Stablecoins do not create a stable financial system


Steven Kelly is a senior research associate at the Yale School of Management Financial Stability Program.

The three largest stablecoins – Tether’s tether, Circle’s USDC, and Paxos and Binance’s BUSD – are currently in a security measurement contest. After the implosion of the largest algorithmic stablecoin, Terra’s UST, they have been increasingly transparent about their reserves and security.

This is a natural response to unwarranted FUD on Tether’s past reserves and brief unpeg from its stablecoin following Terra’s failed UST. This also appears to be the emerging consensus among regulators and lawmakers, including the rapidly emerging bipartisan bill from the US House Financial Services Committee.

Due to their backing by safe reserves and stable prices throughout the recent crypto rout, stablecoins are now characterized as a safe haven in the crypto universe: a place to “park your funds” when you want to sit on the sidelines of the broader crypto volatility and the The source stability in an otherwise volatile market. So, according to the story, if we can be sure that these stablecoins are not backed by risky assets, we can protect the end user and leave these stability beacons as they are.

Tether addressed this issue with a series of comments highlighting its ability to respond to takeovers and its reduction in commercial paper holdings – noting that all of these holdings will soon be depleted and replaced by treasury bills. Paxos has released BUSD’s banking partners and CUSIP-level disclosure of its Treasuries, both held directly and obtained through repos. Not to be outdone, Circle quickly followed with its own disclosure of banking partners and T-bill CUSIPs.

This highlights the problem underlying the stablecoin story. They can only import stability, not manufacture it, making it a net loss of financial system stability.

Just imports, no exports? !

Market and regulatory inspired migration to safer crypto assets is making stablecoins more popular, but it means there are more investment vehicles gobbling up the safe assets that otherwise grease the wheels of the financial system. traditional. In the absence of rehypothecation, stablecoins will be a giant sucking sound in the financial system: absorbing safe guarantees and killing their velocity. A limited supply/speed of treasuries (and treasuries/bonds obtained through repos) risks causing shortages of collateral, incentivizing the creation of private alternatives (which are never really so safe ) and put downward pressure on interest rates. And of course, rehypothecation introduces counterparty risk.

Bank deposits currently do not need to be backed by safe assets on a one-to-one basis, but that would change if those deposits moved on-chain through a non-bank stablecoin.

Additionally, near-zero interest rates can put a strain on stablecoin sponsors. When the Fed reached the lower bound of zero during the pandemic, money market funds that focused on government assets had to waive their fees to avoid eroding investors’ principal. Had they also faced significant liquidations, as one would expect from cryptosphere assets during a period of financial instability, their solvency might have been more at risk; let’s not forget, their municipal and principal peers needed support.

While the stablecoin sector looks like great yield-harvesting activity in the immediate future – Fed rate hikes and no obligation to pass the yield on to holders – can these companies maintain peg/solvency if the rates reach zero again?

Second, the euphemism “parking fund” likens stablecoin purchases to a “flight to silver” that often takes place in traditional markets. Yet unlike a central bank that expands available deposits to stop a traditional sell-off in the market, this is not how the stablecoin impression the striking mechanisms work. The three big stablecoins (despite the occasional loan from Tether to Celsius) mint their coins only against the integration of new fiat. In other words, if the supply of stablecoins needs to expand to compensate for a risky sale of coins, the cryptosphere needs to integrate new fiat. Those injecting new money into the cryptosphere should then swap those stablecoins for riskier crypto to stop the slide. This may have been the case when the crypto winter started in late 2021; perhaps some fiat holders thought they saw attractive valuations early in the crypto selloff. The total crypto market capitalization has started to decline and the supply of stablecoins has swung upwards:

But since the crypto winter accelerated in May – notably, this time, against the backdrop of a risky macro environment – ​​investors have completely exported fiat from the crypto ecosystem. They went through the process of moving off-chain, resulting in a liquidation of $18 billion in reserves from fiat-backed stablecoins (and some reallocation away from Tether). Fortunately, it was a slow burn so far.

Still, let’s say it’s true that stablecoins really could respond quickly to all redemptions in any environment, as sponsors are wont to suggest.

This is a victory for stablecoin consumer protection: holders are paid at par on a timely basis. Yet it would also require a massive liquidation of money market assets: stablecoin holdings in bank deposits and repos (likely with banks, dealers, hedge funds as counterparties). Even the liquidation of treasury bills risks cannibalizing normally reliable short-term funding. The repaid funds could be traced back to the same borrowers, but it would be a tedious process and certainly wouldn’t happen overnight, which could be the deadline. Stablecoin issuers like to reassure markets, legislators, and regulators that they are not “fractionally reserved.” Even if you accept their slightly liberal interpretation of “fully reserved”, the fact remains that there are partially reserved entities whose liabilities roll in the same markets as stablecoins.

And, as we’ve seen since May, an outright exodus from the stablecoin system has nothing to do with concerns about guaranteed support. If investor appetite suddenly shifts from the need for a reliable crypto-trading asset, it could trigger a sell-off in the money market. And, if the investor switch happened due to widespread macroeconomic instability, well, we could call that bad timing.

If stablecoins were simply tokenized instead Bank deposits, the above concerns take a back seat. They would no longer depend on imported stability that drains the security of the traditional financial system. Moving from stablecoins to fiat, as there would no longer be such a distinction, would not risk disrupting traditional funding markets. (“Interoperability”!)

To draw a line under the trade balance metaphor, stablecoins are indeed vulnerable to a common problem of persistent net importers: the sudden stop.

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Don F. Davis