We’ve often argued that a stablecoin is nothing more than a glorified exchange traded fund (ETF).
So when it comes to the fuss about how to regulate stablecoins like Libra, is it possible that most of the hard work has already been done on account of the regulatory environment that governs ETFs?
That’s an idea being proposed by Luciano Somoza and Tammaro Terracciano, PhD candidates from the University of Lausanne and the University of Geneva respectively.
To start off, note the structural similarities between an ETF structure and the proposed Libra system as drawn out in the following diagram by the authors:
Fairly similar.
As the authors note, the Libra Association defines a basket of assets that can be traded for Libra tokens by selected intermediaries, called authorised resellers (ARs). ETFs use a similar system of authorised participants (APs).
As they go on to explain:
ARs purchase these assets on the market and give them to the Libra Association. Assets are transferred to third-party custodians and Libra issues new tokens, which are delivered to the ARs. Retailers can purchase Libra tokens only through ARs. On the contrary, when the demand for Libra decreases, ARs can redeem the tokens in exchange for the basket’s assets.
The ARs operate in an arbitrage corridor: when the price of the token is higher than the basket price, they create new tokens – and vice versa when the price of the token is lower than that of the basket. This arbitrage opportunity guarantees that the token’s price remains close to the basket’s price.
All of which they rightly point out feels awful like the ETF creation/redemption system.
The main difference with stablecoins is the distribution. ETF units are bought and sold on public exchanges. (The clue is in the name).
With Libra, however, the tokens are supposed to be distributed over a permissioned blockchain. And that’s where many of the regulatory concerns come in — especially with respect to money laundering rules.
The fee structures and legal structures are different too. Libra seems to think they can offer this product for next to nothing, while ETF returns are often massively eaten into by the manager fees that have to be deducted from their performance. We imagine there is a reason for this beyond ruthless predatory intermediation.
But looking beyond these marginal differences, it has to be said the essence of the economic structure is the same.
So how might ETF regulation be repurposed for stablecoins?
From the authors:
This regulation would bind stablecoins to an ETF-like structure, with full backing, token convertibility, a primary market with authorised participants, third-party custodians, and full disclosure of the underlying basket. Stablecoin sponsors should also be required to collaborate with the regulator to develop orderly liquidation plans. Regulation would turn stablecoin sponsors into a specific kind of ETF sponsor, reducing uncertainty around their business model.
Further regulation is needed to allow tokens to be traded freely and easily by retailers. In particular, it would be reasonable to constrain stablecoins to include only risk-free securities and deposits in their basket, avoiding excessive financial risks for the financially unsophisticated retailers who might use them as a means of payment.
Of course the problem remains — regardless of how purportedly risk-free the basket underlying the stablecoin is — that unlike ETFs a key feature of stablecoins is their bearer nature. That’s also what makes them money-like.
The authors acknowledge this (our emphasis):
For most digital currencies, users possess their own keys. This allows them to store their tokens physically (for example, on a USB stick) and to move them anonymously. This clearly poses huge capital flight risks, or the danger they can be used to support criminal activity. Therefore, we propose that users who want to dispose of their tokens always pass through a certified institution (maybe using a mobile application)
Finally, when the regulator expects the launch of a stablecoin to have a large impact (Libra is a good example here), it could impose a step-by-step introduction. The sponsor and the regulator would pre-emptively agree on temporarily constraints on the basket, such as picking shorter maturities or imposing a higher share of deposits. Something similar already happens in the ETF industry.
But the authors also suggest that this is a feature that prevents the crowding out of banks, as some services within this sector will still have to be provided by licensed institutions.
There’s also a suggestion that the ETF reduces run risk.
On that last point we’re not so sure. People are slowly waking up to the liquidity risks that reside in ETFs. Yes the AP creation/redemption mechanism works beautifully in theory, but it’s increasingly clear that the mechanism is vulnerable to choppy markets or situations when AP risk appetite is abruptly reduced. When the flash crash occurred in 2010, it was ETFs that were disproportionately impacted, highlighting how important it is to have a committed dealer of last resort always present in the market to keep it working properly.
The face value of ETF units often has the capacity due to all sorts of structural, liquidity or legal reasons to entirely disconnect with the net asset valuation. That’s unlikely to be different for Libra. And while the soundness of the underlying collateral helps reduce this risk, it doesn’t eliminate it entirely. As the Eurozone crisis has taught us it’s not impossible for securities previously considered risk-free to be suddenly considered anything but.
But the other notable risk of ETFs comes when they get too big — leading to a situation where the tail begins to wag the dog rather than vice versa. The sheer scale and ambition of Libra runs that risk ten-fold, and via that opens the door to the other notable but little talked about risk in ETF structures — how free or not they are to earn extra revenue by lending out the securities they hold to the market.
Because once they start doing that, we come back to another analogy we often make: that central banks themselves look an awful lot like ETFs as well.
Related links:
Stabilising stablecoins: A pragmatic regulatory approach – VoxEU
ETFs are like central banks – Dizzynomics
