With the arrival of stablecoins, is it time to pay farewell to traditional payment rails? – Bank Underground

Aly Soliman

Stablecoins have emerged as an innovative form of money in the financial landscape. While they represent a small fraction of the global financial system, stablecoins have grown by US$30 billion in the last few months (as reported on DefiLlama). The potential effect of stablecoins on the payment industry could be substantial and merits attention.

This post aims to shed light on the transformative potential and risks of stablecoins on the retail payment sector – for local and cross-border retail payments. Stablecoins have the potential to modernise the traditional payment rail process into a streamlined ‘peer-to-peer’ payment transaction. That in turn may reduce the dependency on payment networks and a long chain of intermediaries associated with traditional payment rails.

The payment rails

Throughout history, payment methods have continually evolved, marking significant milestones from the traditional use of cash to the adoption of cards. This journey, however, while innovative, often brought with it complex processes. Whether you are paying for a cup of coffee or for an item at a department store, it is usually a simple swipe of your bank card or your phone wallet to make the payment. However, what may not be apparent to clients (the cardholders) is that on the merchant’s end, these quick transactions depend on intricate and costly processing procedures.

A simple swipe of your card to make a payment initiates a process known as ‘payment rails’. This is a sophisticated system involving multiple intermediaries and associated fees and these costs are initially met by the merchant. Whether payments are digital or cash-based, local or international, merchants may transfer the costs they incur from these transactions to customers, either partially or fully. This can influence the overall costs of goods and services. While there are specific regulations governing payments fees, these can vary across different jurisdictions. 

The financial ecosystem has seen significant fintech innovations in recent years, with distributed ledger technology (DLT) and the emergence of stablecoins – a type of crypto asset which aim to maintain a stable value versus stable assets like fiat currencies or precious metals (like gold) – as one of the key applications. 

Stablecoins are part of the broader DLT financial applications suite. Stablecoins have features that could combine the immediate processing and security of blockchain transactions with the stable value of state-backed fiat money. They are currently emerging as a candidate to revolutionise the retail payments landscape. These digital forms of money and their underpinning technology could redefine the norms for retail payments by offering a reliable, scalable and secure alternative.

Stablecoins and DLT have caught the attention of various stakeholders in the financial arena especially by claiming to be a promising tool for the future of money settlement. Although their integration into mainstream settlement processes is still at a nascent stage. Currently, the possible full integration of DLT fast-paced innovation into payments would be considered to be at the early stages rather than the end of a potentially transformative journey.

However, that notable fast-paced innovation raises a critical question: could stablecoins, with DLT’s help, create a future where retail payments (local and cross border) are made with minimal costs and without the dependency of payment networks, service fees and the maze of service intermediaries, while still fulfilling their functions?

Stablecoins’ role in the broader financial system is still in development though it could contribute to the future evolution of a new financial ecosystem. The extent to which this occurs remains contingent upon issuers’ business models and operational plans as well as comprehensive regulatory frameworks.

Could stablecoins take us to that future?

Stablecoins have the potential to redefine traditional financial transactions through offering a more streamlined, peer-to-peer payment model. While they aim to reduce dependency on a multi array of intermediaries there are acknowledged challenges that need to be navigated. These include building a user-friendly access infrastructure, establishing robust consumer protections, addressing instances of fraud and optimising for speed and cost-efficiency on the blockchain.

In the emerging stablecoins ecosystem, wallet providers and exchanges have taken on a pivotal role. They are not traditional intermediaries but are necessary for transaction facilitation and to provide essential services, including security measures. This new ecosystem offers a different approach to payment processing. It may not be entirely intermediary-free and it could potentially simplify the payment chain by replacing multiple transactional layers with a simpler process close to a peer-to-peer payment transaction.

Therefore, while stablecoins may not currently offer a completely intermediary-free solution, they are a key driver of the conversation about the future of retail payments. As the technology and regulatory landscape evolve, so too may the mechanisms through which stablecoins can achieve a more efficient payment process.

Benefits, risks, and concerns

The integration of stablecoins into the payment ecosystem could potentially streamline transactions, suggesting possible benefits of efficiency and cost-effectiveness for both customers and merchants, possibly outperforming traditional financial methods in terms of speed and simplicity.

For merchants the appeal of stablecoins lies in the prospect of potentially reduced fees from payment processors and a potentially immediate transaction settlement. This could translate into better cash-flow management and more competitive pricing for consumers. This efficiency could support a more dynamic economic landscape where businesses could potentially benefit from faster payments alongside operational cost savings.

For this vision to materialise, it is essential to confront and mitigate current and potential challenges directly. There is apprehension regarding the volatility of transaction fees, particularly ‘gas fees’, and instances of depegging highlight the market’s sensitivity and the need for robust stabilisation mechanisms. Additionally, the risk of destabilising capital flows between traditional banks and stablecoins, or within the stablecoins market itself, poses a significant concern for financial stability. There are also concerns around the application of anti-money laundering (AML) and ‘know your customer’ (KYC) regulations, as the anonymity and cross-border nature of digital currencies can complicate the enforcement of these crucial safeguards. Also, the emerging field of quantum computing poses a futuristic yet tangible threat, with its potential to disrupt the cryptographic foundations that secure digital currencies.

These considerations underscore the necessity for stablecoins issuers to establish viable business models that not only ensure profitability but also address scalability, customer protection and adherence to regulatory standards. The discourse around stablecoins must, therefore, evolve to include these critical aspects, ensuring that while their transformative potential is embraced, the risks are not understated.

Recognising these challenges, key parties within the financial ecosystem – including regulatory bodies, fintech innovators, and academic researchers – are actively engaged in assessing these risks. After all, it is important that the adoption of stablecoins does not compromise the integrity and security of the financial system. The fintech industry is actively working on innovative solutions, for example, advancements like ‘zero knowledge proof’ technology are being developed to enhance privacy while still complying with AML and KYC regulations, without revealing the underlying data. Additionally, the development of blockchain Layer 2 solutions (L2 solutions) is a response to the need for greater efficiency on blockchain networks, building upon Layer 1 (L1) foundations to overcome their limitations. These examples, along with the exploration of central bank digital currencies, signifies many industry participants’ intent to pave the way for a more secure and dependable future for stablecoins.

Are stablecoin payments a matter of ‘if’ or ‘when’?

The financial landscape is keenly attuned to the evolution of stablecoins. PayPal’s initiative with a US dollar-pegged stablecoin and Société Générale’s listing of a stablecoin on a trading platform indicate ongoing innovation and could pave the way for more stablecoin related projects. These initiatives are happening while the proliferation of digital wallets is simultaneously enhancing stablecoins’ accessibility for users and bridging the gap between traditional finance (retail payments) and the digital currency space.

Regulatory bodies across the globe, from the UK to Singapore and Hong Kong, are also playing a critical role, crafting frameworks that aim to regulate the expanding stablecoins market. These proposed regulations are testament to the seriousness with which the financial system is approaching the potential wave of stablecoin adoption.

As discussions progress and technology advances, the possibility of payment evolving beyond traditional intermediaries becomes more conceivable. However, this future is contingent upon a mixture of sustained innovation, adaptive regulation and market readiness. Such transformation, if realised, could potentially set a new benchmark in financial transactions.

The question, may be, is not about whether stablecoins will influence the future of payments, but rather about how and when they will make a visible impact across the payment ecosystem.

Aly Soliman works in the Bank’s Payment Innovation Team.

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