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Central Banks and Financial Markets from a Traditional Viewpoint

The central bank maintains price stability by formulating and implementing effective monetary and credit policies, provides support for the healthy development of the national economy, and ensures the stability of the financial market. The main functions of South Korea's central bank "Bank of Korea" include issuing national currency, formulating and implementing monetary and credit policies, maintaining the stability of the financial system, providing deposit and loan services for financial institutions, receiving and withdrawing treasury funds, ensuring stable and safe payment and settlement, and ensuring stability management of foreign exchange reserves and foreign exchange assets, and conduct economic research and statistics.

Financial markets are where funds are traded to support real economic activity. The Korean financial market includes (1) a loan market in which savings business financial institutions such as banks, savings banks, mutual credit, and credit unions use depositors' funds to provide loans to loan demanders; (2) a capital market that provides short-term investment products ( money market) and the capital market that provides long-term investment products; (3) the foreign exchange market that trades foreign exchange assets according to foreign exchange demand and supply; (4) was born to control the price fluctuation risk and credit risk of traditional financial commodities and foreign exchange Derivative financial commodity trading market.

The function of the central bank is to regulate market interest rates and money supply, ensure price stability, and support economic growth. The benchmark interest rate of the Bank of Korea refers to the policy interest rate used by the Bank of Korea and commercial financial institutions for conditional repurchase of securities (Repurchase Paper, regular repurchase at a pre-determined price) or deposit and loan transactions (the benchmark interest rate of the Bank of Korea is used The fixed interest rate of selling 7-day RP and the lowest interest rate when purchasing 7-day RP, the deposit and loan interest rates of various financial institutions can go up and down on this basis -100bp (-1%pt), +100bp (+1%pt) ).

When the Financial and Monetary Committee of the Bank of Korea changes the benchmark interest rate, this change will have an impact on the overall economy through interest rate channels, asset price channels, credit channels, exchange rate channels, and confidence channels[4]. If the forecast is that the economy will shrink as it is now, unemployment will increase, and prices will stay below the reasonable level of +2%, the central bank will cut the benchmark interest rate. After the central bank's benchmark interest rate is lowered, the current loan interest rate, fixed deposit and loan interest rate, and long-term market interest rate will all gradually decline. At that time, enterprises will increase loans, increase investment and employment, and households will also increase loans and consumption. At the same time, the government will also increase loans. , Increase government spending by issuing treasury bonds (you can imagine the impact on the overall economy through asset price channels, credit channels, exchange rate channels, and confidence channels).

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Introduction to Stablecoins

Stablecoins are a concept that has not yet been fully defined. The European Central Bank (ECB) believes that a stable currency is not a specific currency (or a currency basket), but a digital value unit that relies on a stabilization tool that uses a specific currency to minimize market price fluctuations.

In the blockchain and cryptocurrency camp, the necessity of stablecoins stems from the large fluctuations in the prices of cryptocurrencies such as Bitcoin and Ethereum. Among the three functions of currency as (1) means of payment, (2) means of storing value, and (3) a measure of value, encrypted currency assets such as Bitcoin and Ethereum have the first two functions, but cannot become a measure of value. For currency, the measure of value is an important function it should have, not just a concept. If it cannot become a measure of value, its function as a means of payment and a means of storing value will also be difficult to realize. As such, stablecoins aim to provide value-level stability to cryptocurrencies.

According to the definition of ECB, the price stabilization mechanism of stable currency is based on (1) issuer responsibility (accountability of issuer), (2) decentralization of authority (decentralization of responsibility), (3) asset value guarantee (value supported by) three The standards are divided into four types: tokenized fund, off-chain collateralised, on-chain collateralised, and algorithmic. (reference picture)

The types of stablecoins that comply with the value stabilization mechanism are roughly introduced as follows.

(1) Tokenized fund: This type is supported by a fund, which means that a specific subject (manager) is required to guarantee the repayment ability of the token issuer. The value of a tokenized fund stablecoin is that the value of a tokenized fund can be very stable for the currency it represents, as long as users trust the organization or business that supports it, even if there are no clear terms to prevent users from being fraudulent . Tokenized funds do not include new types of assets, and when they are in circulation, they display a specific currency unit, similar to the way traditional electronic money is used for retail payments and the upfront funding of some existing payment systems. However, fund initiatives for tokenized funds need to be governed by appropriate regulatory frameworks. Tether is a typical example of this type of stablecoin.

(2) Off-chain collateralised: This type is supported by other traditional assets and needs to be kept by a manager. The assets are owned by the issuer until the user requests payment. The goal of off-chain secured stablecoins is to realize the tokenization of traditional assets through distributed ledgers, and responsible managers and issuers are required to ensure the stable preservation and redemption of collateral items. However, such a stablecoin requires the use of a common intermediary financial system. The issuance of stable coins can be adjusted within the floating range of the value of collateral to ensure price stability. Libra is typical of this type.

(3) On-chain collateralised: This type of stablecoin relies on an asset (usually an encrypted asset) that can be safely kept in a decentralized manner without identifying the issuer. Moreover, stablecoins guaranteed on the chain can usually provide economic returns to potential users, aiming to turn cryptocurrency, a highly floating collateral item, into a stable asset. This type of stablecoin operates without the involvement of responsible parties, and the collateral is held directly by the participants of the blockchain network. The issuer can supervise the rules and assume the responsibility for liquidating the collateral as required, but the issuer's business activities are usually carried out in a decentralized manner. The issuance of this stable currency can be adjusted within the floating range of the value of the collateral, and the price is guaranteed to be stable within this range. Typical such stablecoins include MakerDAO, etc.

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Stablecoins are crypto assets, the central bank of the digital economy

It is interesting to look at the different types of stablecoin price stabilization mechanisms from a traditional economic point of view.

(1) Central banks with a fixed exchange rate system: This type of central bank relies on U.S. dollar reserves and requires a specific entity (IMF) to guarantee the U.S. dollar solvency of currency issuers. When reserves of U.S. dollars are low or a possible shortage occurs, the value of the currency can drop significantly. The monetary policy of this kind of central bank cannot be independent, it is under the control of the Federal Reserve (Fed), and it can implement fiscal policy independently, but the issuance of additional currency will cause the value of the currency to plummet. Both the fiscal policy and the monetary policy of the central bank of countries with fixed exchange rate regimes will be subject to international supervision and institutional frameworks. Among them, the central bank of Singapore is in good condition, but the central bank of Argentina is facing major problems. Most Asian countries faced foreign exchange and currency crises in the late 1990s.

(2) Currency basket exchange rate central bank: This type of central bank relies on traditional assets such as dollarization, euro, pound, yen and other foreign exchange and gold. In order to ensure stable currency value, stable asset portfolios such as foreign exchange and gold are needed as guarantee. In order to maintain an independent monetary policy, the central bank that implements the currency basket linkage system needs to do a good job in foreign trade and ensure the continuous inflow of foreign exchange. The desire of these central banks to devalue their currencies requires the international community to develop a constraining framework for trade and exchange rate policies. The People's Bank of China has done well in this regard, but is still seeking to achieve higher status.

(3) A central bank with a floating exchange rate system: This type of central bank relies on a current account surplus and foreign exchange reserves (usually dollar reserves). Asset classification is the same as the implementation of the currency basket exchange rate system. In order to ensure a stable currency value, a stable asset portfolio such as foreign exchange and gold is required as a guarantee. In this case, the fluctuation of the exchange rate depends on the supply and demand of the foreign exchange market, and the inability to effectively control the fluctuation of the exchange rate can ultimately be attributed to policy failure. A central bank with a floating exchange rate system can conduct independent monetary and fiscal policies, but it needs to continually prove that it has sufficient solvency against the dollar. These central banks will also have a desire to devalue their currencies, requiring the international community to develop a constraining framework for trade and exchange rate policies. Central banks in countries such as Japan and Germany have done a good job of doing this, but they want more status. South Korea is currently doing well, but it is affected by the Federal Reserve at the currency level and China at the economic level, which is a headache for the Bank of Korea.

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The Fed's Attempts and Stablecoin Challenges

In the wake of the novel coronavirus pandemic, the Federal Reserve cut its policy rate to zero and announced an unlimited supply of credit and unlimited quantitative easing. At the Jackson Hole global central bank meeting held last week, the Federal Reserve announced the implementation of the average price target system and plans to maintain the zero interest rate system for a long time. The current value of the US dollar is depreciating steadily. Under the situation of economic stagnation, the steady decline of currency value is conducive to economic recovery. But the Fed's decision appears to be detrimental to the U.S. economy's goals of full employment, price stability, and financial stability.

Stablecoins, which play the role of a "central bank" in the encrypted asset camp, and the DeFi ecosystem, which plays a role in financial markets, are undergoing dramatic changes. The next column will introduce readers to the relevant situation of DeFi in detail.

JOIND Lim Dongmin Economist at Kyobo Securities