Digital money runs possible even with safe reserves
A new Federal Reserve paper reveals that digital money can experience runs even when fully backed by safe reserves. This fragility stems from the interaction of network externalities and congestion fees on permissionless blockchains.
The paradox of unbundled trust
Digital money unbundles trust, relying on decentralized verification with congestion-sensitive 'gas fees' rather than a central institution.
This creates a novel fragility from two opposing forces: network externalities, which increase digital money's value with rising adoption, and congestion fees, which make it more costly to use.
These forces generate strategic complementarities in redemption decisions, meaning an individual's choice to redeem is influenced by others' actions.
This can trigger sudden, discrete jumps in redemptions, leading to runs even when the digital money is backed by perfectly safe and liquid reserves.
The Federal Reserve paper formalizes this mechanism in a global games model and empirically tests it using Ethereum-based stablecoins.
It identifies a source of instability distinct from traditional credit or liquidity risk, driven entirely by the interaction of network externalities and the inherent congestion costs of decentralized settlement.
The rail, not just the liability
The paper distinguishes between the 'liability' (reserve assets) and the 'rail' (payment network).
It argues that even perfectly safe reserve assets cannot prevent fragility if the underlying permissionless blockchain rail has volatile, congestion-sensitive fees.
This mechanism applies to various digital monies, including stablecoins, tokenized deposits, and CBDCs on platforms like Ethereum.
Comparing Ethereum's gas fees to Fedwire, the authors find gas fees are orders of magnitude higher and more volatile.
This highlights significant stability consequences, suggesting that decoupling transaction costs from network congestion could mitigate this risk.
A new fault line for digital finance
This paper identifies a crucial, previously overlooked vulnerability in digital money designs.
By demonstrating that even perfectly safe assets cannot prevent runs on permissionless blockchains, it forces a re-evaluation of fundamental assumptions.
Regulators must now consider the 'rail' as critically as the 'liability' when designing future digital currencies.