Stablecoins: E-Money Just Got a Crypto Makeover

How stablecoins are changing the payments landscape under our nose.

Since my first contact with the concept of e-money, I have been frustrated with it. To be honest with you, I couldn’t explain why until recently. Something about the regulatory burden of trying to describe and define all types of exchanges between parties seemed like an impossible task. Even more intriguing was that the name was pretty good – e-money is an electronic form of money, as e-mail is an electronic form of mail or e-commerce of commerce – it made more sense than the concept itself. It should be that e-money works just like cash in a digital world. A central authority issues it, has a set of parameters for verification purposes, has nominal value, serves as a payment instrument and after issuance, it’s free to circulate in the economy with few questions asked. Well, not exactly. But that was not the concept at first.

Let me start from Brazil, where I am from and have more experience. The Brazilian central bank started flexing its payment regulation to incentivise innovation. It was a smart move. New frameworks were created, new types of payment institutions (“PI”) were invented, and many entrepreneurs and investors decided to take their chances in Brazil’s highly concentrated payments and banking sector.

I was at Stone by the time, and we took direct advantage of this by becoming an Acquiring Payment Institution – but that is a conversation for another moment. At the same time, the central bank created the Electronic Money Issuer Payment Institution. As the name suggests, this was a specific PI focused on the activity of issuing electronic money. By hearing that, you could say: “It’s like the balance that appears on my bank app when I deposit or transfer money to it”. Well, not exactly. Bank deposits are slightly different.

The Difference Between E-Money and Bank Deposits

E-Money: Short for electronic money, e-money is digital value stored on electronic devices or remote servers. It’s issued against the receipt of funds and is intended for executing digital transactions or peer-to-peer payments. E-money can be accessed via digital wallets, online accounts, or smart cards, embodying the concept of ‘money on the move’.

Bank Deposits: These are funds placed into banking institutions for safekeeping. Deposits can take various forms, including savings accounts, checking accounts, and fixed deposits, among others. Unlike e-money, bank deposits are not specifically designed for rapid digital transactions but serve as a safe store of value, with the added potential for interest accrual.

E-Money was specifically conceived so non-bank institutions could participate in the payments and financial services industry without doing a bank’s core activity: receiving deposits from part of its customers while lending funds to another part. In economic terms, monetary base expansion is when a bank takes $100 as a deposit, lends $50, and keeps that $100 redeemable for the original depositor. After repayment, the new monetary base increased from $100 to $150 plus interest charged. Meanwhile, funds received by e-money issuers must be safeguarded either by segregating them in a bank account (or by securing them through an insurance policy or guarantee in the UK’s case). E-money issuers cannot use these funds for lending but can invest a small fraction of the total in low-risk assets like government treasury bonds.

As an innovation framework, e-money in Brazil started with a blank canvas but was constrained by a 100% minimum deposit ratio in a segregated account. However, each institution was allowed to design its own rules of engagement. This resulted in each institution writing very detailed rules and registering them as its own payment scheme. As time went by, Brazil had more than 100 newly registered payment schemes – each e-money issuer trying to come up with its own set of rules. The situation becomes even more complex to manage if you imagine that each of these payment schemes is usually interoperating among themselves.

From the liabilities standpoint, both bank deposits and e-money are claims against the institutions that are issuing the papers. So why would the central bank allow this? I don’t think It was a conscious decision, and its always an easy job to make claims after many years have passed.The brazilian central bank goal was to set up the industry for innovation to thrive, and you can say this was achieved in the past few years.

It is important to note that e-money issuers, most of the time, don’t have direct access to their respective central bank’s infrastructure, so they hold their assets and cash positions in banks, who are the de facto holders of central bank deposits.

Banks like Clear.Bank in the UK and Star Bank in Brazil are specialised in providing services to e-money issuers.

Why E-Money Became So Relevant In The Payments Industry?

The ascent of e-money as a dominant force in the payments industry isn’t coincidental; it’s a direct response to the evolving demands of the digital economy and consumer behavior. Several key factors contribute to its growing relevance and adoption:

Financial Inclusion: E-money has a pivotal role in extending financial services to unbanked or underbanked populations, especially in developing regions. By bypassing traditional banking barriers, e-money platforms offer access to financial services via simple mobile devices, bringing millions into the fold of the formal economy. E-money per se has no innovation, but the regulatory apparatus around it facilitated the boom of companies that innovated in the sector.

Regulatory Support and Innovation: Governments and regulatory bodies worldwide have begun to recognise the potential of e-money to enhance their digital economies. Regulatory frameworks are evolving to support the safe and responsible growth of e-money systems, fostering innovation while protecting consumers.

Impact on the Payments Landscape: E-money’s ascent has profoundly reshaped the payments landscape. It has introduced dynamism and flexibility previously unseen, challenging traditional banking institutions to innovate or partner with e-money providers. The rise of e-money also heralds a shift towards a less cash-dependent society, with digital transactions becoming the norm for a wide range of services and purchases.

The relevance of e-money today is a testament to its ability to address the needs of a digital and globalised economy, offering a glimpse into the future of financial transactions. But as we continue to move towards an increasingly digital world, new forms of digital assets circulating in new shapes of networks can change the entire landscape once again.

Introduction to Crypto dollars, Reais, Euros: Fiat-Backed Stablecoins

Diving into the digital finance revolution, one might ask, “What are stablecoins, anyway?” They’re not just another buzzword in the cryptocurrency frenzy; they represent a groundbreaking bridge between the traditional stability of fiat currencies and the innovative, borderless world of blockchain technology. Fiat-backed stablecoins, like cryptodollars, cryptoreais, or cryptoeuros, stand out as digital tokens pegged to the value of traditional currencies, ensuring they maintain a stable value akin to the fiat they represent.

Issued on blockchain platforms, these stablecoins carry the promise of global financial inclusion and efficiency by being easily transferable across borders without the typical constraints of traditional banking systems. They are designed to be as stable as the currencies they’re tied to, such as the US dollar, offering a less volatile alternative to traditional cryptocurrencies. This approach allows them to gain life “on-chain,” free to be traded on secondary markets and programmable into a myriad of applications, starkly contrasting with the geographically and jurisdictionally bound nature of e-money and bank deposits.

While our focus today zeroes in on fiat-backed stablecoins for their direct linkage to well-understood monetary values, it’s crucial to acknowledge the broader stablecoin ecosystem, including crypto-backed and algorithmic stablecoins. These variations promise a rich tapestry of innovation yet to be fully explored in future discussions.

Cross-Border Constraints: E-Money, Bank Deposits, and the Freedom of Stablecoins

When examining the cross-border constraints of e-money and bank deposits, it’s crucial to understand that both are fundamentally tethered to their monetary jurisdictions. This limitation stems from the regulatory oversight, the nature of the deposits, and the traditional banking infrastructure, which is inherently localised. Both e-money and bank deposits operate within the confines of national boundaries, influenced by specific countries’ regulatory frameworks and economic policies. This creates a natural barrier to their global fluidity and interoperability.

Regardless of their digital or physical form, e-money and bank deposits are confined by the monetary policies and regulatory oversight of the jurisdictions in which they are issued. This means that for both, expanding services across borders involves navigating a complex web of international regulations, banking partnerships, and compliance requirements. Retail banking, with its roots in serving local communities, particularly exemplifies this, as its model is built around national network effects that rarely extend beyond its home country’s borders.

In stark contrast, stablecoins — especially those pegged to fiat currencies like the dollar, euro, or real — transcend these traditional barriers by existing on blockchain networks. Once issued, stablecoins are not just digital representations of money; they become part of a global, decentralised ledger that knows no borders. This unique characteristic allows them to be freely traded on secondary markets, integrated into digital applications, and programmed for a wide array of financial transactions without the direct oversight of a central monetary authority. This is interoperability by design.

Unlike e-money or bank deposits, stablecoins can effortlessly cross borders, enabling instant and cost-effective international transactions. Their blockchain-based nature facilitates a level of interoperability and accessibility unparalleled by conventional financial instruments.

The ability to be embedded in smart contracts and other decentralized applications (dApps) further amplifies their utility, allowing for innovative financial services that can operate globally without the need for traditional banking infrastructure.

In the realm of international commerce, stablecoins have already begun to demonstrate their transformative potential. Take, for instance, the case of a small business owner in Brazil, importing goods from a supplier in Europe. Traditionally, this transaction would entail navigating multiple banks, incurring hefty fees, and waiting days for payment processing. However, by leveraging a fiat-backed stablecoin like the cryptoeuro, the Brazilian entrepreneur can instantly and cost-effectively send payment across borders. The supplier, in turn, receives the cryptoeuro and can choose to convert it to their local currency or keep it as a stable digital asset. This not only simplifies the transaction but also significantly reduces the costs associated with currency conversion and international money transfer fees.

Furthermore, remittances, a lifeline for millions of families worldwide, have seen a similar enhancement through stablecoins. Consider workers abroad sending money back home; by using stablecoins, they bypass traditional remittance channels, avoiding exorbitant fees and delays. A real-world example is a blockchain platform that enables Filipino workers in Japan to send remittances home in the form of a fiat-backed stablecoin, which their families can easily convert into Philippine pesos. This method has proven not only faster and cheaper but also more reliable, offering families immediate access to funds.

Navigating the New Risks Associated with Cryptodollars

As we peel back the layers of innovation surrounding stablecoins, it’s crucial to confront the risks associated with their use, especially considering their burgeoning role in the digital economy. One notable concern is the secondary price risk, which hinges on market pricing and confidence in the stablecoin issuer. Unlike traditional fiat currencies, whose value is relatively stable and backed by government entities, stablecoins rely on the trust that issuers have correctly managed and reserved the assets backing them. This confidence is paramount; a wobble in trust can lead to fluctuations in market pricing, potentially causing a stablecoin to drift from its peg, thereby affecting its stability and utility.

The reserves of the issuer present another critical point of vulnerability. The ideal scenario is one where each stablecoin in circulation is backed one-to-one by fiat currency or equivalent assets held in reserve. However, the reality is often more complex, compounded by the difficulty of auditing issuers, especially those operating outside the jurisdiction of the fiat currency to which their tokens are pegged. This geographical and regulatory disconnect can obscure the true state of reserves, raising questions about the issuer’s ability to maintain the peg in challenging times.

Moreover, the issue of redeemability casts a long shadow over the stablecoin landscape. Conceptually, holders should be able to redeem their tokens directly with the issuer, assuming a clear contractual relationship exists. Yet, in practice, many holders may find themselves at a disadvantage if the secondary market tanks. Issuers, particularly those with whom the holders have no direct relationship, may refuse redemption claims for myriad reasons, including compliance with Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations. This situation underscores a critical gap in understanding and expectations: just because a stablecoin theoretically offers a mechanism for redemption doesn’t mean every holder will be able to utilise It Under All Circumstances.

What To Expect From The Future?

In the swiftly evolving narrative of digital finance, stablecoins emerge as both a testament to human ingenuity and a reminder of the complexities inherent in pioneering new monetary forms. They encapsulate the drive towards a more interconnected and accessible global economy, unshackled from the cumbersome constraints of traditional financial systems. Yet, as we chart this unexplored territory, we’re reminded that innovation, while exhilarating, carries its share of risks that must be navigated with vigilance and a forward-thinking mindset.

The conversation around stablecoins, particularly fiat-backed variants, is just starting. It opens up a broader dialogue on how we perceive, utilise, and govern digital money in an increasingly decentralised world. As we delve deeper into the potentials and pitfalls of stablecoins, our journey is as much about shaping the future of finance as it is about understanding the intricate balance between innovation and stability, freedom and regulation. In this dynamic landscape, our collective challenge is to harness the revolutionary promise of stablecoins while ensuring they serve as a secure and stable medium of exchange for all, heralding a new era of financial inclusivity and empowerment. How powerful can a public blockchain token representing a claim on a JP Morgan deposit be? Can you imagine a future where all bank deposits are on-chain, being traded and priced in real time? What impact would that have on the payments market? And other markets?

Long Reads

• I highly recommend reading Nic Carter’s Cryptodollar paper published in 2021. It’s probably the one document that made me realise what I was missing before.

• The EU is front-running the entire discussion on regulated stablecoins and has already published its first set of rules for the MICAr regime.

• This smaller piece from Coinmetrics breaking down Tether's meteoric rise and dominance among stablecoins is also quite interesting.