Do Crypto Stablecoins Threaten Financial Stability?

Authorities are rightly sounding the alarm over the risks to financial stability from certain stablecoins -- increasingly popular cryptocurrencies that are supposedly tied to fiat currencies such as the dollar and euro. The lack of transparency around many of these offerings is worrying because it is often unclear how such digital tokens are actually backed by fiat currencies or other assets.

Stablecoins are tokens that attempt to peg their market value to another asset, usually a fiat currency. When it comes to asset-backed tokens, the focus indeed tends to be on fiat currency-backed stablecoins, such as Libra. Facebook received worldwide attention, and regulator resistance when it announced its intention last year to issue its own token backed by a basket of currencies.

But while the focus has been on a Libra token that may never end up being created, similar stablecoins have already gained significant market share. Tether, a stablecoin that has faced persistent legal challenges, has surged in recent weeks and is now one of the largest cryptocurrencies with a market capitalization of almost $9 billion. To put this in perspective, daily trading volumes of Tether alone can be up to 20 times larger than the Singapore stock exchange’s volume.

It is unfortunate, therefore, that many popular fiat-backed stablecoins do not have proper audits, often because bank policies prohibit depositing funds backing stablecoins in the first place. Hence it is often impossible for some of these tokens to prove that they actually hold the funds they claim to hold. This systemic lack of transparency is what prompted the G20’s Financial Stability Board to report that these assets may “generate risks to financial stability if they are adopted at a significant scale.” The European Central Bank reinforced the regulatory watchdog’s warning in its own report earlier this month: "A robust regulatory framework needs to be put in place in order to address these risks."

Proof of reserve

But instead of disparaging an entire asset class, investors, governments and central banks should look beyond often opaque, fiat-backed stablecoins to the benefits of tokens that do provide more transparency. Alternatives are indeed coming to market that clearly demonstrate that physical commodities, such as gold, can function as the underlying asset backing a digital token. Properly executed, a digital token can represent one gram or one troy ounce of gold held in a secure vault. In these uncertain times, this should be welcome to regulators and investors alike, given that both gold and cryptocurrencies have generally increased their value during the coronavirus turmoil.

Cryptocurrencies have struggled to attract mainstream adoption, in part because of questions around transparency and concerns about market manipulation. But gold-backed tokens can have perfectly transparent “Proof of Reserve” systems that provide photographs and use RFID tags to track, in real-time, each individual bar backing the tokens. If regulators worry that fiat-backed currencies might not actually be backed by the currencies as promoted, they can have little argument with a physical asset stored in a vault transparently tracked for the public to see.

Furthermore, if the tokens can be efficiently converted into physical gold, they provide cryptocurrency markets the ability to participate in the deep liquidity of gold markets, which trade up to $270 billion USD per day. Gold-backed tokens combine the benefits of a transparent, appreciating safe-haven asset and great liquidity -- gold -- with the convenience and efficiency of digital assets. A market with liquidity and safe-haven assets should not trouble regulators.

Store of value

One of the primary problems with fiat-backed stablecoins is the blanket de-risking policies of banks and their refusal to hold funds for some stablecoins. Since holding billions of dollars as physical cash is not an option for stablecoin operators either, it is easy to see why some stablecoin issuers have resorted to offshore shell corporations to obfuscate the purpose of their funds. The news of Tether’s $850 million loss to Panamanian payment processor Crypto Capital Corp, is a reminder of just how fragile and opaque fiat-backed stablecoins can be.

Regulators have repeatedly warned banks not to indiscriminately close the accounts of legitimate fintech companies because such blanket policies will drive fintech companies underground and that is indeed what has happened. However, in practice, there are few incentives for banks to support the growth of fiat-backed stablecoins because they represent a threat to legacy financial institutions. Large banks are therefore unlikely to ever give legitimacy to such stablecoins.

On the other hand, those few banks that are willing to knowingly store funds for stablecoins risk being ostracized by the banking community and may have their correspondence accounts closed which can be an existential threat to those banks that do not fall in line.

Fiat-backed stablecoins often find themselves in an impossible position because the lack of bank cooperation means that they cannot have the transparency that regulators and investors rightly demand. Without proper audits of the dollars backing these tokens, how can an investor holding the token really know that their “stablecoin” has any fiat currency reserve at all?

Yet, as the ECB put it, many token holders mistakenly believe there to be some innate guarantee: "There is a risk that end users will regard the stablecoin as being equivalent to a deposit, given the promise of 'stable' value and the possibility of converting coin holdings back into fiat currency at any time."

Opaque stablecoins have grown so large that, once trust in them evaporates and they become worthless, the damage to cryptocurrency markets will be much worse than the hack of the then-dominant Mt. Gox exchange in 2014 that wiped out a third of Bitcoin’s value.

Gold-backed tokens, on the other hand, are much less reliant on banks and can rely on established gold dealers for liquidity avoiding this banking conundrum. As a matter of fact, well designed gold-backed tokens with next-generation asset tracking systems can provide a level of transparency that is much better than banks themselves have.

Gold-backed tokens, within proper regulatory frameworks, that have proper checks and balances as well as functional redemption have the potential to become a viable long term asset class to store wealth. Should faith in the U.S. dollar diminish, such tokens could provide an alternative. That would be, overall, a positive development for financial stability, not a threat.

(Gregor Gregersen is the CEO of CACHE, a provider of asset-backed tokens.)