By Marco Santanché, Quant Fellow, Hedder
The collapse of startup-focused Silicon Valley Bank last Friday rattled the crypto community: Circle, the issuer of the second largest stablecoin USDC, maintained $3.3 billion in deposits held by the failing bank, and the news sent USDC plunging and breaking its one-to-one peg with the U.S. dollar.
While FDIC eventually stepped in and rescued all the depositors, this incident highlights the importance of subjecting stablecoins to both audit and stronger regulations, as stablecoin must rely on traditional finance by construction.
Stablecoins vs other cryptocurrencies
The need for transparency is greater for stablecoins than any other cryptocurrencies. The nature of a stablecoin is designed to maintain a stable value relative to a specific asset or basket of assets, typically a fiat currency like the U.S. dollar (i.e. ‘dollar-collateralized’). They are often used as a means of exchange in the cryptocurrency ecosystem, as they can offer the stability of traditional currencies without the volatility that is commonly associated with other cryptocurrencies.
The risk profile of a dollar-collateralized stablecoin is therefore similar to that of a money market fund, and where the reserves are maintained is a critical factor in determining how strong the dollar peg is.
Circle has always been transparent about where its reserves are held. And this linkage to the traditional banking system is precisely the reason why USDC suffered a scare when SVB went under.
Note that not all stablecoin issuers are always transparent and upfront about their operations. Tether, the issuer of USDT, was fined $41 million in 2021 by the U.S. Commodity Futures Trading Commission for misleading statements and omissions of material facts on their reserves. Earlier that same year, the owner of Tether and Bitfinex settled with the New York Attorney General’s Office for $18.5 million in fines to end the investigation over allegations that the firm tried to cover up $850 million in losses.
The irony is, Tether’s lack of transparency may have actually worked in its favor during the SVB fallout, as it’s difficult to tell whether Tether had exposure to any bank. It also benefited from huge inflows of capital as holders of USDC switched to USDT in the wake of the fallout.
Tether got lucky this time, but this remains a huge risk for holders of USDT, and this risk remains understated.
Why regulation matters
What happened last week shows how important it is for regulators to protect holders of stablecoins as if they were holding a bond, or a cash account. Additionally, stablecoin issuers should develop a contingency plan in case of a major failure of the financial or crypto sector.
Can stablecoins sever their ties with the traditional banking system by holding alternative assets as collateral? In theory yes, but algorithmic stablecoins like Terra, which had a fallout in 2022, show how unsustainable it is for a stablecoin to hold reserves in anything but fiat cash and cash equivalents, and the non-regulation of crypto trading exposed the entire ecosystem to attacks.
Dollar-collateralized stablecoins will be here to stay, and as such there is a need to hold these stablecoins to a higher regulatory standard.
Counterparty risk is real, too
The SVB fallout also exposed the problem of counterparty risk, no matter how transparent a stablecoin is.
Traditionally, regulators have been skeptical of cryptocurrencies, including stablecoins, as they are perceived to be more likely to suffer financial stress (although the current turmoil illustrates why this view is not necessarily true). The challenge for stablecoin issuers is to find a custodian who is willing to do business with them in an unfriendly regulatory environment.
Now, with the fall of three crypto-friendly banks (SVB, Silvergate, Signature), a few options remain. Mercury and Axos are two candidates for the future while at present, for USDC, the options are BNY Mellon and Cross River Bank. So far, it appears that there are still major banks who are willing to back the crypto business.
Will the SVB crash have any further knock-on effect on stablecoins? With the bank being bailed out, the crisis seems to be contained. Note that SVB was not recognized by the government as a “systematically important” bank, but it is still highly relevant – relevant enough for a government bailout. And therefore its bailout not only sets a bad precedent, but also shows the government’s failure in its regulation of a highly relevant bank. It is time to also introduce regulations to stablecoins.
