Stablecoins can pose a danger to the banking system

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In November, the cumulative value of all crypto assets surpassed USD 3 trillion ($2.2 trillion) for the first time. During pandemic lockdowns, the market appears to have reaped the benefits. As a result of the recent creation of the first bitcoin-backed ETF (a listed fund that makes it easier for more investors to obtain exposure to this asset class), significant investment funds and banks have also gotten involved. The value of stablecoins like Tether, USDC, and Binance USD has surged in tandem with this.

Stablecoins, like other cryptocurrencies, use the same blockchain technology as other cryptocurrencies. The distinction is that its value is tied to a non-crypto currency asset, such as the US dollar rather than a cryptocurrency. As a result, they no longer require a bank account to retain money in their digital wallets less volatile than bitcoin.

Stablecoins are an essential part of a movement that aims to break away from banks and other financial institutions.

Investors can better protect themselves in a declining market by transferring money into stablecoins rather than selling their ether for bitcoin, as the rest of crypto tends to rise and fall together.

Stablecoins make up a large number of the crypto market’s transactions. Uniswap, for example, does not have a single business in charge and does not allow the usage of fiat currency.

Today, stable coins are worth $139 billion, up from a low of $20 billion just one year ago. Stablecoins are a sign that the cryptocurrency sector is maturing, but regulators are concerned about their threats to the financial system. Who’s to blame, and how do we fix this?

There is a single person in charge of stablecoin operations, which were first introduced in the mid-2010s.

Tether is ultimately controlled by Bitfinex, a British Virgin Islands-based crypto exchange. Coinbase, Circle Payments, and Bitmain are all part of a consortium that owns the USDC virtual currency.

Binance Another cryptocurrency exchange, Binance, is based in the Cayman Islands and owns the USD.

In contrast to the decentralized notion of cryptocurrency, so much of the market is concentrated. It’s possible that these organizations may not be able to sustain 1:1 fiat-to-stablecoin exchange rates in the case of a financial catastrophe.

One: one ratio aren’t generated by magic. They rely on stablecoin providers to have reserves of financial assets equal to the value of their stablecoins in circulation, which respond to investor demand.

If you look at the charts below, you’ll see that even though the providers claim to hold reserves worth 100% of the value of their stablecoins, it isn’t exactly correct.

As of March 2021, Tether holds 75% of its reserves in cash and equivalents. In May 2021, USDC will have 61 percent. Thus both are well shy of 100%. Commercial paper, a sort of short-term firm debt, is a significant source of both operations’ assets. You could lose your entire business if the value of these assets suddenly falls. This is not cash equivalent.

So, what could go wrong? Interest rates are still at record lows. The US Congress just agreed to accept another economic stimulus plan costing USD 1.2 trillion, so the availability of money is unlikely to be drastically cut any time soon. Inflation is the only threat to this oversupply of money.

At this time, the market still believes that the “Goldilocks” scenario, in which inflation and growth rise together at high but controllable levels, is the most plausible.

For example, central banks can allow inflation to rise between three and four percent in this situation.

A condition of high inflation and a recession could result if the economy overheats.

The US dollar would become a popular alternative to riskier assets like bonds. As a result, the value of risky investments such as commercial paper would plunge.

Stablecoin providers’ reserves could be severely impacted by this. Investors may panic and try to convert their stablecoins into, for example, US dollars, and the stablecoin providers may be unable to give everyone their money back at a 1:1 ratio. This might harm the cryptocurrency market, as well as the entire financial system.

The stability of stable coins is clearly a concern for regulators. According to a recent assessment by the President’s Working Group on Financial Markets, they could constitute a systemic risk, as well as the risk that a large amount of economic power could wind up concentrated in the hands of one provider.

In October, tether was fined $41 million by the US Commodity Futures Trading Commission for pretending to be 100% backed by fiat currency between 2016 and 2019. “Difficult questions” were raised by Bank of England Governor Andrew Bailey, when he noted that the bank was still debating how to regulate stablecoins.

However, it appears that regulators are still unsure about their approach. Stablecoin suppliers should be required to become banks, according to the President’s Working Group report, although Congress was given the final say in the matter. I am concerned that stablecoins may already be too large and dispersed to be effectively controlled by any one company.

As more stablecoins enter the market, the dangers may decrease. Diem, for example, is a stablecoin planned by Facebook/Meta. For now, CBDCs will put fiat currencies on the blockchain as soon as they’re ready to do so.

A digital pound, for example, is being considered by the Bank of England while the EU and China are also making progress in this area. Stablecoins may have fewer systemic hazards if the market is more diverse.

For the time being, we’ll just have to wait and see. It’s worrisome how quickly this perplexing threat has emerged.

Digital assets might face a 2008-style financial meltdown unless governments and central banks step up their efforts to regulate them.