Stablecoins do not make for a stable financial system

Steven Kelly is a senior research associate at the Yale School of Management’s Program on Financial Stability.

The three biggest stablecoins — Tether’s tether, Circle’s USDC, and Paxos and Binance’s BUSD — are currently in a safety-measuring contest. After the implosion of the largest algorithmic stablecoin, Terra’s UST, they’ve been increasingly transparent about their reserves and exactly how safe they are.

This is a natural response to the not-unjustified FUD over Tether’s past reserves, and the brief de-pegging of its stablecoin following the failure of Terra’s UST. This also seems to be the emerging consensus among regulators and lawmakers, including the bipartisan bill quickly emerging from the U.S. House financial services committee.

Because of their backing by safe reserves and their stable prices throughout the recent crypto rout, stablecoins are now characterised as a refuge in the crypto universe: a place to “park your funds” when you want to sit out the broader crypto volatility and the source of stability in an otherwise volatile market. So, the story goes, if we can be sure these stablecoins aren’t backed by risky assets, we can protect the end-user and leave these beacons of stability be.

Tether has addressed this question with a series of comments highlighting its ability to meet redemptions and its reduction in commercial paper holdings — noting that all such holdings will soon run off and be replaced with Treasuries. Paxos released BUSD’s banking partners and a CUSIP-level disclosure of its Treasuries, both directly owned and obtained through repos. Not to be outdone, Circle soon followed with its own disclosure of banking partners and owned Treasuries’ CUSIPs.

This highlights the problem that underlies the stablecoin story. They can only import stability, not manufacture it, making them a net drain of stability from the financial system.

Just imports, no exports?!

The market- and regulation-inspired migration towards safer crypto assets is making stablecoins more popular, but that means there are more investment vehicles gobbling up the safe assets that otherwise grease the wheels of the traditional financial system. Absent rehypothecation, stablecoins will be a giant sucking sound in the financial system: soaking up safe collateral and killing its velocity. A limited supply/velocity of Treasury bills (and Treasury notes/bonds obtained via repos) risks causing collateral shortages, incentivising the creation of private alternatives (which are never really as safe), and putting downward pressure on interest rates. And of course rehypothecation introduces counterparty risks.

Bank deposits do not currently need to be backed by safe assets on a one-for-one basis, but that would change if those deposits moved on-chain via a nonbank stablecoin.

Moreover, interest rates near zero may put some strains on stablecoin sponsors. When the Fed hit the zero lower bound during the pandemic, money-market funds that focused on government assets had to waive their fees to avoid eroding investors’ principal. If they had also been facing large liquidations, as could be expected of cryptosphere assets during a period of financial instability, their solvency may have been more at risk; lest we forget, their municipal and prime peers needed support.

While the stablecoin business looks like it’ll be a nice yield-harvesting business for the immediate future — rising Fed rates and no obligation to pass yield on to holders — can these firms maintain parity/solvency if rates hit zero again?

Second, the “parking funds” euphemism analogises stablecoin purchases to a “flight to cash” that often takes place in traditional markets. Yet, unlike a central bank expanding available deposits to arrest a traditional market sell-off, this is not how stablecoin printing minting mechanisms work. The big three stablecoins (notwithstanding the occasional stray Tether loan to Celsius) mint their coins only against the onboarding of new fiat. That is, if the supply of stablecoins is to expand to offset a risky coin sell-off, the cryptosphere needs to onboard new fiat. Those putting new cash into the cryptosphere would then need to trade those stablecoins in for riskier crypto to stop the slide. This may have been the case when crypto winter began in late 2021; perhaps some fiat holders thought they saw attractive valuations at the beginning of the crypto sell-off. Total crypto market cap began falling, and the stablecoin supply inflected upwards:

But since crypto winter accelerated in May — notably, this time, against the backdrop of a risk-off macro environment — investors have exported fiat from the crypto ecosystem altogether. They’ve gone through the process of moving off-chain, leading to $18 billion of reserve liquidation from fiat-backed stablecoins (and some reallocation away from Tether). Thankfully it has been a slow burn thus far.

Still, let’s say it’s true that stablecoins really could meet all redemptions expeditiously in any environment, as sponsors are wont to suggest.

That constitutes a win for stablecoin consumer protection: holders get paid out at parity on a timely basis. Yet it would also require a mass liquidation of money-market assets: stablecoins’ holdings of bank deposits and repos (likely with banks, dealers, hedge funds as counterparties). Even Treasury bill liquidation risks cannibalising normally dependable short-term funding. Redeemed funds could find their way back to the same borrowers, but it’d be a clunky process and certainly wouldn’t happen overnight, which could be the deadline. Stablecoin issuers love to reassure markets, lawmakers, and regulators that they’re not “fractionally reserved.” Even if you accept their slightly liberal interpretation of “fully reserved,” the fact remains that there are fractionally reserved entities whose liabilities roll in the same markets as stablecoins.

And, as we’ve seen since May, an outright exodus from the stablecoin system need not have anything to do with concern over the backing collateral. If investor appetite suddenly shifts from the need for a reliable crypto-transaction asset, it could spark a money-market sell-off. And, if the investor shift occurred because of broad macro instability, well, we might call that bad timing.

If stablecoins were instead just tokenised bank deposits, the above concerns recede into the background. They no longer would rely on imported stability that drains safety from the traditional financial system. Moving between stablecoins and fiat deposits, because there would no longer be such a distinction, would not risk disrupting traditional funding markets. (“Interoperability”!)

To draw a line under the trade balance metaphor, stablecoins are effectively vulnerable to a common problem of persistent net importers: the sudden stop.