Stablecoins: these cryptocurrencies threaten the financial system, but no one is getting to grips with them

Cryptocurrencies have had a banner year, reaching a combined value of more than US $ 3 trillion (£ 2.2 trillion) for the first time in November. The market appears to have benefited from the public having free time during pandemic closures. In addition, large investment funds and banks have intervened, especially with the recent launch of the first bitcoin-backed system. ETF - an exchange-traded fund that makes it easier for more investors to be exposed to this asset class.

Along with this, there has been an explosive rise in the value of stablecoins such as tether, USDC, and Binance USD. Like other cryptocurrencies, stablecoins run on the same online accounting technology known as blockchains. The difference is that its value is linked 1: 1 to a financial asset outside the world of cryptocurrencies, usually the US dollar.

Stablecoins allow investors to keep money in their digital wallets that is less volatile than bitcoin, giving them one less reason to need a bank account. For an entire move that is a declaration of independence from banks and other centralized financial providers, stablecoins help facilitate that. And since the rest of the cryptocurrencies tend to go up and down together, investors can better protect themselves in a bear market by moving money to stablecoins than, for example, by selling their ether for bitcoin.

A substantial proportion of the buying and selling of cryptocurrencies is done using stablecoins. They are particularly useful for trading on exchanges such as Uniswap, where there is no single company in control and there is no option to use fiat currencies. The total dollar value of stablecoins has skyrocketed from the low $ 20 billion a year ago to US $ 139 billion today. In a sense, this is a sign that the cryptocurrency market is maturing, but it also has regulators concerned about the risks stablecoins could pose to the financial system. So what is the problem and what can be done about it?

The stablecoin problem

Initially introduced in the mid-2010s, stablecoins are centralized operations; in other words, someone controls them. Ultimately, Tether is controlled by the owners of the Bitfinex crypto exchange, which is based in the British Virgin Islands. USDC is owned by an American consortium made up of payment provider Circle, bitcoin miner Bitmain, and cryptocurrency exchange Coinbase. Binance USD is owned by Binance, another crypto exchange, which is based in the Cayman Islands.

There is a philosophical contradiction between the decentralized ideal of cryptocurrencies and the fact that such a significant part of the market is centralized. But also, there are serious doubts as to whether these organizations have sufficient financial reserves to be able to maintain the 1: 1 fiduciary ratios of their stable currencies in the event of a crisis.

These 1: 1 ratios are not automatic. They depend on stablecoin providers having reserves of financial assets equal to the value of their stablecoins in circulation, which are adjusted to the supply and demand of investors. The providers promise to have reserves worth 100% of the value of their stablecoins, but that is not entirely accurate, as you can see in the charts below.

Mooring bookings

USDC Reserves

Tether holds 75% of its reserves in cash and equivalents as of March 2021. The USDC has 61% as of May 2021, so both are somewhat below 100%. Much of the assets of both operations are based on commercial paper, which is a form of short-term business debt. It is not equivalent to cash and presents a solvency risk in the event of a sudden collapse in the value of these assets.

So what could derail the machine? There is almost unlimited money in circulation today, interest rates are still at record lows, and the US government is down. just voted To accept another US $ 1.2 trillion economic stimulus package, the money supply is unlikely to be significantly reduced anytime soon. The only element that could challenge this abundance of money is inflation.

There are several possible inflation scenarios, but the market still considers the “goldilocks” scenario to be the most likely, with inflation and growth rising together to high but manageable levels. In this case, central banks can let inflation remain at levels of 3% to 4%.

But if the the economy overheats, could lead to an explosive situation of high inflation and economic recession. A lot of money would be moved from risky assets and bonds to safer havens like the US dollar. The value of those riskier assets, including commercial paper, would fall off a cliff.

This would seriously damage the value of the stablecoin providers' reserves. Many investors with their money in stablecoins might panic and try to convert their money into, for example, US dollars, and the providers of stablecoins might not be able to return all of their money at a 1: 1 ratio. This could drag to the crypto market and potentially to the financial system as a whole.

Regulatory actions

Regulators are certainly concerned about the stability of stablecoins. A report from the USA. published a few days ago by the President's Working Group on Financial Markets, said they potentially represent a systemic risk, not to mention the danger that a great deal of economic power will end up concentrated in the hands of a single provider.

In October, the US Commodity Futures Trading Commission fined Tether $ 41 million for claiming it was 100% backed by fiat currency between 2016 and 2019. Bank of England Governor Andrew Bailey said in june that the bank was still deciding how to regulate stablecoins, but that they had some "tough questions" to answer.

However, overall, it appears that the response from regulators remains tentative. The President's Task Force report recommended that stablecoin providers be forced to become banks, but delegate any decision to Congress. With several major vendors and such a flourishing international market, my concern is that stablecoins may already be too large and disparate to control.

Risks may be reduced as more stablecoins hit the market. Facebook / Meta has well publicized plans for a stable coin called diem, for example. Meanwhile, central bank digital currencies (CBDC) will place fiat currencies on the blockchain when they arrive. The bank of england is to consult in a digital pound, for example, while The United States and especially china they are also advancing here. Perhaps the systemic risks of stablecoins will be reduced in a more diversified market.

For now, we wait and see. The speed at which this perplexing risk has arisen is certainly cause for concern. Unless governments and central banks accelerate regulation, a 2008-style crisis in digital assets cannot be ruled out.