Stablecoin risks spur central bank digital currency

The author is an economics professor at Rutgers University

One of the big misnomers in the crypto world is stablecoins. These digital assets are intended to provide safer crypto exposure, with coins pegged to stores of value such as dollars or gold to limit price fluctuations and facilitate transactions.

But they are anything but stable. My research showed that the 2016 and 2019 vintages of new stablecoins had a failure rate of 100 percent and 42 percent, respectively. The problem for overall financial stability is that even the successful coins that have seen explosive growth have flaws.

The Biden administration has recognized the risks and a working group advising the US government this month issued a series of recommendations that are urgently needed given the sector's rapid expansion.

There are five stablecoins with a market cap of more than $5 billion – Tether, USD Coin, Binance USD, Dai and TerraUSD. In total, there are around $140 billion in stablecoins outstanding. Classified purely by asset size, the market would correspond to a top 30 US bank.

Stablecoins were used for $1.77 trillion in transactions in the second quarter of 2021. While this revenue still represents less than 10 percent of the $18.4 trillion in payment volume in the same quarter through Automated Clearing, the main electronic funds transfer system in the U.S., stablecoin transactions are up more than 1,100 percent year-over-year.

A major issue is the transparency and quality of collateral for stablecoins. If doubts about the securities backing the coins trigger a redemption rush, it could damage the entire payment mechanism as well as the prices of assets like Bitcoin and Ethereum, with a combined market cap of more than $1.5 trillion.

Tether, the stablecoin leader with around $75 billion in coins, has been accused in the past of making misleading claims about the assets backing them. Last month, it agreed to pay a $41 million penalty to settle a charge by a regulator that it misrepresented that its digital tokens were fully backed by dollars. Earlier this year, Tether and affiliated exchange Bitfinex also agreed to pay an $18.5 million penalty after New York's attorney general accused them of covering up "massive" financial losses.

The support of USD Coin, a stablecoin leader founded by a consortium that includes cryptocurrency exchange Coinbase and technology company Circle, has also come under scrutiny. The Coinbase website has claimed in the past that each coin was backed by dollars held in US government-backed depository institutions. It now says its coins are “backed by fully reserved assets.”

Dai backs its stablecoin with collateralized debt positions in Ethereum network assets, but it appears to have strayed from its peg during rapid changes in Ether prices, according to data from CoinMarketCap. Dai - which was supposed to trade with the equivalent of $1 in asset backup - fell below $0.97 on February 20, 2020 and rose to $1.11 on March 13, 2020.

The Biden administration report recommends that stablecoin issuers be covered by insurance from the US Federal Deposit Insurance Corporation. While some coins such as Binance USD are partially backed by bank deposits backed by the FDIC, current law may only protect issuers, not coin holders.

Aside from collateral, stablecoins pose additional risks. Driven by high-frequency trading, more than $100 billion in Tether is traded on exchanges every day. This is a level comparable to the trading volume of the NYSE.

Unfortunately, the infrastructure for stablecoin trading is not as robust as some would hope. The two largest exchanges, Binance and Coinbase, experienced platform outages on May 19 as China banned most crypto payments and Bitcoin prices fell more than 30 percent. Investors have little regulatory protection from the consequences of such incidents.

There are also risks as the number of stablecoin blockchains diversifies. Most stablecoins come from the Ethereum network. But fee increases are spurring the migration of tokens to other platforms. Median fees for transferring holdings on the network have increased by more than 3,500 percent year-over-year for Tether. This is because the fees are set in Ethereum and the price increased from $226.31 to $2,274.55 in the year ending June 30.

The payment mechanism needs to be modernized and the blockchain technology that underpins cryptocurrencies made safer and cheaper. A central bank that has issued digital currencies with major financial institutions as intermediaries can achieve these goals.