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The explosion in stablecoins revives a debate around “free banking”

Did privately issued money in the 18th and 19th centuries lead to chaos or stability? THE FAST-MOVING frontier of financial innovation can seem an intimidating place. Concepts such as decentralisation, distributed ledgers and symmetric encryption can befuddle the outsider. Scholars and regulators may therefore have been relieved to spot parallels between the burgeoning world of stablecoins—digital tokens that are pegged to an existing currency or commodity—and America’s free-banking era of the 19th century. Indeed, recent discussions about stablecoins have sparked a lively debate around the history of privately issued money. Together the dozens of stablecoins in existence, which include Dai, Tether and USD coin, have a market capitalisation of close to $150bn. As they have exploded in value, their similarity to banks has begun to exercise regulators. Like banks, they in effect take deposits and promise immediate redemption; if many holders want to withdraw their money at the same time, and the issuer holds risky assets, then the digital coins could be in danger of collapsing. On November 30th Janet Yellen, America’s treasury secretary, said that the tokens presented “significant risks” and pressed for more regulation. Before America instituted a national currency in 1863, banks issued their own banknotes, backed by assets and redeemable for gold or silver. Critics of stablecoins often point to this period of free banking, and the example of unstable “wildcat” banks in particular, as a cautionary tale. Gary Gensler, the chairman of the Securities and Exchange Commission, America’s main markets watchdog, and Elizabeth Warren, a Democratic senator, have both compared stablecoins to wildcats, as has a recent paper by Gary Gorton of Yale University and Jeffery Zhang of the Federal Reserve. The comparison is not so clear-cut, however. The lack of a national currency before 1863 created obvious economic inefficiencies. Dollars issued by unfamiliar banks a long way from home traded at a discount, due to the lack of information about the financial health of their issuers. For the issuing bank, having notes circulate far away was an advantage, since the holders were very unlikely to turn up to redeem them. This arrangement led to the appearance of scam artists like Andrew Dexter, who bought up banks across north-eastern America and issued huge volumes of fraudulent notes. One bank was found to have issued around $580,000—around $13m in today’s money—while holding all of $86.48 in precious-metal specie. In another case in 1838, state officials in Michigan found that the boxes which should have contained the coins for which depositors could redeem their notes were bulked up with lead and broken glass. Critics argue that the comparisons with stablecoins are clear. Tether, the largest single stablecoin issuer, with $74bn in tokens in circulation, was fined $41m by the Commodity Futures Trading Commission in October for misrepresenting itself as fully backed by assets between 2016 and 2019. (Tether responded with a statement saying that “There is no finding that Tether tokens were not fully backed at all times—simply that the reserves were not all in cash and all in a bank account titled in Tether’s name, at all times,” and that it had never failed to satisfy redemption requests.) Yet there are also differences between stablecoins and the private money of antebellum America. Back then, anyone who needed banking services or currency had to place their financial fate in the hands of opaque and risky institutions. By contrast, no one in the rich world is obliged to hold stablecoins; safer alternatives, such as insured bank deposits and cash, are readily available. Nor is it clear that wildcat banks are the summation of all historical experience of privately issued money. George Selgin of the Cato Institute, a libertarian think-tank, has likened the use of wildcat banking by critics of private-money issuance to the use of Germany’s interwar hyperinflation by critics of central-bank money issuance: both are extreme and negative examples, rather than representative. Scotland’s free-banking system between 1716 and 1844, for instance, is often cited as a period of stability. Three large banks and several smaller lenders all issued currency and redeemed each other’s notes at their full value. Furthermore, at least some of the problems with American free banking may have reflected poor regulation rather than a total absence of it. Banks were often not allowed to have networks of branches and interstate banking was near-impossible, which limited the expansion of successful and trusted institutions. Many were also made to hold volatile state bonds as collateral. Slumps in the value of these could—and did—spark local banking crises. Policing the frontier History alone, littered as it is with both scam artists from 19th-century America and upstanding financiers from Georgian-era Scotland, cannot settle the question of how dangerous stablecoins are. But perhaps one less-appreciated lesson from American free banking is that, if innovation is not to be smothered, the quality of regulation matters. A report published by America’s President’s Working Group on Financial Markets last month recommended treating stablecoin issuers like deposit-taking institutions. Providers say that this degree of supervision is stifling. Such regulation would offer them a prize, however: accounts at the Federal Reserve, which would allow them to settle payments directly, rather than piggybacking on commercial banks. One idea, detailed by Messrs Gorton and Zhang and supported by Mr Selgin and Dan Awrey of Cornell University, would be to make reserve accounts easily available to any stablecoin provider, on the condition that they hold all their assets in such an account. That would mean that the coin is fully backed with the safest possible asset: central-bank reserves that carry no risks in terms of liquidity, maturity or credit. Scholars may be divided over whether too much or too little regulation led to the wildcats’ demise. But stablecoins could still avoid their fate. ■ Read more from Free Exchange, our column on economics: Measuring the universe’s most important sector (Nov 27th 2021) Janos Kornai understood capitalism by studying its opposite (Nov 20th 2021) A whodunnit on Zillow (Nov 13th 2021)

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