Cryptocurrencies had an exceptional year, reaching a combined value of more than US$3 trillion (£2.2 trillion) for the first time in November. The market seems to have benefited from the fact that the public had free time during the pandemic closings. Additionally, major investment funds and banks have stepped in, including the recent launch of the first bitcoin-backed ETF – a listed fund that makes it easier for more investors to gain exposure to this class of currencies. assets.
Along with this, there has been an explosive increase in the value of stablecoins like tether, USDC, and Binance USD. Like other cryptocurrencies, stablecoins move on the same online ledger technology known as blockchains. The difference is that their value is pegged 1:1 to a financial asset outside of the crypto world, usually the US dollar.
Stablecoins allow investors to hold less volatile money in their digital wallets than bitcoin, giving them one less reason to need a bank account. For a whole movement that is 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 better protect themselves in a falling market by moving money into stablecoins rather than, say, selling their ether for bitcoin.
A significant portion of buying and selling crypto 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 ability to use fiat currencies. The total dollar value of stablecoins has grown from US$20 billion a year ago to 139 billion US dollars today. In a sense, this is a sign that the cryptocurrency market is maturing, but regulators are also concerned about the risks stablecoins could pose to the financial system. So what is the problem and what can be done to fix 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 Bitfinex crypto exchange, which is based in the British Virgin Islands. USDC is owned by an American 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, there are serious questions about whether these organizations hold enough financial reserves to be able to maintain the 1:1 fiat 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 equivalent to the value of their stablecoins in circulation, which adjust to supply and demand from investors. Providers promise to 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 equivalent reserves as of March 2021. USDC has 61% as of May 2021, so both are nowhere near 100%. Much of the assets of both operations are based on commercial paper, which is a form of short-term corporate debt. It is not cash equivalent and presents a solvency risk in the event of a sudden 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 historic lows and the US government having just voted agreeing to another economic stimulus package worth US$1.2 trillion, the money supply is not expected 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 sees the “golden loop” scenario as the most likely, with inflation and growth rising together to high but manageable levels. In this case, central banks can let inflation run at levels of 3-4%.
But if the the economy is overheating, this 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 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, for example, US dollars, and stablecoin providers might not be able to return their money to everyone at a ratio of 1:1. This could drag 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 pose systemic risk, not to mention the danger that an enormous amount of economic power could become concentrated in the hands of one sole supplier.
In Octoberthe U.S. Commodity Futures Trading Commission fined Tether $41 million for claiming to be 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 had “tough questions” to answer.
Overall, however, it seems that the response from regulators is still hesitant. The President’s Task Force report recommended that stablecoin providers be forced to become banks, but delegated any decision in Congress. With several large vendors and a booming international market, I fear stablecoins are already effectively too large and disparate to control.
It is possible that the risks will decrease as more stablecoins hit the market. Facebook/Meta a well announced plans for a stablecoin called diem, for example. Meanwhile, central bank digital currencies (CBDCs) will place fiat currencies on the blockchain if and when they arrive. The Bank of England is to consult on a digital book, for example, while the EU and especially China are also progressing 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 troubling risk has emerged is certainly concerning. Unless governments and central banks kick regulation into high gear, a 2008-style digital asset crisis cannot be ruled out.