Financial risks of stablecoins. New paradigm?

Origin: what is a stablecoin?

Stablecoins are defined by the ECB[1] as “digital units of value that do not belong to a specific currency, based on a set of stabilization tools that promote the minimization of fluctuations in the price of such currencies”. Without going into an in-depth analysis of the technology implemented for this purpose, stablecoins are constituted through a Smart Contract (protocols that automate the execution of contracts), which is embedded under the infrastructure of distributed ledgers (DLTs), and which allows eliminating or reducing the dependence on a third party in the verification of the operation. They aim to protect the cryptoasset ecosystem from the high level of volatility that affects it.

The value of stablecoins, although assumed to be linked to a given currency at 1:1 parity, does not have to be maintained, since the collateral only serves to guarantee the redemption of an initial valuation agreement, but does not prevent the potential variation in the demand for such token from causing its value to fluctuate. The difference with “traditional” cryptoassets is that stablecoins have price stabilization mechanisms, which are basically of two types:

• Issuer: this involves managing fluctuations in the price of stablecoins by modifying the money supply through token purchase and sale operations. The protocols that make it possible to modify the money supply are centralized in nature, regardless of whether they are executed on an infrastructure of distributed ledgers (DLTs) such as blockchain.
• Participants: involves the creation of incentives on participants/investors to arbitrage supply and demand in such a way that the latter is stabilized around the price originally established in the protocol. Protocols that allow the incentive system applied to participants to be modified by aligning their interests with those of the protocol are decentralized in nature.

Through these two stabilization approaches, the entire stablecoin ecosystem can be understood, subsequently deriving second-level regulatory classifications, which are the ones currently applied in the legal frameworks that are being discussed.

The ECB understands the different stablecoin modalities from a triple dimension:

• The existence or absence of an issuer, responsible for satisfying the rights arising from the obligations it has contracted through the issuance of such tokens.
• The level of centralization or decentralization of responsibilities over the stablecoin.
• The system for fixing the value of the stablecoin, and its stability against the reference currency.

This gives rise to four types of stablecoins:

• Backed by funds.
• Backed by another asset class (traditional), which requires the participation of a custodian, and which are held by the issuer to the extent that the token holder does not demand their return (off-chain collateralized stablecoins).
• Backed by cryptoassets, which can be secured in a decentralized manner, and do not require the identification of the issuer (on-chain collateralized stablecoins).
• Backed by holders’ expectations about the purchasing power of their tokens, which require neither determination by either party, or the third-party custodian intermediary (algorithmic stablecoins).

On the other hand, the European regulation of the cryptoassets market, still at the proposal stage (MiCA, Market in Crypto Assets), makes a double distinction: Asset Referenced Tokens (ARTs), and E — Money Tokens (EMTs), to refer to tokens backed by a basket of currencies, an asset or a basket of assets (ARTs), or a single currency (EMTs). Despite of this is the basis on which the entire classification of stablecoins will pivot upon approval, we don’t want to ascribe to this new regulatory framework, but rather address the complexity of Tether without predetermined schemes.

Risks of stablecoins:

Stablecoins generate risk. But what risk? And, above all, why is it a risk different from that generated by other cryptoasset issues?

Cryptoassets other than stablecoins do not pose a risk to financial stability. Despite forecoming regulation includes utility tokens, major efforts are concentrated on the stablecoin figures, and specifically excludes first generation of cryptoassets (Bitcoin, Ethereum, etc.). Why? Because, although they are highly volatile, they do not have implications in terms of monetary policy, nor do they affect the proper functioning of payment systems or financial market infrastructures.

For stablecoins, the FSB (Financial Stability Board), an international forum for banking cooperation, has identified a matrix of relevant risks. In terms of asset management, these are concentrated in two sub-types: the risk of liquidity of funds, which has a direct impact on the stablecoin itself, and the risk of contagion to the financial sector, as a result of the previous vulnerability of the stablecoin.

The financial stability impacts generated by a global stablecoin can be very diverse in nature. Stablecoins can introduce credit and liquidity risk to issuers’ balance sheets if they reinvest the funding in financial assets with risk greater than 0, and expose themselves to the risks inherent in such assets, although MiCA [2]aims to manage this risk by requiring the application of safeguard accounts for EMTs, or reinvestment in highly liquid, low-risk assets in the case of ARTs (Asset Referenced Tokens, as defined by MiCA as those stablecoins which are backed by more than one currency or an asset).

However, when reinvesting the funds in risky assets to increase its interest spreads, losses of confidence from token holders, due to the issuer or the network, may trigger significant redemptions of the tokens and other assets, with the associated liquidity risk if, due to maturity transformation, the issuer becomes unable to meet the repayment obligation. The risk is ultimately held by the holder, as the issuance of tokens is not covered by a depositor protection scheme, nor is the issuer’s solvency and liquidity subject to prudential supervision.

In addition, the liquidation of assets to cover the redemptions demanded by the holders may generate a contagion effect in the financial system, depending on the size or market cap of the stablecoin, and depending on its interconnection with other mechanisms and institutions of the financial system, as well as impacts on prices (market risk due to price fluctuations).

In terms of monetary policy, under a traditional commercial banking model, the transfer of retail customers’ deposits — specially in the current context, where interest rates are at negative or 0% — to stablecoins (if stablecoins are used as a mean of payment and collateral for DeFi industry), may lead to a switch in the funding of credit institutions. From traditional retail funding structure to a more depending corporate deposits layer, or even deposits from the stablecoin issuers themselves, this may increase volatility due to a lack of stability and, consequently, short-term and structural liquidity risk [3]. The latter case, which will be analyzed later, may be a possible scenario since the risk of retail deposits is categorized as low as they are not complex products.

It can be questioned, on the other hand, whether deposits made directly in stablecoins shall be treated as complex instruments, as they replicate the behavior of money and introduce an additional layer of risk and, therefore, should be subject to specific regulations under the liquidity and solvency frameworks of such depositors.

In any case, the increase in the cost of funding credit of institutions considering that stablecoins take over the raising of retail funds — and this is especially possible in scenarios of low interest rates, and with the DeFi phenomenon offering higher interest spreads — would have repercussions on the interest rates applied in lending operations, increasing the costs of loans to the SME and retail sector, and even affecting the interbank market. This vicious circle could be broken, as there are currently fintech lenders that could offer more competitive interest rates than those of credit institutions, affecting the institutions themselves, which would be subject to higher costs for liabilities and more competition for assets.

Dependence on central bank liquidity is also affected, as banks might offset liquidity shortfalls with contributions from stablecoin issuers [4]. On the other hand, the impact on the money market could only push interest rates lower. But how? The reinvestment of collaterals in low-risk assets by stablecoin issuers to ensure an appropriate balance between the return objectives of the funds acquired and the risk assumed, will provide for an capital inflow from issuers in these markets, increasing the demand for the money market.

However, an excessive volume of purchases of high quality assets could reduce the interest generated by them, and limit the ability of central banks to provide liquidity to the market, either through quantitative easing (QE) programs, or through open market operations (in the case of Europe), since such operations require collateral to be posted, either in the form of a sale, repo or pledge. Ultimately, banks would lose access to a major source of funding, and dependence on global stablecoins would increase.

In a situation of concentration of funding sources, the risk derived from the potential liquidation of stablecoin deposits would increase due to the risks mentioned above (USD backed by USDT, for example), which may collapse the funding structure of credit institutions, leading institutions to resolution processes [5].

Finally, it is worth mentioning that negative interest rate environments may affect stablecoins, provided that the funding collected by issuers, which is reinvested in traditional corporate deposits of credit institutions, would incur costs for the maintenance of such collateral. If stablecoins become global, besides switching into other money market instruments, this could alter the funding structures of credit institutions, obliging them to resort to debt-type funding mechanisms.

However, new DeFi (Decentralized Finance) structures could lead stablecoin holders to place token holdings in separate DeFi protocols and generate interest derived from contributions as collateral in these decentralized business models (yield farming), given their stable nature as underlying. In other words, DeFi financial models, based on stablecoins, reproduce traditional financial schemes (loans, deposits, etc.) through a decentralized architecture, and make it possible to compensate for the lack of profitability in the traditional financial system with these financing strategies. [6]

Conclusions:

• The main purpose of stablecoins is to manage exposure to the volatility of the cryptoasset ecosystem.
• Despite this, the MiCA regulation understands that issuers of stablecoins should be classified differently depending on the type of collateral that supports them.
• Risks to the stability of the financial system stem from the imbalances created in the monetary policy transmission mechanism, in the disruption of bank funding structures, and in the lack of consumer protection schemes, which can trigger massive sell-offs.

[1] Paper: “In search for stability in crypto-assets: are stablecoins the solution? “ (Dirk Bullmann, Jonas Klemm, Andrea Pinna)

[2] Market In Crypto Assets: Proposal of European Regulation

[3] Implications in terms of short-term liquidity ratios (LCR, based on Delegated Regulation 2015/61/EU) due to the application of higher run-offs to corporate clients. It seems likely that deposits by non-regulated entities will be subject to higher run-offs, given the volatility and uncertainty associated with their business models, and loss absorption mechanisms.

[4] Instead of using the auctions provided for in the ECB’s open market operations in the European market.

[5] BRRD (Banking Resolution and Recovery Directive) is the European directive in charge of designing and supervising the resolution process of significant European credit institutions.

[6] Currently, as the DeFi ecosystem is built on Ethereum, and this network is unable to scale to the levels required to assume all the operations generated on it, there is a transaction congestion that has led to very significant increases in the cost of transactions on the network, and makes it very difficult for retail customers to access this market. It is expected that with the entry of Ethereum 2.0 and with the contribution of more platforms on which to build DeFi protocols (Cardano, EOS, Binance, among others), the burden of commissions can be lightened and the average cost of transactions reduced.

[7] Digix DAO Whitepaper

[8] IMF website