Why even the safest stablecoins could fail

Settlement delays, insolvency risks mean collateralised coins could falter

Events in May showed that stablecoins can be anything but. The collapse of terraUSD proved that flaws in design can send a currency’s value to zero and wipe out billions of dollars of wealth.

TerraUSD used only an algorithm to steady its value against the dollar, an approach now largely discredited. But could safer – fully collateralised – stablecoins run into trouble too?

To some, the terraUSD blowup was a natural stress test that safer stablecoins passed.

Coins that are fully collateralised such as USD Coin, DAI and binanceUSD – actually saw their prices rise during the turmoil as panicked investors sought refuge in a more secure currency.

To others, stablecoins may never be perfectly safe.

Tether – the largest stablecoin by market capitalisation and one that has grown 18-fold since the start of 2020 – briefly lost its peg to the dollar during the terra turmoil.

Perhaps that’s no surprise. Tether’s collateral backing the coin includes roughly $20 billion in commercial paper, assets that could lose their value in a stress event.

Tether has also faced criticism and legal action already over its reluctance to share details of reserves.

Increased attention is being paid to the quality of collateral – in particular how liquid, diversified and secure it is.

Some say Treasuries might not be good enough if monetising the collateral takes too long to stop a crypto run that plays out in hours.

“Even a stablecoin issuer that is 100% backed by Treasury bills still faces run risk,” state the International Monetary Fund’s Manmohan Singh and Custodia Bank’s Caitlin Long writing for Risk.net. The most liquid securities do not settle same-day. At one point, terra’s luna token shed three-quarters of its value overnight.

Under US law, collateral held at a bank insured by the Federal Deposit Insurance Corporation will be recoverable in the event of insolvency. But the process can take days. That, also, might be too long in a crisis.

History suggests even the sturdiest stablecoins face some risk of runs.

In the 1840s and 50s, banks in the US issued private banknotes backed by state bonds. The notes were far from steady, though. A note issued by a bank in Tennessee might circulate at a 20% discount in Philadelphia. Specialist ‘banknote recorder’ newspapers published lists of current values.

The use of private bank notes “was a failure because they did not satisfy the no-questions-asked principle”, wrote Gary Gorton of Yale School of Management and Jeffrey Zhang of the Federal Reserve in a paper last year.

Banknotes must be exchangeable at par without due diligence on their value.

Private notes never met that standard, hence the variation in their buying power.

As Gorton and Zhang see it, stablecoins will always be vulnerable. And that will only change if the coins are effectively transformed into public money, either because they are issued by banks covered by a deposit insurance scheme, or because they are backed one-to-one with Treasuries or central bank reserves.

Critical role

All this matters because stablecoins have grown rapidly into a critical role in crypto markets as a place to park wealth between investments.

Tether draws in about two-thirds of all bitcoin traded into a fiat currency or equivalent, according to data provider Cryptocompare. It is the third biggest crypto after bitcoin and ethereum. USD Coin is fourth.

US legislators swept the private note system away in 1863 with the National Bank Act, creating banks that could issue national bank notes backed by US Treasury bonds deposited with the US Treasury. The government later taxed private banknotes out of existence.

The obvious corollary in crypto land would be the creation of a central bank digital currency (CBDC) and the elimination of alternatives. It’s the route China is following. China launched the digital yuan this year after banning cryptocurrencies in September 2021.

In the US, the Federal Reserve released a discussion paper on a possible CBDC in January. But such a project will take time. Private stablecoins, meanwhile, will fill the need for a place to park value on-chain.

For holders of stablecoins backed by high-quality liquid assets, the possibility of a blowup may be low. But even for the safest coins, it’s a risk to keep in mind all the same. And, for sure, the collateral backing stablecoins deserves close examination.