Rattling crypto industry may emerge stronger after USDC depeg
USD Coin (USDC), the world’s second largest stablecoin, may simply have been in the wrong place at the wrong time.
The site was Silicon Valley Bank (SVB), a commercial bank with $209 billion in assets, where USDC issuer Circle had deposited $3.3 billion of its cash holdings for safekeeping.
The time was the present: one of rapidly rising interest rates in which institutions such as SVB, which had long collected short-term deposits to buy long-term assets, were whipped.
For several harrowing days, the USDC lost its peg to the US dollar, falling as low as $0.85 (depending on the exchange) before recovering to $1.00 on Monday, March 13th. This was the coin that many considered to be the poster child for fiat-based stablecoins, i.e. the most transparent, compatible and frequently audited.
An unpredictable course of events?
“It’s ironic that what was supposed to be the safest place to put stablecoin reserves caused a depegging,” Timothy Massad, a fellow at the Kennedy School of Government at Harvard University and former chairman of the United States Commodity Futures Trading Commission (CFTC), told Cointelegraph . “But that was a temporary problem, not an indication of fundamental design weakness,” he added.
Nevertheless, a depegging is still a serious affair. “When a stablecoin loses its link, it defeats the purpose of its existence — to provide value stability between the crypto and fiat worlds,” Buvaneshwaran Venugopal, assistant professor in the finance department at the University of Central Florida, told Cointelegraph. A depegging confuses existing and potential investors and is not considered good for crypto adoption.
Some saw this as an aberrant incident. After all, the last time a Federal Deposit Insurance Corporation (FDIC)-insured bank as large as SVB collapsed was Washington Mutual back in 2008.
“That a bank run like this would have happened would have been far-fetched for many – until the bank run happened,” Arvin Abraham, a UK-based partner at law firm McDermott Will and Emery, told Cointelegraph. “Part of the problem is that the bank partners for the crypto space tend to be some of the riskiest banks. Circle may not have had options in some of the bigger banks with safer profiles.”
Long-term consequences
The depegging raises a number of questions about USDC and stablecoins – and the broader cryptocurrency and blockchain industry.
Will the US-based stablecoin now lose ground to industry leader Tether (USDT), an offshore coin that retained its dollar peg during the crisis?
Was USDC’s depegging a “one-off” circumstance, or did it reveal fundamental flaws in the stablecoin model?
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Did Bitcoin (BTC), Ether (ETH) and some other cryptocurrencies show resilience during the banking crisis while some banks and stablecoins faltered? And what else can be done to ensure that other depeggings do not occur in the future?
“Some people will point to this as a reason not to encourage the development of stablecoins, while others will say that the vulnerabilities of big banks are exactly why we need stablecoins,” Massad added. None of them are really accurate in his view. What is needed is comprehensive banking and stablecoin regulation.
Investors may lose confidence in both the USDC and the entire stablecoin sector in the short term, Abraham said, “but in the long term I don’t think this will have a significant impact.” Still, the situation highlighted poor “fiscal cure management” on Circle’s part, Abraham suggested, adding:
“Holding nearly 10% of total reserves in a bank that is not viewed as ‘too big to fail’ is a risky move for any business, let alone one that claims to maintain a stable peg to the dollar.”
That said, Abraham expects Circle to learn from this experience and ultimately emerge stronger than ever. “This scare will likely cause Circle to take a step back and think about better controls to put in place so it’s not subject to extreme counterparty risk again. It will make USDC, which is already a great product, even safer.”
The USDC was never really in any existential danger, in Abraham’s view. Even if the US government had not stepped in to “back-stop” depositors, “the USDC would have been fine since their deposits were already in the process of being transferred before the FDIC receivership was initiated.” The billion reserves held by SVB would have been deposited in another bank by March 13 anyway, Abraham said.
Bitcoin and Ether show resilience
The good news is that Circle survived, and crypto pillars like Bitcoin and Ether held up surprisingly well while the banking contagion spread to other institutions like Signature Bank, First Republic Bank and Credit Suisse.
“Is anyone else surprised that a top Stablecoin [USDC] could just depeg by ~10% immediately, with virtually no ripple effects across other coin prices? Especially since this is pretty much the core of a lot of DeFi trading,” tweeted Joe Weisenthal. ARK Invest’s Cathie Wood even celebrated cryptocurrencies as a safe haven during the banking crisis.
Others, however, were more measured. BTC and ETH started falling on March 10 and the early part of that weekend, Abraham noted. “If the US government had not stepped in to stop depositors in the US, and HSBC had not bought the UK bank, there would likely have been significant pain in the crypto sector when markets reopened on Monday [March 13].”
Others suggested that the USDC was basically doing everything right; it was just unfortunate. “The USDC reserves are mostly cash and short-dated securities, with 80% held in the latter, probably the safest asset out there,” Vijay Ayyar, vice president of corporate development and global expansion at Luno, told Cointelegraph. “Therefore, the USDC itself has no real problems if you look deeper into what happened.”
In Ayyar’s view, the more urgent need is “to have a digital system with a full dollar reserve that helps us move away from the systemic risks of the current fractional system.”
What does this mean for stablecoins?
What does this disconnect mean for stablecoins in general? Does that prove that they are not truly stable, or was this a one-time event where the USDC happened to be in the wrong Federal Reserve member bank? One lesson that has no doubt been learned is that stablecoin survival is not all about reserves. Counterparty risk must also be assessed.
“Fiat-backed stablecoins have a number of intersecting risk factors,” Ryan Clements, assistant professor at the University of Calgary Faculty of Law, told Cointelegraph, further explaining:
“Much of the discussion to date about the risks of fiat-backed coins like the USDC has focused on the issue of reserve composition, quality and liquidity. This is a material concern. Yet it is not the only concern.”
During the current crisis, many were surprised “by the extent of the duration mismatch and the lack of interest rate hedges at SVB, as well as the extent of Circle’s exposure to this bank,” Clements said.
Other factors that could cancel a stablecoin are issuer insolvency and reserve custodian insolvency, Clements said. Investor perceptions must also be considered – especially in the age of social media. Recent events demonstrated “how investors’ fear of insolvency in reserve deposits can catalyze a depegging event due to a redemption run against the stablecoin issuer and a sale of the stablecoin on secondary cryptoasset trading platforms,” he added.
As Venugopal of the University of Central Florida previously said, depeggings erode the confidence of new investors and potential investors who are sitting on the fence. “This further delays the widespread adoption of decentralized financial applications,” Venugopal said, adding:
“The only good thing is that such mishaps bring in more scrutiny from the investor community – and regulators if the ripple effects are large enough.”
Why Tether?
What about USDT, which remains stable throughout the crisis? Has Tether put some distance between itself and USDC in pursuit of stablecoin supremacy? If so, isn’t that ironic, given that Tether has been accused of a lack of transparency compared to USDC?
“Tether has also had its share of questions raised in the past regarding issuing audits on its holdings, which has resulted in a depeg in the past,” Lunos Ayyar said. “Therefore, I don’t think this incident proves that one is stronger than the other in any way.”
“Crypto markets have always been rich in irony,” Kelvin Low, a law professor at the National University of Singapore, told Cointelegraph. “For an ecosystem that is supposed to be decentralized by design, much of the market is centralized and heavily intermediated. Tether only appears to be stronger than USDC because all its flaws are hidden. But flaws can only be hidden for so long,” Low added, “as the FTX saga demonstrates.”
Still, after dodging a bullet last week, the USDC might want to do things differently. “I suspect the USDC will seek to strengthen its operations by diversifying its reserve depository base, keeping its reserves in a larger bank with stronger duration risk management measures and interest rate hedges, and/or ensuring that all reserves are adequately covered by FDIC insurance,” said the University of Calgary’s Clements.
Lesson
Are there any more general insights to be drawn from recent events? “There is no such thing as a completely stable stablecoin, and SVB illustrates that perfectly,” replied Abraham, who, like some others, still sees USDC as the most stable of stablecoins. Still, he added:
“Before [USDC] going through a 10% depegging event shows the limitations of the stablecoin asset class as a whole.”
Going forward, “It will also be very important for stablecoin investor transparency to continuously know what proportion of reserves are held in which banks,” Clements said.
Low, a cryptoskeptic, said recent events showed that regardless of design, “all stablecoins are subject to risk, with algorithmic stablecoins perhaps the most problematic. But even fiat-backed stablecoins are also subject to risk — in this case, counterparty risk.”
Stablecoins “remain exposed to the risk of loss of confidence.” This also applies to cryptocurrencies such as Bitcoin; although BTC has no counterparty risk or depegging issues, Lav continued. “Bitcoin prices are [still] subject to downward pressure when there is a loss of confidence in the same.”
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Ayyar stated that USDC already had various banking partners, with only 8% of assets held by SVB. “Therefore, that in itself is not the solution.” One needs to think more long-term, he suggested, including implementing comprehensive consumer protections “as opposed to relying on the current patchwork approach.”
As for former CFTC chief Massad, citing the need to reform both stablecoins and banking, he told Cointelegraph:
“We need a regulatory framework for stablecoins, as well as an improvement in the regulation of medium-sized banks – which may require strengthening the regulatory framework, better supervision, or both.”
