3 Reasons Why Your Money isn’t Really Safe in Stablecoins

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  1. TL;DR

TL;DR

1. Hard reserves risk. Risk of stablecoins not fully backed by the assets as claimed by the stablecoin issuer. (eg. Tether’s USDT)

2. Bank run risk from investors losing confidence in the stablecoin or company issuing the stablecoin.

3. Counter-party risks arising from different reserves and assets held by stablecoin issuer and the lack of regulations to protect investors from stablecoins losing its peg. (I know, this is a highly contentious and sensitive argument, but do read more to understand why I think this is a risk)

A Brief Introduction to Stablecoins and the Risks Involved

Circle’s USDC website

A stablecoin is a type of cryptocurrency that is designed to emulate a specific currency, usually the US dollar. Hence, the value of a stablecoin is pegged to the value of the real currency. For instance, 1 USDT = 1 USD and vice versa.

There are a few prominent names in the stablecoin market like USDT, USDC and BUSD. The stablecoin market has grew tremendously in the past few years. According to the federal reserve, nearly $130 billion of USD-pegged stablecoins are circulating on September 2021, reporting a more than 500% increase from the past year. The following is the current market cap (or value) of the top stablecoins in circulation in May 2022.

Top Stablecoins ranked by market capitalisation adapted from CoinMarketCap
  • USDT — $74.13B
  • USDC — $52.34B
  • BUSD — $18.40B

The top 3 stablecoins circulating supply in the crypto market already far surpassed the value in September 2021, even in a bear market. This signifies the explosive demand and user growth in the crypto world.

As the masses adopt the use of the stablecoins, I cannot help but wonder if our monies are really safe in stablecoins. With the recent collapse of TerraUSD, it made me question even more. We should always consider the risks involved in any asset class, especially for stablecoins which we consider it as ‘safe’ in a volatile crypto market. As such, I have identified and collated the top 3 reasons why your money isn’t really safe in stablecoins as it should be.

Reason #1: Hard Reserves Risk and Transparency Issues

The real risk of stablecoins is that they are not 100% backed by the reserve currencies as claimed. The issuer of the stablecoins should have enough reserves to support the current circulating supply of the stablecoin. For example Tether would require a reserve of at least $74,142,986,425 (as per 18 May 2022 supply on CoinMarketCap). If reserves are lower than circulating supply of the stablecoin, reserves risk is introduced. Such risks will cause the stablecoin to have problems regaining its peg when a big volatile move occurs in the crypto market.

Let us analyse the reserves Tether is using to back the world’s largest stablecoin, USDT.

Asset breakdown of Tether’s asset. Data adapted from Moore Cayman independent audit report 2021.
  • Cash & Cash Equivalents & Other Short-Term Deposits & Commercial Paper — $65,880,789,583. The report further breaks down this segment to T-Bills, Money Market Funds, Certificates of Deposits & Commercial Paper and Cash & Bank Deposits. Commercial Paper here refers to short-term debt issued by corporations to Tether and certificates of deposit are short-term deposits issued by financial institutions. This means that Tether has deposits in Banks and Financial Institutions. However, the exact number allocated to each financial institution was not entirely disclosed.
  • Secured Loans — $4,142,957,365. Although the amount of secured loans was disclosed, the origins of the loans were not disclosed in the report. Secured loans would require some type of collateral for borrowing. The type and amount of collateral was not disclosed as well.
  • Corporate Bonds, Funds & Precious Metals — $3,628,506,483
  • Other Investments (including digital tokens) — $5,023,389,246
  • Total Assets: $78,675,642,677

As such, on the surface it may seem that Tether has very well disclosed its asset holdings, and also happen to have a surplus of assets (exceeding its total liabilities). However, as analysed above through some examples, Tether’s disclosure practices are far from transparent. It is still lacking.

Daily report of balances from Tether. (updated as at 18 May 2022). Adapted from Tether’s website.

Nonetheless, progress has been made with Tether as the stablecoin issuer reports the value of their reserves daily and updated at least once per day.

Transparency remains a contention in the stablecoin market as people can start to speculate if a stablecoin is backed by actual reserves. If the lack of transparency becomes a persistent issue, investors may lose confidence in the stablecoin. When this happens, mass-market panic ensues, and this may cause a huge selling pressure on a stablecoin, causing it to de-peg. The recovery of a stablecoin to its peg will always be dependent on the reserves held by the stablecoin issuer. If no actual reserves are backed or not 100% of the reserves are back to a stablecoin, the stablecoin will have difficulty recovering from its de-peg as there are insufficient funds to buy back the stablecoin to maintain its peg to 1 USD.

The recent collapse of TerraUSD $UST is a prime example of this scenario where a stablecoin not backed by any reserves quickly de-pegs and never recovers as mass panic and selling pressure persists.

Reason #2: Risk from losing investors’ confidence in the stablecoin —Example of UST and Anchor Protocol’s Bank Run

There are varying reasons on why investors would lose confidence in a stablecoin. The list presents some of the more common issues with stablecoin. It is not exhaustive.

  • A stablecoin that de-pegs consistently
  • The stablecoin issuer runs in regulatory and legal problems
  • Lack of transparency of reserves backing the stablecoin

Let us now take a look at the recent case of UST collapse from a Bank Run.

A ‘Bank Run’ occurs when large groups of depositors withdraw their money from banks on fears that the bank or institution will become insolvent. More and more investors will then start to lose confidence in the stablecoin peg as panic spreads like wildfire. To put this into context, Anchor Protocol has lost more than 99% worth of UST deposits over the past 2 weeks. This is a classic case of a bank run. What transpired to the demise of the UST stablecoin that was once worth a massive $18.5B in circulating supply?

  1. It started when whales tried to attack the peg by selling large amounts of UST into the market. UST briefly lost its peg to $0.80 and then quickly recovered again.
  2. However, investors started to lose confidence in the stablecoin peg. This resulted in the withdrawal of UST from Anchor Protocol (a savings deposit account for UST stablecoin) at a tremendous rate.
  3. Since UST is an algorithmic stablecoin, no actual reserves were backing the stablecoin. As the stablecoin de-pegs, the support UST got was a computerised algorithm that burns and mints $UST and $LUNA tokens, based on supply and demand to maintain its peg. In hindsight, this system failed when such massive volatility occurred.
Anchor Protocol TVL. Adapted from Defi Llama as at May 11.

From the UST saga, it is important to understand that investor’s confidence is extremely important when it comes to stablecoins. Of course, the collapse of UST was not only due to the lack of reserves and losing investors confidence in the Terra ecosystem, it was also due to the inherent issues with algorithmic stablecoins. As the value of reserves backing stablecoin are consistently changing, it is important for the stablecoin issuer to be transparent and disclose its reserves as detailed as possible.

Reason #3: Regulation Risks (or the lack of thereof) and Counter-party Risks

The multi billion dollar question — Should we regulate stablecoins to protect investors?

The multi billion dollar question is: should we regulate stablecoins to protect investors?

The purpose of stablecoin is to minimise price volatility and create an asset to trade against more volatile assets like Bitcoin, but it is not meaningfully regulated. When a hostile player tries to attack the peg, or should any of the hard assets held by the issuer loses their value, the peg to the dollar would be seriously compromised. The absence of regulations to protect the peg makes the stablecoin market more susceptible to such events. Investors of stablecoin would be at the losing end.

If held assets like Bitcoin drop 90% due to a black swan event, what will happen to stablecoins that are backed substantially by Bitcoin? Obviously, this is just an extreme example for you to picture the effect. Thankfully, stablecoin issuers like Circle has over-collateralised assets backing their USDC stablecoin. This brings me to my next point — counter-party risks.

It may seem like only the stablecoin issuer is managing the assets. In fact, you’re dealing with multiple parties, including the bank holding the reserves and deposits, financial institutions holding investment assets and government-issued treasury bonds and yields. These intermediaries must manage the assets well by doing the right things to ensure the asset value does not tank.

Concluding thoughts?

Photo by Alesia Kozik

Stablecoins will remain the essential safe haven for us as investors in a volatile asset class like cryptocurrencies in the foreseeable future. As Bitcoin and Ethereum continue to plunge and set at lower prices, investors flee for safety to stablecoins.

Today, stablecoins like USDT and USDC are also essential because almost all crypto assets are traded against USDT. It is difficult to imagine cryptocurrencies without stablecoins in this day and age. Stablecoins are like a bridge between fiat and decentralised currencies.

As such, I feel that this essentiality demands more scrutiny from us and we should be aware of the risks involved in an asset that is considered ‘safe’ in the crypto world.

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Disclaimer: I am not in any way a financial advisor. Always DYOR and stay safe!