MiCA v2 — where some of the above concepts are iterated upon — will deliver higher-quality and more efficient on-chain money than bank deposit tokens, and in fact probably allow the financial markets to form on-chain in a stronger and more resilient format than today.

Which, in the end, is what all these changes are all about.

CBDC?

Central Banks will sit, as always, at the top of the money quality pyramid and settle — maybe in token format/CBDC — between banks, tFIs, tCIs and other relevant institutions, and provide central bank liquidity (CBDC format maybe) to these institutions — also as always. However, not much need for further CBDC use or any Central Bank intervention is necessary.

Allowing new institutional formats (tFI and tCI) to deliver on-chain money and participate in the dynamic money creation/destruction process — and then ensuring market forces are allowed to play out — on balance seems the appropriate approach for letting blockchain technology, venture capital and entrepreneurs into the process of re-architecting the financial system for the better. Not an extension of the CBDC product deeper into commercial banking, commercial transactions or retail.

Originally published on Medium, April 2025.