Stablecoins could wreak havoc in the financial system
Cryptocurrencies have had an exceptional year, for the first time reaching a combined value of over US $ 3 trillion (£ 2.2 trillion) in November. The market appears to have taken advantage of the free time the public has during pandemic lockdowns. Additionally, large investment funds and banks have stepped in, most notably with the recent launch of the first bitcoin-backed ETF – a listed fund that makes it easier for more investors to gain exposure to this asset class.
Along with this, there has been an explosive rise in the value of stablecoins like Tether, USDC, and Binance USD. Like other cryptocurrencies, stablecoins move on the same online ledger technology known as blockchain. The difference is that their value is tied 1: 1 to a financial asset outside of the crypto world, usually the US dollar.
Stablecoins allow investors to keep less volatile money than bitcoin in their digital wallets, giving them one less reason to need a bank account. For a whole movement about a declaration of independence from banks and other centralized financial providers, stablecoins help facilitate that. And since the rest of crypto tends to go up and down together, investors can protect themselves better in a falling market by transferring money into stablecoins than, say, selling their ether for bitcoin.
A substantial proportion of crypto buying and selling is done using stablecoins. They are especially useful for trading on exchanges like Uniswap where there is not a single company under control and no option to use fiat currencies. The total dollar value of stablecoins has increased from US $ 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 worries regulators about the risks stablecoins could pose to the financial system. So what is the problem and what can be done about it?
The problem with stablecoins
Originally introduced in the mid-2010s, stablecoins are centralized operations – in other words, someone controls them. Tether is ultimately controlled by the owners of the British Virgin Islands-based crypto exchange Bitfinex. USDC is owned by a US consortium made up of payments provider Circle, bitcoin miner Bitmain, and crypto exchange Coinbase. Binance USD is owned by Binance, another crypto exchange, headquartered in the Cayman Islands.
There is a philosophical contradiction between the decentralized ideal of cryptocurrencies and the fact that such a large part of the market is centralized. But also, serious questions arise as to whether these organizations hold enough financial reserves to be able to maintain the 1: 1 fiduciary ratios of their stablecoins in the event of a crisis.
These 1: 1 ratios are not automatic. They depend on stablecoin providers with reserves of financial assets equal to the value of their outstanding stablecoins, which adjust to investor supply and demand. Suppliers promise they have reserves worth 100% of the value of their stablecoins, but that’s not entirely accurate – as can be seen in the charts below.
Tether holds 75% of its cash and cash equivalents in March 2021. USDC holds 61% in May 2021, so the two are nowhere near 100%. Much of the assets in both operations are based on commercial paper, which is a form of short-term corporate debt. They are not cash equivalents and pose a solvency risk in the event of a sharp drop in the value of these assets.
So what could derail the machine? Currently there is almost unlimited money in circulation, interest rates are still at record highs and with the US government just voting to agree to yet another $ 1.2 trillion economic stimulus package. dollars, the money supply is not expected to be reduced significantly anytime soon. . The only element that could jeopardize this abundance of money is inflation.
There are several possible inflation scenarios, but the market still considers the “golden loop” scenario to be the most likely, with inflation and growth increasing together to high but manageable levels. In this case, central banks can let inflation sit at levels of 3-4%.
But if the economy overheats, it 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 safe havens like the US dollar. The value of these riskier assets, including commercial paper, would fall off a cliff.
This would seriously damage the value of the reserves of stablecoin providers. Many investors with their money in stablecoins might panic and try to convert their money to US dollars, for example, and stablecoin providers might not be able to return their money to everyone in a ratio of 1: 1. This could bring down the crypto market and potentially the financial system as a whole.
Regulators are certainly concerned about the stability of stablecoins. A US report released a few days ago by the President’s Task Force on Financial Markets said they potentially represent a systemic risk, not to mention the danger that a huge amount of economic power could end up concentrated in the hands. from a single supplier.
In October, the United States Commodity Futures Trading Commission fined Tether $ 41 million for claiming to be 100% fiat-backed between 2016 and 2019. Bank of England Governor Andrew Bailey said in June that the bank is still deciding how to regulate stablecoins, but they have “tough questions” to answer.
Overall, however, it appears that the response from regulators is still tentative. The president’s task force report recommended that stablecoin providers be forced to become banks, but delegated all decisions to Congress. With several large suppliers and a booming international market, I’m concerned that stablecoins are already effectively too big and disparate to control.
It is possible that the risks decrease as more and more stablecoins enter the market. Facebook / Meta has some well-known plans for a stablecoin called Diem, for example. Meanwhile, central bank digital currencies (CBDCs) will put fiat currencies on the blockchain if and when they arrive. The Bank of England must consult on a digital book, for example, while the EU and especially China are also advancing here. Perhaps the systemic risks of stablecoins will be reduced in a more diverse market.
For now, let’s wait and see. The speed at which this worrying risk has arisen is certainly of concern. Unless governments and central banks take regulatory action to the next level, a 2008-type digital asset crisis cannot be ruled out.
Article by Jean-Philippe Serbera, Senior Lecturer, Sheffield Hallam University
This article is republished from The Conversation under a Creative Commons license. Read the original article.