Deciphering stablecoins: A financial stability risk?

Unlike normal cryptocurrencies, stablecoins are pegged to a fixed amount – normally the dollar – either through backing with assets or an algorithmic process. Therefore, they have little use as a speculative asset class. So why should institutional investors be interested in stablecoins, and why are regulators such as the Bank of England so worried about them?

Stablecoins have increasingly attracted attention from regulators, with BoE governor Andrew Bailey saying last year that he was “sceptical” that stablecoins could ever be a safe asset. Last week, a consultation paper suggested the UK Treasury would give the BoE authority to address the collapse of failed, systemic stablecoins.

With the collapse of major algorithmic stablecoin Terra (or TerraUSD) last month, regulators have begun to increase their focus on the risks that stablecoins could cause to financial stability, both within the crypto market and the broader economy.

The stablecoin market had seen rapid growth until recently. According to Fitch Ratings, the stablecoin market shrank between the end of March and the end of May for the first time since it began tracking it, mainly due to the Terra’s collapse.

The firm said: “The aggregate market capitalisation was $162bn at end-May, a 14% fall from $188bn at end-1Q22.”

The firm also noted that “the prices of other algorithmic stablecoins also decreased, with FRAX and DAI similarly falling by 47% and 32%, respectively, between end-1Q22 and end-May. Nonetheless, new algorithmic stablecoins have been launched that have rapidly gained market share, partly due to aggressive staking promotions.”

Key to stablecoins’ success has been their use in borrowing and lending, often offering higher yield relative to traditional money market instruments. Yves Choueifaty, president and CIO at TOBAM, explained that “this is what 99% of owners do with their stablecoins”.

However, the recent downfall of Terra has put this practice under criticism, with many accusing high yield crypto returns as functioning like a Ponzi scheme.

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Adam Sze, head of digital assets product at Global X ETFs, also said that stablecoins were essential to the crypto economy as they “provide an on-ramp to the digital asset ecosystem,” making it easier for investors to buy other digital assets, such as Bitcoin or NFTs.

Anatoly Crachilov, CEO of Nickel Digital Asset Management, agreed, remarking that “stablecoins are a way of efficiently moving USD between trading venues using crypto rails, which is far faster and efficient than using slow and constrained fiat rails”.

Clara Medalie, strategic initiatives and research director at Kaiko, added further weight to the argument: “Stablecoins are systemically important for cryptocurrency markets and enable liquidity for the full spectrum of crypto assets”.

Libra and Tether

One of the most well known stablecoins was one that never existed: Libra, which was announced by Facebook (now Meta) in 2019 as a proposed stablecoin in collaboration with companies such as PayPal, eBay, Mastercard, Visa and Stripe.

Following a rebrand to Diem in 2020 and numerous legal and regulatory challenges, as well as announcing it would be changing its peg from multiple currencies to just the US dollar, it was eventually abandoned at the beginning of this year.

The full history of Libra is beyond the scope of this piece, but it is perhaps one of the most important stablecoins to understand, despite never existing. The serious regulatory pushback from the Federal Reserve and Treasury Department that Libra faced caused it to shut down, while other stablecoins such as Tether have flourished with no regulatory oversight.

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Tether is currently the biggest stablecoin by market share, designed to be pegged to $1, and the most traded cryptocurrency in the world. But in the last seven years, it has experienced myriad controversies and legal troubles.

Tether is issued by a company owned by Bitfinex, a cryptocurrency exchange. Problems with the asset included Tether’s reserves being used to cover up losses from Bitfinex and lies about the amount of cash versus commercial paper used in its reserves have plagued the cryptocurrency. Nevertheless, it still remains incredibly popular, despite also briefly deviating from its peg during the collapse of Terra last month.

Kaiko’s Medalie argued that because Terra “relied on a deeply flawed algorithmic stabilisation mechanism”, investors in backed stablecoins should not compare it to others such as Tether. However, she noted that “Tether could collapse should it come to light that the stablecoin is not fully backed, which would result in a loss of confidence and depegging”.

Crachilov explained that the firm behind Tether has not been “particularly forthcoming in its communication with the market, which historically caused residual concern of the quality of their reserves”. Nevertheless, he argued that Tether’s “recent de-peg to 0.95 cents was well defended, with USTD largely returning back to its peg within hours”.

Fitch noted: “The market remains concentrated, with Tether and USDC accounting for about 63% of total assets at end-May. Tether’s portfolio has reduced its credit risk and duration, and increased its liquidity. As of end-1Q22, less than 0.5% of the CPs and CDs in the reserve portfolio were rated ‘F3′ or below. It holds 48% of its portfolio in the form of US treasury bills”.

Financial stability

Analysts continue to disagree on whether stablecoins represent a serious financial stability risk. Choueifaty argued that “the size of the global stablecoin market is $150bn [£123bn]”. He added: “In a single day, the negative return of Snap Inc resulted in as much loss as Luna/Terra”.

Crachilov agreed, stating that “stablecoins are still small compared to the equity and bond markets”, though he did note that “their potential impact would be greater crypto ecosystem, as they play an important role in derivative market structure”.

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However, last week the Treasury said a failure of a systemically important stablecoin could pose “a wide range of financial stability as well as consumer protection impacts”.

“Since the initial commitment to regulate certain types of stablecoins, events in cryptoasset markets have further highlighted the need for appropriate regulation to help mitigate consumer, market integrity and financial stability risks,” the Treasury said.

The Treasury added that the failure of a systemic firm that operates a stablecoin could threaten the “continuity of services critical to the operation of the economy and access of individuals to their funds or assets”.

Analysts agreed that regulation was impending, as watchdogs such as the BoE begin to worry that a collapse in crypto could cause wider financial problems.

Crachilov said he expected “much stricter reserve requirements, alongside increased transparency and disclosure expectations.

However, regulation may actually “help reduce speculation among digital assets, which could lead to lower volatility and increased investor confidence,” according to Sze.