Algorithms Are Unreliable; Fiat-Backed is the Answer ~Part2
“We look at them and we say, they’re part of an overall ecosystem that needs protection for the investors, protection against fraud and manipulation,” the SEC’s Gensler said of stablecoins.
It’s understandable that investors are increasingly unwilling to park their funds in a place where a dollar might turn out to be worth 70 cents, or a quarter. It’s also reasonable to wonder, in light of the issues faced by Tether’s USDT, if fiat-backed stablecoins might be seen as similarly suspect.
Let’s look at its brief depeg in May. The world’s biggest stablecoin by market cap fell to 95 cents after the collapse of Luna, but there were a few ameliorating factors. First, this occurred during crypto’s most unstable moment, its Krakatoa — an earthquake that ended up erasing a third of the market’s value. It would have almost been more surprising if USDT, which bears much of the burden of stablecoin potential, had not wobbled amid the vast panic. Second, this happened on secondary exchanges, rather than primary markets, and would better be described as a break in parity: USDT continued to offer 1:1 redeemability even during the so-called depeg. And finally, the reliability of USDT’s asset base had been widely questioned since last year, when a settlement with the New York Attorney General revealed that nearly half of USDT’s collateral (44%) was a form of short-term, unsecured corporate debt known as commercial paper. Tether has since reduced this figure to 30 percent and vowed to continue the reduction. But some market concern about its asset base is understandable.
The other top fiat-backed stablecoin has also raised some eyebrows of late. USDC’s asset base is cash and short-term U.S. government bonds, as detailed in its monthly report. As a result, it’s widely perceived as a safer and more transparent asset than USDT. However, it may now have the whiff of criminality about it. The US Treasury Department’s Office of Foreign Assets Control (OFAC) last month sanctioned prominent mixer Tornado Cash, which is thought to have been used to launder more than $9 billion, including some North Korean funds. In response, Circle froze 75,000 USDCs that have been linked in any way to Tornado Cash, blocking their owners from using the coins out of fears that they may have been involved in illicit dealings. This is of course problematic for USDC owners who’ve done nothing wrong, and being linked to fraud is troubling, but it’s also an understandable move by Circle to ensure the security of the stablecoin.
This could be seen as merely the cost of going legit. The U.S. Commodity Futures Trading Commission fined Tether $41 million for “making untrue or misleading statements” — a reference to its claim that USDT was 100 percent fiat currency-backed when its asset base included sizable amounts of commercial paper. In both cases, this is precisely how the system should work. A fiat-backed stablecoin needs to be precisely that — backed 100 percent by corresponding fiat — and would be wise to steer clear of nefarious laundering tools. “We look at them and we say, they’re part of an overall ecosystem that needs protection for the investors, protection against fraud and manipulation,” the SEC’s Gensler said of stablecoins.
Finally, we come to the most worrying fiat-backed hiccup thus far. In mid-August, Huobi’s HUSD fell all the way to 82 cents after the exchange FTX announced that it had removed HUSD from its list of approved USD-backed stablecoins. In response, Huobi said that it had been dealing with a short-term liquidity issue after closing some regional accounts and that the problem would soon be resolved. HUSD quickly regained its peg, and though its market cap had been falling sharply since May, it has held steady since late July, appearing to have weathered the crisis.
Rather than becoming the first fiat-backed stablecoin to collapse, as doomsayers predicted, HUSD may end up underscoring the resilience of the model.
It’s not impossible for a fiat-backed stablecoin to lose its peg — and this is OK, as the concept is still being refined and the market should have doubts. Yet when it does happen, a depeg tends not to crater the coin. In full disclosure, GMO Trust’s own fiat-backed stablecoin ZUSD experienced a minor recent episode. In mid-July the price of ZUSD briefly fell to 50 cents on one order book of an exchange before quickly recovering. As with USDT’s May hiccup, it’s important to point out that ZUSD did not actually lose its peg — the coin always maintained its 1:1 redeemability. Thus, this was not a true depeg, but a momentary loss of parity, likely due to a thin order book and slippage due to a surprisingly large transaction.
Ultimately, this underscores the game-changing value of full-fiat collateralization. At a time when investors fear the pressure of inflation and recession, fiat-backed stablecoins provide a more immediate and secure link between crypto and traditional finance, between virtual currencies and government-backed money. This is why of the $150 billion or so invested in stablecoins, about 80% of it is in USDT and USDC.
In contrast to algorithmic stablecoins, fiat-backed stablecoins are significantly more stable because they are backed by actual real-world money. The collateral value is ensured, which makes fiat-pegged stablecoins the more trusted option. It also means these coins need to play by the rules. The two main concerns about fiat-backed stablecoins today are that the value of underlying assets could be affected by macroeconomic changes — just as with fiat currencies — and the impact of looming regulations.
We have seen considerable activity on the regulatory front in recent months, with more set to come. Leading financial regulators seem to prefer a bifurcated regulatory system, in which fiat-backed stablecoins like USDC and USDT, not to mention GMO Trust’s ZUSD, will be classified as securities or payment infrastructures and expected to observe the relevant restrictions, while algorithmic stablecoins will be viewed as problematic and cordoned off. SEC chief Gensler described it as separating stablecoins and non-stablecoins.
In July, the Bank for International Settlements and the International Organization of Securities Commissions published a final guidance confirming that systematically important stablecoin arrangements should observe international standards for payment, clearing and settlement systems, known as financial market infrastructures. Also in July, the finance ministers and central bank governors of G20 states echoed this position, announcing their support for the Financial Stability Board’s view that stablecoins need to be supervised under effective legislation and endorsing the FSB’s principle of “same risk, same regulation”. This echoed the Financial Action Task Force (FATF), which made clear in its late 2021 guidelines that the major factor in determining stablecoin risk is the potential for broad adoption — the possibility of the stablecoin becoming “systemic”.
Relevant legislation in the UK also looks set to extend financial regulations over systemic stablecoins, with the bill set for parliamentary debate in September. In the United States, the SEC and the Commodity Futures Trading Commission and Congress are in the latter stages of finalizing stablecoin regulations, with most signs pointing toward a similar approach. The Biden Administration has gone a bit further, asserting in a report from the President Working Group on Financial Markets that “legislation should require stablecoin issuers to be insured depository institutions”. Congress has pushed back on this, with some legislators arguing that states should be able to charter stablecoin issuers.
But no government seems to want to restrict stablecoins as much as the European Union, where in late June the EU Commission agreed on the Markets in Crypto-Assets (MiCA) bill. The proposed law would place limits on stablecoins not denominated in an EU currency and, similar to the Biden report, require stablecoin issuers to maintain enough reserves to meet redemption requests in the event of a run. The EU Council and EU Parliament still need to approve the bill before its adoption, but crypto advocate Blockchain for Europe argues that MiCA would effectively ban USD-pegged stablecoins like USDC and USDT and result in “extreme short-term volatility”. The group points out that trading volumes in euro-pegged stablecoins sit at about $21M, compared to $53B for USD-pegged coins.
Many questions remain unanswered, including how regulators will determine which stablecoins are systematically important. Presumably, the line will be related to the stablecoin’s degree of reliance on fiat currency vs code. Another key concern is which approach will ultimately see broader uptake, the EU-style view that favors its own markets, or the FATF and FSB view that stablecoins should be treated much like established payment infrastructures. Only time will tell.
Industry observers and the broader market, along with regulators across Asia, seem to be leaning toward the latter view. “I would not be surprised if markets regulators in different markets said, ‘You can’t put an algorithm stablecoin on your exchange and commingle that with these other things’,” Circle CEO Jeremy Allaire said on a recent Bloomberg podcast. “The analogy I like to use is if you go into a supermarket and you go down one of the aisles and you’ve got rat poison and baby food next to each other, and they’re kind of positioned similarly, that’s a real problem.”
Whether pegged to dollars, yen, gold or cosmic wisdom, the extent to which a coin holds fast to its value over an extended period is equal to its usefulness as a store of value and method of payment, within crypto and beyond. Nailing down and promoting the safest and wisest crypto investments is thus a crucial endeavor. One that may even be existential for the industry: the latest Pew survey found that, despite the steady stream of celebrity-filled crypto TV ads, the share of Americans who have invested in crypto remained unchanged over the past year, at a measly 16 percent.
Stablecoins are critical to the future of crypto largely because they enable investors to hold blockchain-based assets backed by hard currency, encouraging the reluctant and inexperienced to dip their toes into the water, rather than dive in head first. This is the surest route to reaching a critical mass of crypto participation, which may be the only way to spur stablecoin use in payments, leading in turn to broader everyday use. While algorithmic stablecoins look set to suffer a slow and agonizing death, fiat-backed stablecoins remain poised to be a key step in our progression from purely physical to almost wholly virtual currency.
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