What backing should stablecoins have: cash or other assets too?
The issue of stablecoin reserves has been the focus of heated debate between lawmakers and crypto executives. Still, a long-awaited report on stablecoins barely addresses this issue.
O report, drafted by a working group of President Biden that includes US Treasury Secretary Janet Yellen and Federal Reserve Chairman Jerome Powell, was published this month and was expected to provide clarity on how stablecoin issuers such as Tether and Circle should back their tokens.
Instead, it contained only a definitive and rather backward statement.
The statement addresses the possible risk of a “run” of stablecoins and how this could affect broader financial markets:
The financial stability risks of a stablecoin run would be greater in the context of stablecoins backed by potentially volatile and illiquid assets than in the context of stablecoins backed at 1:1 par with high quality liquid assets.
The consequence of a run, according to the authors, would be much worse if the issuer’s reserves contained non-cash assets such as commercial bonds (a practice carried out by some issuers, such as Tether, as it allows them to earn more money on reserves) .
But while stablecoins backed by non-cash assets are more prone to losses, it is not the same as massive financial instability.
Considering the dot-com debacle at the beginning of this century, which wiped out $8 trillion of US stock market wealth (an amount more than 50 times that of the stablecoin market), but which did not generate systemic and financial uncertainty.
On the other hand, a weak offsets market in 2017 turned into a full-blown financial crisis when a $2.2 billion French fund that no one had heard of, with 1/3 of its assets in junk and debt securities. high ranking, suspended redemptions and generated a run on all the financial institutions and high-rated assets they were using as collateral.
Unlike the dot-com meltdown, which was limited to stock markets, the French fund’s troubles involved assets that were key pieces of the banking system, resulting in a devastating financial panic.
Stablecoins, for now, are not connected that way. Remember May 2021, when the value of all cryptocurrencies dropped. $470 billion or more than 20% in just two days. What happened next? Nothing.
The financial system was stable and the economic recovery continued apace. We were lucky that crypto was self-sufficient.
This may not be the case if, as regulators have stated in their report, the Financial Stability Oversight Board (or FSOC) requires stablecoin assets to be backed by safe assets.
The case of Tether
Upon closer analysis of Tether, a stablecoin issuer with a dubious reputation, shows why it would be unwise to require such companies to own all physical cash assets.
Tether, who has issued more than $70 billion worth of stablecoins, has repeatedly covered up information about his reserves and still refuses to show what is actually stored.
What we know about the company’s behavior is not legal (allocations in commercial securities and China, loans crypto-backed to other brokers, a large Deposit in a shrinking bank in the Bahamas and so on).
All of this resulted in fines and investigations and this legal problem will not end any time soon.
If a common money market fund (where large corporations and pension funds allocate their liquid assets) had experienced at least one of these incidents, investors would have put an end to it.
Still, Tether more than tripled in size by 2021 and makes up more than half of the stablecoin market.
Meanwhile, a crypto trader worries that Tether could “break the market” and go below $1 (which is what happened to money market funds in 2018), despite the company’s statements about its reserves being , at best, doubtful.
All of this is explained by the fact that Tether is an ecosystem present in crypto markets and that it remains popular because of the value in its executed traders, huge network effects and extensive interoperability between blockchains.
That’s not to say that Tether or other stablecoins won’t one day implode, especially given their connection to volatile crypto markets.
In fact, it’s not hard to imagine situations that can put stablecoins in a loop of bad feedback: big drops in crypto prices, margin adjustments, hacks or operational failures, and so on.
However, if a situation like this occurs and a run occurs, the last thing we want is for stablecoin issuers to have huge physical cash deposits, fast maturing repurchase agreements, or ties to borrowers who are at the heart of the banking system.
For now, it is better to leave stablecoins as they are in the crypto sector rather than anchor these assets at the center of financial markets.
Banking-type legislation (proposed by the report) is absolutely the way forward before stablecoins start to go through wide adherence and usage. But an interim “solution” that requires stablecoins to back their issuance with safe assets could backfire.
Any solution must not “solve” the risk of a run by crypto traders by replacing it with a higher risk of a run of stablecoins that could damage our core financial system.
*Translated and edited by Daniela Pereira do Nascimento with permission from Decrypt.co.