Is the US Dollar stablecoin triggering an inflation bomb? The "GENIUS Act" may unleash a global currency tsunami.

The rise of the US dollar stablecoin and the signing of the GENIUS Act are bringing profound effects to the global financial markets. This act, which was signed into law last week, brings stablecoins (digital tokens pegged to the US dollar) into the regulatory mainstream. Although it is still in its early stages, it is conceivable that this act will trigger the largest scale reform of the US and even the global monetary system since the collapse of the Bretton Woods System over 50 years ago. Macro strategists are beginning to worry that further adoption of stablecoins will lead to a steeper yield curve, widening swap spreads, and rising price pressures. Given the increasingly entrenched inflation, this is particularly problematic for the United States. Are we on the brink of monetary turmoil?

1. stablecoin: A new type of dollar and currency hierarchy structure

The key to understanding stablecoins lies in the hierarchical structure of currency. The author of "Money and Empire", Perry Mehrling, describes currency as layered. The safest and least elastic form of currency—central bank reserves—sits at the top of the pyramid, followed by bank deposits, and finally securities. Stablecoins will be located at the bottom of the second layer. They are (currently) effectively zero-yield bank deposits, despite their limited settlement capability.

Crucial to the currency system are bank deposits and central bank reserves for parity settlement. The "GENIUS Act" stipulates that stablecoins must be backed by very safe assets, such as government bonds and money market fund shares. At least in theory, this should lead to stablecoins being settled at parity. Therefore, in practice, stablecoins represent a new type of bank deposit, and thus a new type of dollar. Merlin used the analogy of European dollars, equating "on-chain" dollars (i.e., stablecoins) with offshore dollars in the fiat world. This could have far-reaching implications, not only because the new dollars will shift capital from elsewhere, but equally importantly, stablecoins will purchase assets to collateralize new tokens. Ultimately, it will depend on how the velocity of money and asset duration change as stablecoins grow.

2. The Impact of Stablecoins on the National Debt Market and Inflation

First of all, many people, including the Secretary of the Treasury, expect that stablecoins will lead to an increase in demand for U.S. Treasury bonds. Therefore, the GENIUS Act is ostensibly part of an overall government plan aimed at lowering interest rates (through the replacement of the Federal Reserve Chair), reducing borrowing costs by issuing more short-term bonds, and increasing demand for such borrowing. So far, so good: stablecoins are the third-largest buyer of 2024 notes and the tenth-largest holder.

However, whether they can create new demand for government bonds depends on how they change duration. If they mainly attract demand from the short-term, low-duration market (such as money market funds), then given that money market funds already hold a large amount of government bonds, it is unlikely to reduce government financing costs. This is similar to the "Fiscal Quantitative Easing" implemented by the U.S. Treasury in 2023, when it significantly increased the issuance of Treasury bills. Short-term funds purchased these Treasury bills through the Federal Reserve's reverse repurchase agreements, while the scarcity of long-term assets forced buyers to turn to riskier alternatives such as stocks. Although the huge fiscal deficit created a crowding-out effect, it still supported these Treasury bills. From the perspective of the Treasury, this may be the most benign outcome.

But it will ultimately lead to inflation. Experience shows that an increase in demand for high-risk assets, a potential decrease in government financing costs, and an increase in the number of "monetary" assets (such as short-term bills) with stronger characteristics/shorter durations will lead to structural price increases. As the weighted average maturity of outstanding government bonds shortens, the yield curve also steepens.

3. Long-term Effects: Changes in Circulation Velocity and Asset Duration

In the long run, the situation may not be so. It can be imagined that as stablecoins gradually mature in the traditional financial system, investors will gradually get used to using them as a bridge to invest in cryptocurrencies or depositing them into interest-bearing platforms like Nexo. This may lead to a decline in demand for long-term bonds, thereby continuing to exert pressure on the yield curve and causing the swap spread to widen.

Therefore, if investors start earning returns through stablecoins or ultimately pay interest themselves, stablecoins will face increasingly fierce competition with traditional bank deposits. This may lead to a decrease in the circulation speed of the entire system, as money will move out of a high duration, high circulation speed world into the low circulation speed and low duration track that stablecoins currently occupy.

However, the story of the velocity of circulation is far from over. With the improvement in the operational efficiency of payment systems, the interchangeability of stablecoins and traditional currencies will ultimately increase (according to estimates by the Boston Consulting Group, payments currently account for only 6% of usage). The tokenization of short-term assets will effectively allow stablecoin holders to use instruments like notes and money market fund shares in small amounts (this is already happening). Therefore, ultimately, stablecoins may lead to a higher velocity of circulation, but their form is more likely to result in higher consumer inflation rather than asset inflation.

4. The "GENIUS Act": A Stroke of Genius or a Driver of Inflation?

If no one wants stablecoins, all these analyses and assumptions are meaningless. Apart from illegal reasons, it's unclear why anyone would want stablecoins—given that they are essentially a currency market fund that pays zero yields—rather than holding treasury bills or shares of the money market fund itself.

However, creating a new dollar that trades at par in the monetary system is likely to change the game and attract more fiat money seeking returns into the cryptocurrency space. This is currently the biggest use of stablecoins, accounting for nearly 90% of last year's trading volume. Along with purchasing power, you will find that they have another appeal, which is inflation, especially as governments increasingly rely on notes to finance themselves.

Theoretically, the legalization of the US dollar stablecoin can allow the government to lower borrowing costs, reduce the debt-to-GDP ratio by increasing inflation rates, and attract capital from other parts of the world amidst a decreasing trade deficit in the United States. Time will tell whether the GENIUS Act is a stroke of genius.

Conclusion:

The signing of the GENIUS Act marks the official entry of stablecoins into the mainstream view of financial regulation in the United States. This reform will not only reshape the form of the US dollar but may also have far-reaching effects on the global monetary system, the national debt market, and inflation. The concerns of macro strategists are not unfounded; the changes in the velocity of money circulation and asset duration brought about by stablecoins could indeed lay the groundwork for future inflation. Whether this stablecoin revolution is a genius move by the United States to solidify the hegemony of the dollar or a catalyst pushing the world towards a new round of inflation remains to be seen.