In last week’s Money Stuff newsletter, the inimitable Matt Levine argued that stablecoins are making banking narrower in strange modern ways. He went on to suggest — riffing on Andrew Bailey’s op-ed in the Financial Times — that some central bankers (Bailey, ahem) appear open to the idea, even though not so long ago they would have run a mile.
“In the US, TNB — for “The Narrow Bank” — wanted to issue deposits and park its money in reserves at the Fed, but the Fed said no. It looks like if you tried that in the UK, and called it a stablecoin, the Bank of England might say yes,” Levine wrote.
As the column explains, stablecoins take deposits, issue payment tokens, and invest only in safe assets like government bills. But unlike banks, which back deposits with risky loans, stablecoins separate money from credit. This reflects a broader shift where lending is handled by private credit, while stablecoins — now endorsed by the Bank of England’s Bailey — could evolve into risk-free deposit-taking institutions, potentially with access to BoE accounts.
All very well and good. But Cash Equivalence feels compelled to offer some supplementary thoughts on why central bankers like Bailey are suddenly embracing narrow banking.
The traditional argument against normalizing narrow banks in an economy is that this would severely restrict credit supply and slow economic growth. Moreover, separating “safe money” institutions from lending institutions risks driving lending into less-regulated shadow markets, increasing systemic fragility instead of reducing it.
Bailey surely doesn’t want any of that.
Thus, if Bailey is softening his tone on stablecoins, it probably isn’t linked to the virtues (or not) of separating risk-free deposits from credit-creating ones. More likely, it is linked to what the U.S. government believes the U.K. must do to avoid further destabilization of its economy.
For now, that is one and the same as what U.S. Treasury Secretary Scott Bessent — the preeminent authority on what can and cannot break the Bank of England — thinks the U.K should do. And one needs only to look at his public statements to figure out that means going all in on asset-backed stablecoins.
The BoE can fret and fluster about retaining control and independence, but when it comes to the crunch, it will have to do what the U.S. says.
But why then is Secretary Bessent so convinced that a push towards a narrower banking model in the form of stablecoins is the answer to the West’s economic woes? And what is it about the prospect of separating credit money from payment float that tantalizes him so?
It’s tempting to speculate it has something to do with the secret formula that allowed him to break the ERM peg in 1992 while at Quantum Fund.
But the better answer, we think, is because doing so enables currency reform in countries that are too big to fail. Ideally, without advertising too loudly that those countries are losing control and can only regain credibility by turning either to currency boards, explicit dollarization, or capital controls.
This is all the more pressing now that “serious” market voices are starting to talk about a “debasement trade” that is centered on piling into hard assets like bitcoin and gold — a particularly awkward situation for the U.K., which sold most of its gold between 1999 and 2002 and now retains only 310 tons of gold, compared to France’s 2,437 tons.
Which narrow system is better?
At this point, we can probably all agree that the march toward a narrower banking model — whether via stablecoins or central bank digital currencies — is happening.
What few still understand, however, is that this is not a matter of choice but a matter of necessity. The system, having reached the end of the line on explicit monetization through QE, is now coming head-to-head with the effects of a fiscal and monetary collision at the edges of its “region of stability”. For more on how that works, do see the Bank for International Settlements’ work on the concept here.
But the BIS’s key point is that when the region of stability is threatened, “market sentiment and public trust in the ability of macroeconomic policies to preserve stability can shift rapidly and, in turn, dramatically narrow the fiscal and monetary space. A sharp depreciation of the exchange rate is often the first sign of a loss of confidence as well as a key channel that constrains the policy headroom.”
Setting aside that it is one of the great ironies of modern finance that central bank independence — originally designed to curb the excesses of government money-printing — ultimately enabled the very era of unchecked monetary expansion that defines our predicament today, there’s no escaping that the endgame we are facing is stark.
On one hand, we have the option of opening the door to a market-driven narrowing of the system to prevent the worst, a move that will be expensive but survivable; on the other, we can keep doing what we’re doing and risk abrupt destabilization and collapse.
In the early 1980s, the communist system faced a similar inflection point. Rather than opt for reform, it chose to double down on central planning. By the time it became apparent that the system would need to embrace market-based systems to survive, a dysfunctional collapse had already begun. Many former communist bloc countries did eventually embrace stabilization programs and sweeping currency reforms, but not without significant fallout and misery for ordinary people.
Yet, even if we’re at the point where the West must adopt similar programs to avoid a similar fate, it’s important to understand the varying flavors of the narrow-banking solutions currently on the table.
Three options stand out: 1) central bank digital currencies (CBDCs), 2) tokenized deposits that are underpinned by pre-positioned collateral (the least narrow option, and thus one we won’t go into in this piece), and, last and not least, 3) stablecoins.
The devil is, as ever, in the detail, and in this case, in how differently the three systems treat the assets that underpin our payments systems.
CBDCs put the onus on the central bank. Since the float is a liability for a central bank, digital euros or digital pounds become a function of the asset base that backs central bank liabilities as a whole. In a scarce reserve regime (i.e. the norm before 2008), that would usually mean populating the asset side of a central bank balance sheet with foreign exchange reserves or other hard assets like gold capable of defending the currency on international currency markets. In an abundant regime, however, it means transforming the excess reserves regime introduced to contain the 2008 bank crisis into a permanent feature, while allowing retail users access to that liquidity as well as banks.
Commercialising the central bank’s balance sheet, however, is far trickier than it appears. The imperative to avoid negative carry eventually pushes the central bank into active management of the assets backing its float. In practice, that turns a central bank into something more akin to a state bank or sovereign wealth fund — while also pushing the central bank into direct competition with private sector investors. The entire path raises uncomfortable questions about the boundaries of monetary policy in a capitalist system.
In highlighting this risk, we’ve frequently described CBDCs as a pathway to a kind of “Gosbank” system, in which the central bank — as the chief allocator of cheap credit — is forced to take on the role of a commercial bank, whether it intends to or not. In the Soviet Union, the assets of such a system were primarily made up of the loans and credits it extended to state-owned enterprises, collective farms, and government entities. A planner’s delight. But unlike commercial banks, which must adapt or fail when their lending strategies go wrong, Gosbank faced no such discipline. Its credit flows, which were dictated by a central plan — the “Gosplan” — devised by a central economic committee, skirted corrective feedback from market forces. In the end, this proved one of the Soviet system’s most fatal flaws.
With the digital euro, the ECB is, arguably, wading into very similar territory. It is all the more concerning that it is doing so while campaigning to make access to its liquidity conditional on the greening of banks’ asset portfolios, a process many argue is highly subjective and capable of bifurcating the credit system.
Either way, the result is a dramatic expansion of central bank power over the economy. Yes, in theory, banks still retain deposit businesses under the model. But, in practice, they can’t easily compete with the central bank on both payments efficiency and trust. As to the “narrowness” in the model, that arises because banks under the model lose their privileged ability to recycle customer deposits into credit creation. Instead, loans must be fully funded, a shift that squeezes profitability and fundamentally rewires the economics of commercial banking.
But that’s where the narrowness ends. The central bank still retains the power to dilute its liabilities at will — through helicopter drops, for instance — or to steer credit toward favored sectors and countries (say, green projects in France and Germany) while withholding it from those that go against its will (such as Poland or Hungary). All this, based on the assessment of just a single man with a plan. Who, needless to say, might be wrong.
The outcome is a risky transfer of seigniorage power from the state to the central bank. More concerning still, the model provides no constraint on such credit creation — beyond the vague check of political stigma — for as long as central bank independence remains sacrosanct.
Stablecoins also represent a narrowing of the system — but their narrowness plays out very differently. Instead of forcing banks to compete with the central bank, they’re now forced to compete with non-banks on asset quality and payment efficiency rather than on interest rates alone. The outcome is a clearer divide between deposits assigned to banks on the presumption of risk-free outcomes (usually for payments or safety reasons) and deposits allocated to banks for the purpose of risk-taking activity.
Most importantly, with stablecoins, seigniorage power is transferred away from the central bank and over to the Treasury, since deposits are now consciously assigned to the funding of public/social investment in the U.S. as administered by the government, instead of undefined investments administered by banks (under the guidance of the central bank).
In both cases, private sector banks lose out due to credit extension being centralized.
Thus, to determine which is the better option, ordinary folk need ask themselves only one question: who do they trust more with the power of credit creation? Private sector banks (accountable to shareholders), central banks (mostly accountable to themselves), or governments (accountable, in democracies, to voters)?
Forward stabilization guidance
Even so, stablecoins can’t prop up collapsing regimes unless they are anchored to governments that are fiscally disciplined and that prioritize the quality of investment over its sheer quantity. That is precisely why the standoff over the U.S. debt ceiling and resulting government shutdown matters so much.
The U.S. has one final chance to draw on deficit spending to secure the money it needs to revive growth across the entire Western system. The message to markets, in that sense, is clear: “Give us the money we need one last time, and we will commit to a ‘stabilization program’ and ‘currency reform’ thereafter — at least until growth prevails.” In practice, that amounts to an unshakeable guarantee that the new debt ceiling will be set in stone and that stablecoins — alongside a broader shift toward a bitcoin- or gold-based international settlement system — contain excessive credit creation until growth revives itself.
If markets doubt that such promises will be kept, even stablecoins will lose ground to gold or other hard assets like bitcoin. The same applies if governments rush to slash spending so abruptly that system cohesion breaks down (like what’s going on now in Argentina).
For stablecoins, the sweet spot will lie with the U.S. signaling that it intends to use its “last great credit gift” wisely as part of a reform agenda and in helping people to preserve their lifesavings as the system switches gear from an overly extended and financialized model to a newly rebooted balanced system.
Steady as she goes
It’s worth remembering that the real story of U.S. debt is not about Chinese or Japanese holdings, but about the American banking system itself. The vast majority of outstanding U.S. government debt today — much of it created to plug the enormous hole that emerged in the U.S. financial system after 2008 — is held domestically by U.S. banking institutions or the Fed.
That means a good chunk of the debt-servicing cost that the U.S. government is struggling to meet under its current fiscal package represents outlays to the very same banking institutions it helped to shore up in 2008.
On the plus side, extensive HQLA buffers mean that if a financial crisis were to strike today, the largest and most systemically important institutions would have all the capital and liquidity they need to handle unexpected haircuts, writedowns, or outflows.
On the downside, the additional resilience comes at an ever larger taxpayer cost, and within a structure that all too apparently favors large systemically important institutions over smaller ones, as well as mega-cap equity investments over community loans.
Scott Bessent, for one, has been abundantly clear about why he believes this is a problem. He told audiences on Thursday that “the purpose of Dodd-Frank was to end ‘too big to fail.’ But it ended up creating ‘too small to succeed’.”
He added that “the post-2008 regulatory framework entrenched the dominance of the largest banks by rewarding economies of scale and lucrative lobbying operations in Washington. What followed was a community bank bottleneck that left America’s hometowns reeling.”
This is why, Bessent says, the Trump administration will soon roll back the “harmful regulations”. In theory, the move stands to open the floodgates on non-bank competition. But it also stands to provide depositors with alternative safe harbour options in their hour of need when a financial panic strikes.
Might all this then be part of an elaborate plan to engineer a controlled demolition of the “too big to fail” GSIB system? There’s no saying for sure, but banking regulators certainly seem poised for something.
On Wednesday, the Bank of England’s Financial Policy Committee warned of a growing risk of a “sudden correction” in global markets on the back of soaring valuations as well as a sharp repricing of U.S. dollar assets.
That’s not to say we’re predicting an impending “selective default” on interest payments to GSIB institutions. We’re merely pointing out that one man’s selective default on debt held by systemically important banks is another man’s unexpected windfall tax on bank profits. Besides, governments in Europe have already crossed that Rubicon.
In the end, successful stabilization will depend on the U.S. government convincing markets that, having bailed the system out in 2008, it has a right to dictate which financial institutions should benefit from taxpayer-funded interest payments and which should not. And that, in this case, transferring such flows to decentralized stablecoin providers and away from banks is highly preferable to maintaining taxpayer support for GSIB institutions beholden to an increasingly politicized Federal Reserve with a penchant for mission creep.
Will such a move constitute financial repression? Some might say yes. More creative-minded folks would argue it’s merely the government clawing back its money from the banking system after it failed to transition the economy back to a free-market system that works for all people.
