In my prior post on DeFi, I spoke about Circle, their lending program, and briefly touched on their stablecoin $USDC. I want to go through how these stablecoins work and discuss why some people think they create a systemic risk to the crypto ecosystem.
Circle is a big player in the crypto markets. Back in July they announced plans to go public via a SPAC merger that will value the company at $4.5Bn. The merger was supposed to close by the end of 2021, so it’s not clear whether that will happen or not. Circle is one of the two leading players in the issuance of stablecoins, crypto tokens that are designed to maintain a 1:1 peg to the U.S. Dollar. Circle’s $USDC stablecoin has a market cap of $42Bn. It was launched in partnership with Coinbase in 2018 and has grown rapidly from then. The other giant stablecoin is called Tether ($USDT), and it is even bigger with a $78Bn market cap.
Stablecoins function in some ways like a money market fund but with several key differences. Just like a money market fund, stablecoins take in cash from investors, and they invest the cash in short-term securities. They are supposed to hold enough cash and liquid securities in reserve to cover any redemption requirements so that they value of the stablecoin will maintain its peg to the dollar.
However, unlike money market funds, the organizers of the stablecoin keep all the interest generated by the investments. In a money market fund, that interest is passed to investors, minus the fund’s management fee. Another big difference between stablecoins and money market funds is that there is currently zero regulation of stablecoins, while money market funds are subject to stringent rules on what they hold and disclosure of those holdings.
Stablecoin managers can invest in whatever they want, and the two big ones have never given a complete accounting of their holdings. Circle has been the better of the two managers regarding these issues. Back in July 2021, the company provided an attestation report that said about 61% of its tokens are backed by cash and cash equivalents, meaning cash and money market funds. The remaining 39% was split between Yankee CDs 13%, U.S. Treasuries 12%, commercial paper accounts 9%, and the balance in municipal and corporate bonds. About a month later, in August 2021, Circle changed its policy to move 100% of the assets of $USDC into cash and U.S. Treasury bonds. As far as I can tell, they have the right to change this again, but frankly it is hard to figure that part out. Circle employs a leading US accounting firm Grant Thornton to do a monthly attestation that there is an equal value to the assets and the coins outstanding.
Tether, which manages the largest stablecoin, has repeatedly come under fire for its choice of accounting firm and poor disclosures. Tether is audited by Moore Cayman, a tiny five-person group in the Cayman Islands that is part of the Moore Global confederation of accounting and consulting firms. Not really impressive for a $78Bn investment vehicle. Tether has only produced semiannual reports so far on their holdings, as opposed to monthly reports from Circle. In addition, Tether is taking way more risk chasing short term yields. Remember, these investment returns are kept by Tether, not passed to the stablecoin holders. About half of their assets are in commercial paper, and half of that is not even carrying the highest short term credit rating. Only about one-third of the assets are in Treasuries, cash, and bank deposits. Tether is also playing a term mismatching game, with roughly 20% of the assets in commercial paper with maturities of 6–12 months.
The stablecoin market has gotten really big, really quickly. In addition to Tether and Circle, three other stablecoins have market caps in the $10Bn range — $BUSD, $UST, and $DAI. The total market is rapidly approaching $200Bn. A stablecoin breaking the buck in a meaningful way is definitely a systemic risk to the market. You don’t have to look back much more than 10 years to see problems with money market style instruments in the mortgage and municipal sectors that caused big problems for individual investors.
The regulators in the U.S. need to get their act together and clean up this industry before people get hurt. Stablecoins are important in DeFi and have impacts on several other parts of the crypto industry. It is critical that the market can rely on these instruments to remain pegged as promised. It seems likely that once the regulations are clear on stablecoins, banks or asset managers will come into this market in a big way. If you work in these sectors, you need to understand how stablecoins work and consider what your firm can do in this area. You also should be starting conversations on how stablecoins could work within your traditional account structure, I am confident these are coming to bank and brokerage accounts in the coming years.
One last quick point here is that for the last year or so market participants have been talking about the possibility of central banks issuing their own stablecoins. While there are still big hurdles to this politically, there is a possibility in the future that the U.S. Treasury would issue its own coin, which would be explicitly tied to the U.S. Dollar. Other governments are rumored to be considering this for their own currencies. I’m not sure how this will work or when it will happen, but it seems a good bet this could occur within this decade for at least some countries.
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