Stablecoins could also face a banking crisis

USD Coin (USDC), issued by Circle, has long been the “good guy” among stablecoins — second only to the oft-troubled Tether in market capitalization. Circle’s model is based on investing in cash and short-term Treasury bills and providing transparent disclosures. This is also the basic model that Congress has adopted when trying to pass stablecoin legislation, but it is not wise.

This structure worked very well for Circle for a while. Despite Tether’s first-mover advantage and other advantages, Circle almost caught up in market cap. At the time of the Terra/Luna collapse in May 2022, Tether’s market share of USD-based stablecoins had fallen to less than half, while Circle’s market share had reached almost 40%.

As Circle wrote in its “Trust and Transparency” blog series last July (all emphasis added):

“Comparing Circle to trusts or banks that adopt a fractional reserve model is like comparing apples to oranges. We will not lend USDC reserves to anyone. USDC issued by Circle is a fully-reserved US dollar digital currency. Unlike banks, exchanges or unregulated institutions, Circle cannot lend out USDC reserves…”

This is a point that Circle has repeatedly made in public opinion circles and in Washington, D.C.

As Circle CEO Jeremy Allaire said in testimony before Congress: “A fully-reserve digital currency model like USDC, where 100% of the assets are fully backed in the form of high-quality liquid assets like cash and short-term U.S. Treasuries, is not the same as a bank deposit, which is the process by which a bank takes a deposit and re-hypothecates and lends.”

For stablecoin holders, this sounds great! Customers’ money is completely safe, their money is marked with their name, and they can easily withdraw it for use, and the risky investment of short-term government bonds will not put customers at risk of losing their funds.

So, as a non-bank institution, how can such security be achieved? The answer is "cash" (that is, bank deposits) and short-term Treasury bills. These short-term Treasury bills include money market fund shares and Treasury-backed repurchase agreements with banks and other institutions that may hold long-term Treasury bills. In addition, transparent disclosure of these assets is also necessary so that the market can have confidence in these assets. (To prevent the instability of stablecoins, transparency, disclosure, and third-party verification are key, right?)

OK, let’s look at Circle’s disclosure for February 2023:

As of the reporting date, Circle's cash is held at the following U.S.-regulated financial institutions: Bank of New York, Mellon Citizens Trust Bank, Customers Bank, Commercial Bank of New York, branches of Flagstar Bank of North Carolina, Signature Bank, Silicon Valley Bank, and Silvergate Bank.

So, over a three-day period in March, the backing assets of “fully-reserved” USDC became an enviable portfolio asset for distressed credit investors. And so, too, did USDC itself. USDC began to fall under the weight of the above disclosures (transparency!), and when Circle revealed that there was actually $3.3 billion stuck in SVB, the value of USDC fell even more sharply despite withdrawal attempts:

That weekend, USDC was trading below $0.9 — until the government announced it would backstop uninsured deposits at failed banks:

The “we don’t lend out our reserve funds” narrative has always been ridiculous, and now USDC has gone through a 48-hour exercise that further clarifies this. To be truly “full reserve” is to keep all of the reserves at the central bank.

Otherwise, claiming that something less than full reserve is “full reserve” is extremely misleading. The uninsured dollars in the banks (USDC likely needs at least some of these, and in any case, there are a lot of them) are loans to these banks, because they are the bridge between the traditional financial system and the digital currency system, as they are the digital currency that connects the blockchain system to traditional currency. Circle is issuing demand liabilities and making risk loans, so it is a bank:

In March, transparency into its asset book led to a loss of liabilities (the larger the bank's user deposits or USDC, the greater the liabilities, because these funds need to be redeemed to customers, so they are liabilities), although it ultimately did not face any losses, but this shows that it is a bank. Tether, which is relatively riskier but cleverly reduced transparency, regained a lot of market share in March, so it is also a bank:

So the emerging consensus on how to make “stablecoin payments” stable is still shaky. But from a financial stability perspective, the drop in USDC’s value is not the most important thing. The important part of this story is that Circle tried to withdraw $3.3 billion from the bank when it got bad news about the bank.

Stablecoins, volatile deposits

While $3.3 billion in funding doesn’t change SVB’s fate in this case, it’s easy to imagine a situation where stablecoins, when operating on behalf of their holders, put pressure on systemically important counterparties. If Circle succeeds in getting the funds out, that’s good for stablecoin holders, but it could come at the cost of systemic stability.

Between March 6 and March 31, Circle pulled about $8 billion from the banking system in deposits backing USDC. From a macro perspective, $8 billion is nothing. But for certain banks, it can mean everything; when banks are in survival mode, someone has to play the role of marginal counterparty.

In the first quarter, Tether moved about $5 billion of deposits out of the system and into repurchase agreement transactions, in line with broader trends in the banking market. Even if the funds end up back in the hands of the exact same borrowers, the costs will increase and there may be some temporary disruptions. More likely, some people have lost their source of funding.

But isn’t this the fault of bad borrowers (aka banks) rather than the stablecoin’s fiduciary obligations? After all, holders redeemed about 25% of outstanding USDC stablecoins in March, over $10 billion! Circle must have liquidity to meet these obligations.

However, the existence of non-bank stablecoins is increasing systemic fragility by entering the intermediary chain. Blockchain data shows that most Tether (USDT) and USDC holders hold amounts that should normally be covered by the Federal Deposit Insurance Corporation (FDIC):

So if you cut non-bank stablecoins out of the intermediation chain (or require them to become banks), you’re left with sticky, insured depositors in the banking system.

That is, in order to provide cryptocurrency services to customers, non-bank stablecoins are actually aggregating insured deposits and converting them into uninsured deposits and other wholesale funding. These funding are at risk of not fulfilling their fiduciary obligations at the first sign of trouble. If stablecoins are truly “payment stablecoins” as Congress claims, they should be just a payment technology and exist under the deposit books of the banking system. Non-bank stablecoins can achieve security for themselves, but at the same time they also bring risks to the entire system.

C3 Tip: The views, thoughts and opinions expressed here are the author's own. This article does not contain investment advice or recommendations. Every investment and transaction involves risk. There are three levels of investment: see, understand, and hold. There are also three levels of entrepreneurship: think, do, and make it. Each level seems to be not much different in words, but in fact, there is a huge difference. Each level can eliminate more than 90% of people.