Banks dominate payments — that needs to change

Making deposits at Europe’s Central Banks accessible to payment companies — such as stablecoin issuers — would be a boon to financial stability.

Within 11 days in March, four banks in the United States and one in Switzerland collapsed. First Republic Bank followed in May. Three of the four largest-ever U.S. bank failures occurred in those two months. It was a painful reminder that banks bear significant risks that can quickly spill over to other industries.

Ironically, despite a heavy focus on how the crypto-asset sector could introduce risks to traditional finance, we instead experienced bank failures becoming a critical stability risk to the crypto-asset industry.

Financial regulation should aim to mitigate financial stability risks in the first place and, where possible, limit contagion risks to prevent further damage, independent of the direction of the contagion.

Today, regulated stablecoin issuers are forced to rely on banking partners in order to fulfill the minting and redemption through fiat money. The indirect access to fiat settlement inevitably exposes e-money institutions in the European Union — future issuers of regulated stablecoins, a.k.a e-money tokens — to disproportionate cost and counterparty risk, according to the European Commission’s assessment of the Payment Service Directive (PSD). Ultimately, it constrains innovation and competition in the payments market.

Granting regulated fiat stablecoins (e-money tokens in the EU or payment stablecoins in the U.S.) access to central bank accounts would, therefore, not only be a crucial step for the safety of fiat currencies on the internet, but also for payments innovation writ large.

It would allow issuers to eliminate their exposure to risks associated with uninsured deposits and separate high-velocity payments activity in stablecoins from the illiquidity of loan portfolios in banks.

The landmark MiCA regulation (Markets in Crypto-Assets) in the EU brings tremendous opportunity to the continent. However, as it was already agreed to at the end of June 2022, before the inherent banking risks became apparent early 2023, the regulation mandates that e-money token (EMT) issuers hold at least 30% of their reserves with credit institutions. What was supposed to be a measure to improve the liquidity and risk-exposure of EMT-issuers will ultimately burden EMT-activity with banking and counterparty risk. The recent banking crisis has taught us that, in an age of a social media-centered flow of information and mobile-based banking, we need to change our assumptions about liquid liabilities backed by illiquid assets.

The solution to this problem is by no means new. EMT issuers, and all e-money institutions, should have the ability to access central bank accounts directly. By giving access to a central bank account, EMT issuers could shield EU customers from the credit risk of private banks by moving fiat funds to the central bank directly.

In the United Kingdom, e-money institutions have enjoyed direct access to the Bank of England’s settlement layer since 2017. This would “help increase competition and innovation in the market for payments” and create “more diverse payment arrangements with fewer single points of failure,” according to the Bank of England. Former Bank of England Governor Mark Carney described this legislative change as “potential to deliver a great unbundling of banking into its core function of settling payments, performing maturity transformation, sharing risk and allocating capital.”

But even in the EU, safeguarding e-money reserves at the central bank is already a common practice in one member state, namely Lithuania. The Central Bank of Lithuania allows e-money institutions and payment institutions to open settlement accounts and access the clearing system directly. As of the end of 2022, out of the 84 regulated e-money institutions in Lithuania, 63% held customer funds with the central bank. Overall, more than two thirds of e-money reserves in Lithuania are held with the Central Bank of Lithuania.

It is time to level the playing field and open up this possibility to all e-money institutions across the EU.

The window of opportunity for legislation to accomplish this has never been greater. What is needed is a targeted review of the Settlement Finality Directive, possibly as part of the review of the PSD or the Instant Payments Regulation (IPR).

Negotiations over the IPR are already establishing a political consensus that such a review is necessary, as resolving direct access to settlement would also support and accelerate the rollout of instant payments in the EU.

And the impact assessment of the Payments Service Directive couldn’t be clearer about the need to level the playing field between banks and non-banks in the payment market. The banking vulnerabilities of 2023 give yet another argument to the well-understood EU debate.

The benefits to the safety and liquidity of non-bank financial institutions, but also to greater innovation in a financial system that is becoming increasingly concentrated amongst global systemically important banks, are evident. The case for granting e-money institutions access to central bank accounts has never been stronger, and the EU should not miss this unique opportunity to make its financial system more competitive and resilient.

Patrick Hansen is the director of EU strategy and policy at Circle. He was previously head of strategy and business development at crypto-wallet startup Unstoppable Finance, and head of blockchain policy at Bitkom, Europe’s largest tech trade association. He holds master’s degrees in business and political science.

This article is for general information purposes and is not intended to be and should not be taken as legal or investment advice. The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.