The Stablecoin Surge Is Built on Smoke and Mirrors

What’s driving this growing interest in stablecoins? One explanation might be investors reaching for yield. As global interest rates fall, returns on conventional assets become increasingly disappointing. Stablecoins themselves don’t deliver dollar returns – indeed they are designed not to – but they do give easy access to the crypto world for investors looking for better returns.
There’s a desperate shortage of dollars. Despite the Federal Reserve creating new money at an unprecedented rate, the US dollar exchange rate is rising. The U.S. Government is pouring trillions of dollars into the economy to support failing businesses and people losing their jobs. When governments and central banks put new money into the economy, consumer prices usually rise. But in March, against what you would expect, consumer prices fell by 0.4%.

As dollars are apparently being swallowed up by the black hole created by the coronavirus, issuance of dollar-backed stablecoins is soaring as more and more people invest in them. Especially popular are stablecoins such as USDT, USDC, BUSD and Pax, which are backed one-for-one with dollar reserves.

This is a persuasive argument. Right now, the outlook is bullish for crypto. Partly, this is because of Bitcoin’s forthcoming halving: after previous halvings the price has always risen sharply, so there could be a potential profit opportunity from getting in now. But it’s also because of a growing belief among investors that the Fed’s extraordinary rate of money creation could result in runaway inflation. A century ago, central bank money printing in Germany’s Weimar Republic caused prices to rise so much that people paid for loaves of bread with wheelbarrows full of banknotes. Get your wheelbarrows out, dollar slaves!

Stablecoin supply to May 4,

Runaway inflation in fiat currencies would be good for Bitcoin, and indeed for any scarce asset. After all, who is going to want to keep their savings in the form of dollars, if the dollars are going to be inflated away any time now? So wise investors might exchange their dollars for crypto, thus benefiting from what could be a considerable bull run as fiat currencies burn. Though the Fed’s preferred measure of inflation expectations, the 5-year, 5-year forward spread, is not predicting runaway inflation. If anything, it is deflation, not inflation, that most investors foresee.

CoinDesk’s Mike Casey wonders if the surge in stablecoins could be driven not by investors reaching for yield or expecting high inflation, but by businesses desperate to find a secure source of dollar liquidity at a time of crisis. Stablecoins, after all, are equivalent to dollars. And they provide access to a payments network that is global, usually efficient, and – importantly – doesn’t rely on banks.

“Whether stablecoin issuers can meet the FDIC’s requirements has not yet been tested.”

Banks depend for their survival on the solvency of their borrowers. When the economy crashes, businesses fail and people lose their jobs, banks can become very wobbly. And, since the 2008 crisis, government bailouts of banks have become anathema. These days, deposits can be “haircut” to bail out banks, as they were in Cyprus. Or banks can close their doors, and governments can stop you taking out your money via ATMs, as happened in Greece. So your deposits can shrink or you can lose access to them just when you most need money to keep your business afloat.

Because of the scale of business failures and job losses at the moment, widespread loan defaults – and associated bank failures – seem highly likely. “Given the post-COVID outlook for banks’ loan customers”, says Casey, “some will doubt the security of their deposits, regardless of whether they are denominated in dollars.”

And he continues:

What’s a business to do then? They can’t withdraw and hoard cash to protect themselves; banknotes are hardly a viable payments option in the modern world. But perhaps dollar-backed stablecoins pose an option….

Banks don’t keep enough cash reserves to ensure everyone can withdraw their money whenever they want to. But stablecoins do. So, why not put your money into fully-reserved stablecoins instead of fractionally-reserved banks? Your dollars would be completely safe, and you would also have the opportunity to invest in cryptocurrencies or lend out your stablecoins for a good return.

As Casey puts it, “Since the token issuer commits to hold the full equivalent in reserves for all tokens issued, the fractional reserve system’s perennial question about deposit assurance ceases to be an issue.”

Sadly, this is much too good to be true. The reserve backing of these stablecoins is smoke and mirrors, just like the reserve backing of banks. Indeed it relies on exactly the same confidence trick.

Reserves for the four biggest stablecoins – USDT, USDC, Pax and BUSD – are all kept in banks, mostly in deposit accounts, though some are in money market accounts backed by U.S. Treasuries. The banks have FDIC insurance, of course, but then so do ordinary bank deposit accounts. If businesses’ own FDIC-insured bank deposit accounts aren’t safe, then neither are the FDIC-insured deposit accounts that hold stablecoin reserves.

What’s more, FDIC insurance is limited. The standard limit is $250,000 per customer, depository institution, and ownership category. So, a business with several accounts in one bank whose balances together add up to $300,000 is only covered by insurance for the first $250,000. But if the business has accounts at two different banks with less than $250,000 in each bank, then they are fully insured.

For the four stablecoins I looked at, the quantity of pooled reserves in the deposit accounts appears to exceed FDIC insurance limits. Indeed in the case of Paxos, which manages the reserves of not only its own stablecoin Pax, but also Binance’s BUSD, the auditor’s report specifically says that the amounts in the deposit accounts exceed FDIC limits. So although the reserves exist, they are not fully insured. If the banks in which they are held fail, stablecoin reserves in excess of FDIC limits could be seized to bail out the banks.

“The reserve status of stablecoins may be a confidence trick, but the investment opportunity is real.”

Some stablecoin issuers claim that stablecoin “deposits” (the dollars you pay when you buy stablecoins) qualify for FDIC pass-through insurance. The argument is that the dollars are held in custody in common accounts on your behalf. But FDIC pass-through insurance comes with significant restrictions: for example, people’s individual deposits within the common funds must be clearly identifiable and regularly reported. It also excludes investments such as mutual funds and securities. Whether stablecoin issuers can meet the FDIC’s requirements has not yet been tested. And nor has the legal status of stablecoins that are issued by, and actively traded on, crypto exchanges solely for the purpose of speculation in cryptocurrencies. Speculative assets aren’t covered by FDIC insurance.

So, stablecoin reserves may not be fully protected by FDIC insurance. And if they aren’t, then stablecoins may actually be less secure than ordinary bank deposit accounts. If people really are investing in stablecoins because they think they are safer than bank deposit accounts, I’m afraid they have allowed the smoke to get in their eyes and the mirrors to blind them.

That doesn’t mean that investing in stablecoins is a bad idea. After all, there is that halving coming up, and there is the possibility of inflation. And returns on crypto assets can be really good. The reserve status of stablecoins may be a confidence trick, but the investment opportunity is real. Just remember that nothing is ever completely safe, and there is no such thing as a free lunch.

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