Stablecoins Deliver on Their Promise: Disrupting Banks

Like banks, but worse

USD Coin, the second biggest stablecoin by market cap, received a government rescue in March—proving it really can compete with banks.

Stablecoins Can Have a Bank Crisis Too

USD Coin (USDC), issued by Circle, has long been the leading “good guy” in stablecoins—second in market cap only to the sketchy and constantly-in-trouble Tether. Circle’s model is based around investing in cash and short-term Treasuries with transparent disclosures. This model is also more or less the ball that Congress has been running with as it aims to pass stablecoin legislation. This is ill-advised.

This structure worked out really well for Circle for a while. It nearly converged on Tether, despite the latter’s first-mover and other advantages. Tether fell below half the USD-backed stablecoin market at the time of the Terra/Luna implosion in May 2022. Circle almost breached 40% of the market at the time.

As Circle wrote in July of last year in its “Trust & Transparency” blog series [all emphasis mine]:

Any comparison of Circle to trusts or banks that engage in fractional reserve models is apples to oranges. We do not lend USDC reserves to anyone. Circle issues USDC as a fully-reserved dollar digital currency. […] Unlike a bank, an exchange or an unregulated institution, Circle cannot lend out USDC reserves…

This is a point Circle has repeatedly highlighted both in the court of public opinion and in D.C.

As Circle CEO Jeremy Allaire testified to Congress:

A full-reserve digital currency model, such as USDC, where 100 percent of the assets are fully reserved in high-quality liquid assets such as cash and short-duration U.S. Treasuries, is not the same as a bank deposit where the bank is, in turn, taking the deposit and rehypothecating it and lending it.

And that sounds great for the stablecoin holder! Their money is essentially in a cookie jar with the customer’s name on it. It’s safely protected from the risky investments that put their customers at risk of loss.

How does one do achieve that level of safety as a nonbank? “Cash” (bank deposits) and short-duration Treasuries (inclusive of MMF shares, Treasury-backed repos with banks and others—potentially against longer-term Treasuries)—and transparent disclosures thereof so the market can trust the assets. (Transparency/disclosure/third-party verification is the answer to prevent unstable stablecoins, right? Right?)

Well, let’s check in on Circle’s disclosures from February 2023:

Oof. Pursuantly, over the course of three days in March, the backing assets of the “fully reserved” USDC became a portfolio enviable of a distressed credit investor. And, by extension, so did USDC itself. USDC started to wobble under the weight of the above disclosure (transparency!), and fell more sharply when Circle disclosed it in fact had $3.3 billion stuck at SVB despite attempts to withdraw:

USDC traded at less than 90 cents on the dollar that weekend — until the government announced it would stand behind the uninsured deposits of the failed banks:

The “we don’t lend reserves” refrain was always nonsense, and now USDC has faced a 48-hour drill making that abundantly clear. To be truly “fully reserved” is to have all the reserves at the central bank.¹

Saying anything less is “fully reserved” is egregiously misleading. Uninsured dollars in banks—which USDC likely needs at least some of (and, in any case, had a lot of) as the on- and off-ramps to the blockchain—are loans to those banks. Circle is issuing demand liabilities and making risky loans; it’s a bank.

Transparency about its asset book led to liability flight in March immediately upon bad news (despite ultimately facing no losses); it’s a bank. The decidedly riskier, but shrewdly less transparent Tether regained a ton of market share in March; it’s also a bank:

Data from DefiLlama

Okay, so the emerging consensus for how to make "payment stablecoins" stable still isn't stable. But, from a financial stability perspective, the breaking of the USDC buck isn’t what’s important. The important part of this story is that Circle, upon seeing bad news about a bank, tried to pull $3.3 billion dollars from it.²

Stable Coins, Unstable Deposits

While, in the event, $3.3 billion wouldn’t have changed SVB’s fate, it’s easy to see a story where a stablecoin running on behalf of its holders means a systemically important counterparty gets squeezed. If Circle gets its money out, it’s great for the stablecoin holders, but potentially at the cost of systemic stability.³

Between March 6 and March 31, Circle pulled about $8 billion of deposits backing USDC from the banking system. Macro-wise, $8 billion is nothing. For particular banks, it could mean everything; somebody has to be the marginal counterparty when a bank is in survival mode.

Tether moved ~$5B out of bank deposits and into repos in Q1, mirroring broader market trends amid the bank turmoil. Even if this money found its way back to the exact same borrowers, it’s now more expensive, and there was likely at least some temporary disruption. More likely, someone lost funding.

But, isn’t this the fault of the bad borrowers—that is, the banks—rather the stablecoins following a fiduciary obligation? After all, holders redeemed about 25% of outstanding USDC stablecoins—over $10 billion!—in March; Circle had to have the liquidity to meet these obligations.

But, it’s nonbank stablecoins’ very existence that is increasing systemic fragility by entering the intermediation chain. Blockchain data show that most Tether (USDT) and USDC holders hold amounts that would normally be covered under FDIC insurance:

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

That is, to provide crypto services to their customers, nonbank stablecoins are effectively gathering insured deposits and transforming them into uninsured deposits and other wholesale funding—funding which has a fiduciary obligation to run at the first sign of trouble. If stablecoins really are to be “payment stablecoins” as Congress is wont to call them, they should be just that: a payment technology—and one that exists underneath the banking system’s deposit ledger. Nonbank stablecoins can achieve safety for themselves, but only at the risk of the the system.

Comments welcome via email (steven.kelly@yale.edu) and Twitter (@StevenKelly49). View Without Warning in browser here.

1. Or, allowably, in Treasury bills… Circle’s recent evasion of many of them due to the debt ceiling drama notwithstanding. But Treasury bills are not infinitely elastic; indeed, their supply is already smaller than total assets in government money market funds.

2. It’s not public if they were up to something similar with Signature Bank. An April 2021, Circle blog post, which is no longer up—but, according to the web archive, was available as of the last archive in January 2023—said that Signature had been chosen to manage “billions” of USDC’s backing dollars (when there was only $13B USDC outstanding).

3. For more on this theme of why backing stablecoins with increasingly safe assets is actually bad for systemic stability, see my note in FT Alphaville from last August: Stablecoins do not make for a stable financial system. The broad strokes:

• Safe collateral is not unlimited! Excess demand creates incentive for private creation…Private safe assets are only safe until they’re not. This is not a problem that plagues bank deposits — they are backed by…whatever our banks are doing.

• As discussed above: Having safe-asset-holding, nonbank stablecoins changes the nature of bank liabilities. Makes them flightier. And more expensive.

• Profitability can be an issue. Remember zero interest rates…

• In liquidation, the stablecoin consumer wins, the system loses. Nonbank stablecoins mean separate on-chain activity from rest of economy. On-chain bank deposits, by contrast, avoid that disruption. Compare liquidation of Terra, FTX (no systemic impact) to a run on uninsured deposits/MMFs (crisis). Liquidating risky assets vs. money assets is the difference between a selloff/mild recession and a financial crisis.