Making Stablecoins More Stable

Stablecoins are designed to be stable and immune from the price volatility that plagues their crypto brethren. This makes stablecoins an integral part of the crypto ecosphere and an illustration for the use case of digital assets for business transactions, payment systems, and treasury functions. Stablecoins provide accessible on- and off-ramps between cryptocurrency, state-controlled currency, and therefore traditional financing structures. They are used by brokers to facilitate and settle trades, provide liquidity in the growing DeFi space, and allow for instant payments and transactions.  But why do stablecoins, occasionally become unstable as we have seen recently? Why can they “break the buck”?

Leveraging Liquidity to Keep Stable

Stablecoins can be pegged to a commodity or through an algorithm, but the most commonly used stablecoins are those tied to a fiat currency, such as the USD Coin (USDC) which is pegged to the US dollar. The USDC, like many of its counterparts, is stabilized by maintaining liquid reserves used as collateral for the minted coin. Circle Internet Financial states that USDC is 100% collateralized with cash and US Treasury Bills. To “prove” there’s security with their reserves, stablecoin issuers engage third party providers to conduct Proof-of-Reserve (PoR) audits and attestation reports, and often make these reports public.

Lay of the Land – Breaking the Buck

On paper, the process appears seamless and financial security and stability appear assured. As recent events make clear, however, nothing is ever assured. Following the announcement that Silicon Valley Bank (SVB) was under the control of the FDIC this past week, the USDC was rattled and unpegged from the dollar, falling to just under 87 cents. 

While stablecoins may be 100% backed by highly liquid assets at any given point in time, the security of that collateral is dependent on consumer and investor confidence. In the case of USDC, this confidence relied on the strong reputation and solidity of the traditional US financial institutions holding the cash underlying the minted coin. After the FDIC took control of SVB, approximately 8% of the USDC cash collateral became temporarily inaccessible and concerns over the security of the collateral led holders of USDC to sell off their coin, resulting in a run on the bank, and a reduction in value. 

The USDC has since rebounded with some reassurance from the Biden Administration and Circle’s access to the blocked reserves. But this recent storm has brought to light where stablecoins need to patch the security blanket. It is not just confidence in the underlying asset, but confidence in how much and where that asset resides and what it is. Risk concentration matters, duration matters. 

Looming Regulation

Like everything else in the crypto industry, regulation is looming. Currently, several legislative and regulatory proposals target stablecoins and ensuring protection against run-on-the-bank scenarios, including legislation introduced by Senator Pat Toomey at the end of 2022. The proposed federal regulatory framework would require that all stablecoins are fully backed by high-quality assets, standardize disclosures, and obtain attestations by registered accounting firms. The bill also encourages competition by authorizing several types of entities to issue stablecoins and would authorize the Office of the Comptroller of the Currency (OCC) to establish a new, specific federal license for stablecoin issuers. 

Many prominent stablecoin issuers already boast compliance with requirements similar to those contained in proposed legislation (mostly driven by various regulations set at the state level). New frameworks should reassess the current effectiveness of those regulatory components. For example, attestation reports from a Big Four accounting firm may provide reasonable assurance that USDC in circulation is fully or partially reserved with liquid assets. Those reports, however, generally do not examine whether access to those assets and liquidity is at risk.

We know from experience that a qualitative look at an organization’s assets and liquidity is critical. So, shouldn’t this be more than a simple math exercise, and require both a quantitative and qualitative assessment of the risks? 

This may be answered, in time, upon examination of a Wells Notice the Securities and Exchange Commission (SEC) sent to Paxos in early February, which seeks a response from Paxos related to concerns by the SEC that the stablecoin it issues may be an unregistered security. While details of the Wells Notice remain unknown, part of the SEC’s angst may reside with how the token is collateralized and related disclosures, which in contrast to the USDC, includes a significant portion of long-term maturity assets.

Coincidentally, the Public Company Accounting Oversight Board (PCAOB) issued an investor advisory on March 8, two days before SVB’s seizure by the FDIC, warning of the inherently limited nature of PoR reports, which are not within the PCAOB’s oversight authority, and “do not provide any meaningful assurance to investors or the public.” The PCAOB also asserts that the reports provide only factual findings of the outcome of the procedures performed, and do not attest to the sufficiency of the procedures, the adequacy of the reserves, financial stability, or validity of management assertions.

Last Words

Any federal regulations related to the issuance of stablecoins should include insights from a post-mortem of recent events to ensure that reserve requirements for stablecoins are more than a check-the-box exercise. Supporting the stability of stablecoins requires a deeper dive into both the inherent and external risks that may threaten the stability of the underlying asset. Reserves may be key, but access to those reserves are crucial.