Risk on Stablecoins

  • 7 mins read

Risk on Stablecoins

In recent articles by Alex O’Donnell (founder of the institutional Defi project Umami Labs -found here ) and by Steven Kelly  (Yale Sr. Research Associate for Financial Stability- found here), both men essentially praise Circle’s USDC as a progressive tool for the future of payments.

Mr. O’Donnell is quite clear on this point when he writes:

the Federal Reserve should greenlight Circle for its reverse repo program, which would backstop USDC with a deep well of highly liquid, risk-free loans. Similarly, the Securities and Exchange Commission should encourage the proliferation of compliant, tokenized securities denominated in USDC. Meanwhile, regulators should support Circle’s infrastructure initiatives with clear guidance for issues such as on-chain Know Your Customer, Anti-Money Laundering and financial reporting.

To his credit, Mr Kelly points to issues that USD pegged stablecoins have had keeping their peg – namely Tether weathering the storm off-shore while Circle’s on-shore bail out by the Fed covered about 8.25% of USDC’s uninsured FDIC deposits when Silicon Valley Bank (SVB) failed in March ($3.3 Bn of the $40 Bn total USDC reserves at that time).

Source: Steven Kelly "Stablecoins Deliver on Their Promise: Disrupting Banks"

To hedge a bankrun liquidation (which happened anyway to the tune of about $42 Bn in one day) SVB was forced to sell a $21 Bn bond portfolio consisting mostly of US Treasuries. That portfolio was yielding 1.79% – far below the 10-year Treasury yield (appx 3.9%). This forced SVB to recognize a $1.8 Bn loss, which ultimately took down the stock and the bank. Mr. Kelly concludes:

nonbank stablecoins are effectively gathering insured deposits and transforming them into uninsured deposits and other wholesale fundingfunding which has a fiduciary obligation to run at the first sign of trouble.

At the time, Coinbase halted USDC:USD conversions and Binance shutdown their BUSD:USDC conversions for fear of USDC’s peg being lost for good. Having survived that crisis, Mr. Kelly points to USDC as the model for a true “payments stablecoin”  essentially saying that USDC’s 1:1 cash + treasury assets peg amount to a “cookie jar” – which (BTW) is totally alien to the world of financial engineering at large. 

To that exact point, Mr. O’Donnell draws a clear distinction between USDC and its’ rival USDT here:

Source: CoinTelegraph, A O'Donnell " The US should promote USDC — before it's too late"

Simple 1:1 asset backing is what makes a fiat stablecoin “stable” and Circle clearly has simplified that story for its’ users, clients,  and regulators. The problem is that US banks essentially treat FDIC insured deposits as liabilities, because they take deposits and invest them. Without cash or cash equivalents  on hand to hedge a bad investment, the bank simply becomes a risk on institution – which is what happened to some of Circle’s former banks this year. 

Mr. Kelly paints that picture very clearly pointing out the three banks Circle used that went under this year :

Source: Steven Kelly "Stablecoins Deliver on Their Promise: Disrupting Banks"

Bank runs have always been poison to banks, but now they are an existential threat to the whole existing financial engineering system, because the weight of deposits is simply a Mariana Trench :

Source: Visual Capitalist - click the picture for the source link

This ongoing Peter-Paul situation is prompting some stablecoin experts to call the US a toxic environment for blockchain projects as a whole. To quote one such critic:

The real core driver always comes back to the core problem of fractional reserve banking: the assets might not be worth enough to cover all the deposits. Everything else is just narrative fitting.  Austin Campbell

Fractional reserve banking is a product of irresponsible policy and stewardship that compliance oriented USD stablecoin issuers cannot mime. In our humble opinion, USD based stablecoins essentially all suffer the same fate though – namely the source of their honest 1:1 peg is dishonest  over-extended sovereign floating a tremendous amount of debt. BTW, that same sovereign is also the source of legal ambiguity which is a constant source of stress for blockchain projects overall.

Here are some examples –

  • In February, the SEC issued a notice recommending action against Paxos alleging that BUSD falls under federal securities law.  
  • In March, the Feds Custodia Order appeared to ban stablecoin issuance breaking ranks with the President’s Working Group stand that “no entity other than an insured depository institution can issue stablecoins” 
  • Ripple has been at war with the SEC for 3 years threatening to leave the US, same situation now applies to Coinbase.
  • According to Dune, $8M USDC across 150 wallets have been frozen by Circle at the behest of the US Government.
  • Maker DAO’s founder openly questioned continuing to use USD pegged stablecoincs as collateral after Tornado Cash was banned and assets frozen by issuers.

These are worrisome precedents that even Circle’s CEO has publicly addressed:

The regulatory intervention in this case (Tornando Cash) crossed a major threshold in the history of the Internet, and the history of open blockchain finance, with a major government obliging parties to outright block or limit the functioning of open-source software on the Internet,  Jeremy Allaire

All of this has happened in the absence of regulatory clarity; and all this can be summed up simply as arbitrary regulation by enforcement. Tactics used to bend the goodwill of US based blockchain projects.

There is power in ambiguity and it is actively being used by the DC bureaucracy machine on blockchain projects trying hard to be compliant. SVB felt that pain long before 2023, as has Paxos, and Caitlin Long’s Custodia Bank.

Congress *must* pass stablecoin legislation. Given the right policy, stablecoins will revolutionize the global payment system  Jake Chervinsky

For decades the US has been at the vanguard of technological progress, innovation, and championed democracy via that leadership role. For centuries America held the moral high ground defeating Empires, Fascism, Communism, and now faces Authoritarianism which has absolutely zero regard for the core tenet of Web3 – which is indiviual rights via self-sovereignty. 

The Marquis de Lafayette once wrote:  

The good fortune of America is closely tied to the good fortune of all humanity.

America is not perfect and it never will be, but it has done far more good than harm. For our part, we are no lovers of digital fiat in any form, but we also understand that until a better system arrives (via the hard work and ingenuity of Web3 builders)  the USD holds global finance together – right or wrong there is simply too much reach and too much liquidity tied to it. 

However, as long as the existing situation remains unchanged, we must view USD pegged stablecoins as risk on assets – and that is not the fault of the issuers. It is the fault of hostile DC bureaucracies that do not care about their business and the innovation it represents. We applaud US blockchain projects fighting hard to stay in the country they call home, but they are fighting a senseless uphill battle that can only turn them into expats if it continues.