Are Stablecoins a Threat to Financial Solvency as Regulators take Increasing Note of these Tokens in the Crypto Ecosystem?

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“The values of other algorithmic stablecoins also fell, with FRAX and DAI decreasing by 47 percent and 32 percent, respectively, between end-1Q22 and end-May,” the report added.

Stablecoins are becoming a bigger component of the cryptocurrency world. Tether, the most widely used stablecoin, is also the most traded cryptocurrency, with several billion dollars changing hands every day.

Stablecoins, unlike other cryptocurrencies, are tied to a specific quantity – usually the dollar – either through asset backing or an algorithmic mechanism. As a result, they aren’t very useful as a speculative asset class. So, why should institutional investors care about stablecoins, and why should authorities like the Bank of England be concerned?

Regulators have becoming increasingly interested in stablecoins, with Bank of England governor Andrew Bailey stating last year that he was “sceptical” that stablecoins could ever be considered a safe asset. A consultation paper released last week stated that the UK Treasury will give the Bank of England authority to deal with failed, systemic stablecoins.

Following the collapse of Terra (or TerraUSD), a large algorithmic stablecoin, regulators have began to focus their attention on the threats that stablecoins pose to financial stability, both within the crypto market and throughout the economy.

Until recently, the stablecoin market had experienced fast expansion. The stablecoin market decreased for the first time since Fitch Ratings began tracking it between the end of March and the end of May, owing primarily to the collapse of the Terra.

“The aggregate market capitalization was $162 billion at the end of May, down 14% from $188 billion at the end of 1Q22,” the business said.

In addition, the firm stated that “Other algorithmic stablecoins’ prices fell as well, with FRAX and DAI decreasing by 47% and 32%, respectively, between the end of 1Q22 and the end of May. New algorithmic stablecoins have, however, been established, and they have quickly gained market dominance, thanks in part to aggressive staking campaigns.”

The usage of stablecoins in borrowing and lending, which often offers better yields than traditional money market instruments, has been critical to their development. “This is what 99 percent of owners do with their stablecoins,” said Yves Choueifaty, president and CIO of TOBAM.

However, following the recent demise of Terra, this technique has come under fire, with many accusing high yield crypto returns of operating like a Ponzi scheme.

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Stablecoins are also important to the crypto economy, according to Adam Sze, head of digital assets product at Global X ETFs, because they “give an on-ramp to the digital asset ecosystem,” making it easier for investors to buy other digital assets like Bitcoin or NFTs.

“Stablecoins are a way of efficiently transporting USD between trading venues utilizing crypto rails, which is far faster and efficient than using slow and limited fiat rails,” said Anatoly Crachilov, CEO of Nickel Digital Asset Management.

“Stablecoins are vitally crucial for cryptocurrency markets and offer liquidity for the complete range of crypto assets,” said Clara Medalie, Kaiko’s strategic initiatives and research director.

Libra and Tether

One of the most well-known stablecoins was Libra, which was launched as a potential stablecoin by Facebook (now Meta) in 2019 in conjunction with firms like as PayPal, eBay, Mastercard, Visa, and Stripe.

It was eventually abandoned at the beginning of this year, following a rebrand to Diem in 2020 and various legal and regulatory hurdles, as well as an announcement that it would be shifting its peg from multiple currencies to simply the US dollar.

The full history of Libra is beyond the scope of this piece, but it is perhaps one of the most important stablecoins to understand, despite never existing. The serious regulatory pushback from the Federal Reserve and Treasury Department that Libra faced caused it to shut down, while other stablecoins such as Tether have flourished with no regulatory oversight.

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Tether is the most traded cryptocurrency in the world and the largest stablecoin by market share. It is designed to be tied to $1. However, it has been embroiled in a slew of legal issues and disputes during the last seven years.

Tether is a cryptocurrency that is issued by Bitfinex, a cryptocurrency exchange. Tether’s reserves were used to cover up losses from Bitfinex, and the cryptocurrency has been plagued by deception over the quantity of cash vs commercial paper utilized in its reserves. Despite briefly deviating from its peg during the collapse of Terra last month, it continues to be quite popular.

Investors in backed stablecoins should not compare Terra to others like Tether, according to Kaiko’s Medalie, because Terra “relied on a severely defective algorithmic stabilisation method.” “Tether could collapse if it is discovered that the stablecoin is not completely backed,” she said, “resulting in a loss of faith and depegging.”

Tether’s creators, according to Crachilov, have not been “especially forthright in their communication with the market, which has historically produced lingering anxiety about the soundness of their reserves.” He did, however, note that Tether’s “latest de-peg to 0.95 cents was adequately contested, with USTD mainly returning to its peg within hours.”

Fitch noted: “The market remains concentrated, with Tether and USDC accounting for about 63% of total assets at end-May. Tether’s portfolio has reduced its credit risk and duration, and increased its liquidity. As of end-1Q22, less than 0.5% of the CPs and CDs in the reserve portfolio were rated ‘F3′ or below. It holds 48% of its portfolio in the form of US treasury bills”

Financial stability

Analysts are still split on whether stablecoins pose a real threat to financial stability. “The worldwide stablecoin market is $150 billion [£123 billion],” Choueifaty claimed. “The negative return of Snap Inc resulted in as much loss as Luna/Terra in a single day,” he continued.

Crachilov agreed, saying that “stablecoins are still modest in comparison to the equities and bond markets,” but that “their potential influence would be greater crypto ecosystem, as they play a key part in derivative market structure.”

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Last week, though, the Treasury warned that the loss of a systemically important stablecoin might have “a wide variety of financial stability and consumer protection implications.”

“Events in cryptoasset markets have further underlined the need for adequate regulation to assist manage consumer, market integrity, and financial stability risks,” according to the Treasury.

The failure of a systemic organization that operates a stablecoin, according to the Treasury, might jeopardize “continuity of services important to the operation of the economy” as well as “individual access to their funds or assets.”

Analysts believed that regulation was on the way, as watchdogs like the Bank of England began to worry that a crypto crash may lead to broader financial concerns.

Crachilov said he expected “much stricter reserve requirements, alongside increased transparency and disclosure expectations.

However, regulation may actually “help reduce speculation among digital assets, which could lead to lower volatility and increased investor confidence,” according to Sze.

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