With the growing rise of stablecoins, cryptocurrency, and the regulation of fiat currencies, we often talk about the risks and liabilities associated with these currencies. What we don’t talk about is the infrastructure that is in place to (de)regulate fiat currency and how that might affect the consumer.
The rise of stablecoins has been seriously talked about in financial circles for over a decade now, and many discuss unmanageable regulatory risks and intangible safeguards. What people really want to know is whether or not this new money is safe to use.
In order to understand the potential safeness of the digital currency stablecoin, we have to dive into the fiat money infrastructure.
Asset Backing System of Stablecoins
Much like other fiat money, there is a lot that is swept under the rug. After all, are you, as a reader, aware of how your fiat money is created? In America, we understand that central banks are federally regulated and are responsible for controlling and regulating fiat money.
However, some don’t recognize that central banks aren’t the ones creating fiat money—that rests in the hands of commercial banks—and not all banks that hold and create fiat money are regulated. In fact, there is a whole network of shadow banks, unregulated and often offshore banks, that create and hold fiat money.
Shadow banks are how the cryptocurrency network operates. Primary stablecoin Tether (USDT) uses a part of the shadow banking network, with an offshore jurisdiction located in the Bahamas, away from the control of the US federal regulators.
The stablecoin industry operates largely on these shadow banks, which are really financial institutions that do bank-like things. These institutions aren’t subject to banking regulations and can include non-bank lenders, money market funds, private equity, hedge funds, insurance companies, and investment banks. They might also include special purpose vehicles (SPVs) or subsidiary companies that allow regulated banks to do unregulated things.
Shadow banks hold eurodollars, which really stand for faux dollars (and have nothing to do with euros) and have no federal backing from the US Federal Reserve (or FDIC insurance). Unfortunately, these eurodollars can flow from the shadow banking systems into the regulated ones, and become real money with no backing. So long as the 1:1 ratio of eurodollars to real dollars holds, then the system works okay. However, this is what our cryptocurrency, stablecoin, and even fiat money systems are built upon.
The Instability of Any Money System
In every banking system, there are often fewer cash reserves than what the total amount of holding might be in a given institution. FDIC-insured banking institutions only hold cash reserves, and only insure customers up to $250,000 per customer per institution.
Whether stablecoins like USDT and USDC are able to exchange their eurodollars for real dollars will depend on the adequate US dollar reserves and the solvency of the bank. If there aren’t enough real dollars to pay those who want to withdraw funds, then stablecoin holders wouldn’t be able to get their money back.
This type of instability occurred following the collapse of the money market fund (MMF) the Reserve Primary in the 2008 financial crisis. Instead of keeping all of its reserves backing the shares that the money market account sold, it invested it into commercial paper issued by the shadow bank Lehman Brothers, which failed in September 2008. Lehman Brothers’ commercial paper failed in 2008, and its partner bank the Reserve Primary MMF couldn’t guarantee its investors the 1:1 ratio of share to a dollar value that they had purchased into. The MMF could return 97 cents for each dollar invested.
This announcement, the failure of Lehman Brothers, and the collapse of the insurance company AIG (all in 2008) showed the financial system’s true colors: that you can’t expect your money to be backed up or kept in a cash reserve in a true bank, and that all the money could be lost due to the shadow banking system.
If we take lessons from 2008 and shadow banking networks, as we should, we can recognize the risks that are apparent in any banking system, and even more so in unregulated banking systems. Stablecoin users, for the most part, purchase coins that are pegged to a dollar (much like the Reserve Primary MMF). So stablecoin traders need to be aware that this exchange rate cannot always be guaranteed, and that issuers do not have a 100% cash reserve.
Most people know this. Also crucial to this discussion is the newness of stablecoin. Crypto traders, stablecoins, and their backing banks are only a decade or so old, and, compared to the global financial system of Lehman Brothers, AIG, and the Reserve Primary, if the shadow banks for the crypto or stablecoin networks fail, then it is likely that the Fed will not bail them out. Instead, this will be seen as a minor disruption in the crypto and financial worlds, and a problem that the blockchain ledger networks need to solve, not the Feds.
While the Fed did bail out the shadow banks in 2008, it is unlikely that they will bail out stablecoins until the network becomes more powerful and more people become reliant on the currency. In essence, the Fed will only bail out stablecoin reserves if it absolutely has to, especially since they have no federal requirement to do so considering that a majority of the crypto reserves are in off-shore, deregulated shadow banks.
While this scenario was espoused by a lead financial writer Frances Coppola, it doesn’t always ring true when you look at the range of stablecoin backing options. Coppola’s main argument resides on the fiat-backed stablecoin system, which is following an already flawed fiat money system.
Managing Stablecoin Risk
Inevitably, stablecoins rely on assets and the type and value of those assets can change the level of risk associated with a given stablecoin. Take Tether (USDT), for example. Tether we know is valued at 1 share per 1 dollar and their bank is Deltec. Deltec, however, is located in the Bahamas (offshore jurisdiction beyond US regulation) and is part of the shadow banking network.
Deltec is not backed by Federal Reserve, has no FDIC insurance (i.e., they use eurodollars), and might hold cash reserves in various US-regulated banks. Usually, the reserve amount won’t be enough to back up all of the eurodollar deposits, in addition to the myriad of other problems (outlined above) that could befall a eurobank. Other exchanges might use Deltec bank, or a similar bank, as a settlement bank and others might have accounts with Deltec to make Tether and other stablecoin transactions easier.
In knowing this, investors can look at the numerous factors associated with each stablecoin purchase. The more variable the fiat-backed value is, then the higher risk that stablecoin will have. Additionally, a higher dollar value (like USD vs CAD) will also present risks. Some stablecoins are pegged to the penny, which reduces the rate at which the 1:1 value ratio cannot be met.
Additionally, users can move away from fiat-backed stablecoins and purchase crypto-backed, smart contract supported, and commodity-back stablecoins. While these stablecoins might present their own list of issues, they present less risk around economic crashes. This, and the ability to research reserve banks, gives investors the ability to control their level of risk. If, in fact, you are advised to go with Tether, you may be able to set up additional safeguards (like purposefully investing through other fiats, like the actual Euro and or offshore Chinese currencies) to bypass the US regulation issue.
Other options are to go with stablecoins that use a bank that is more likely to be bought out by the Federal Reserve, or perhaps one that does not use non-regulated banks (openly, at least). You can also spread out your investment to multiple stablecoins in order to manage the amount of non-insured funds that you could accrue.
Are Stablecoins Safe?
To answer the question, stablecoins are reasonably safe. Their level of risk is comparative and minimally different than investing in the stock market. One of the biggest differentiators with stablecoins risk is that their level of risk is relatively known. Compare this to standard investing, where much of the information around reserve accounts, backing banks, and shadow parties are largely researched.
Additionally, the US Office of the Comptroller has accepted stablecoin for banks to use, which likely means that more regulations will be introduced, therefore improving the safety and reliability of stablecoins. There is also the fact that stablecoin backed by crypto uses smart contracts, which ensure that the contractual obligation is met. Embedded regulations could be part and parcel of how stablecoins minimize risk. However, how that obligation is met even when assets are missing could be disastrous and force the onus back onto the obligated bank.
By investing smartly, coin purchasers can mitigate risk. Coin issuers can also take this into account as stablecoins become more regulated in the US federal regulatory system.