Stablecoins Aren’t a Problem for the Financial System, Until They Are

While regulators are circling around the alleged illicit flows in cryptocurrencies, the systemic risks of stablecoins may already have seeped into the financial system.

“Gear down.”

“Gear down,” called out the First Officer Albert Stockstill, as he reached for the gear lever on their (at the time) state-of-the-art Lockheed L-1011 Tristar.

Captain Robert Loft waited for copilot Stockstill to call out the usual “three greens and locked.”

But instead, Stockstill stared at the nose gear light that was supposed to have lit up when the landing gear of their Tristar was down and locked.

“What’s the matter?”

“Only two lights Captain. Something’s not right.”

Unsure if their aircraft had all of its gear down and locked, the flight crew requested Miami International Airport for permission to maintain a holding position somewhere west of the Florida Everglades while they sorted out the problem.

Despite cycling the landing gear the nose light refused to illuminate, so Captain Loft tasked First Officer Stockstill to put the aircraft into autopilot, while the engineer went below the flight deck to figure out whether the gear was really lowered and locked.

While the crew in the cockpit continued to obsess about the nose wheel light that refused to illuminate, they accidentally bumped off the autopilot system sending the Tristar into a gentle decline in the darkness.

Distracted, the pilots didn’t notice the altitude warning chime as the massive jet descended from their selected altitude and in the darkness of night in the Everglades, smashed into the ground at 227 miles an hour.

In the ensuing investigation, it was found that the right engine was still spinning as the Tristar broke up upon impact with the ground.

As it would turn out, the nose landing gear on the Tristar was working just fine, but a small US$12 light bulb had brought down a multimillion dollar jet.

Focusing on the wrong things, can sometimes lead to disastrous outcomes.

Watch the Gear Not the Lights

Which is why even though regulators are obsessing over the potential use of cryptocurrencies for crime and money laundering, the bigger risk to the financial system comes not from those use cases, but stablecoins.

All around the world, regulators are cracking down on the more visible potential weak spots that could facilitate illicit flows, like cryptocurrency exchanges, but the real risks lie hiding in plain sight.

The United Kingdom has cracked down on Binance, the world’s largest cryptocurrency exchange by traded volume, as have regulators in Japan and Thailand.

Their primary beef with Binance has been its allegedly lax know-your-customer and anti-money laundering practices.

Earlier in August, the crypto-savvy Gary Gensler, Chairman of the U.S. Securities and Exchange Commission lamented that cryptocurrency markets were “rife with fraud, scams and abuse,” calling on members of Congress to award his agency with greater regulatory powers.

While governments and regulators have an obligation to fight the deception, tax evasion and money laundering that they allege is endemic in cryptocurrencies, the actual data is far more benign.

Not so Scary

According to an annual report by blockchain analytics firm Chainalysis, illicit transactions as a proportion of all cryptocurrency activity fell to just 0.34% for all of 2020, compared with 2.1% in 2019.

While CipherTrace, another blockchain data firm put the figure at “less than 0.5%.”

And the absolute values of these illicit flows, around US$10 billion in 2020, is a small fraction of global money laundering activities.

According to the United Nations, it’s estimated that as much as 5% of global GDP is connected with money laundering, or around US$4 trillion.

As money laundering tools go, cryptocurrencies are barely a rounding error for illicit flows, let alone the instrument of choice for criminals and other nefarious activities.

If nothing else, cryptocurrencies are far harder to launder than the uninitiated or the mainstream media would have us believe.

Take the proceeds from the Colonial Pipeline hack, Dread Pirate Roberts and the most recent PolyNetwork hack — while criminals may get into the vault, it’s the laundering and spending of those ill-gotten gains that is the biggest challenge.

Yet given the “criminal” overtones that governments like to associate with cryptocurrencies, they are glossing over the much larger risk that this nascent asset class poses to the financial system — they’re like the pilots who focused on the nose gear light instead of flying the plane.

And nowhere is that risk more concentrated than in stablecoins, cryptocurrencies that peg their value or are nominally backed by their fiat currency equivalents or other real assets.

The Myth of Stability

The promise of stablecoins is stability, and while blockchain technology can avoid the need for trusted third party intermediaries, it can’t avoid the need to follow market forces — pledges of stability almost always presage crises.

The 2008 Financial Crisis demonstrates that even banks, which appear on the surface to be stable, can be susceptible to crisis.

By offering deposits that are redeemable on demand and superficially riskless, banks take on risk by backing these obligations with longer-term, less -liquid and riskier assets, making them vulnerable to runs.

And in that respect, stablecoins aren’t so different from banks.

Tether, issuer of USDT, the world’s first and most popular dollar-based stablecoin, is a prime example of how that systemic risk to the financial system is often papered over.

Of US$62 billion worth of USDT in circulation, according to its most recent disclosure in March, only a meager 5% was in cash or safe and liquid securities like U.S. Treasury Bills.

The other 95% of Tether’s assets were in far riskier instruments, with about half in the commercial paper market.

To be fair to Tether, its problems stemmed from the banking system to begin with.

Having been initially denied regular banking services, like a displaced person, Tether has been shuffling to try and find a safe harbor for its dollar reserves.

And commercial paper, especially for some of America’s biggest companies, while not exactly the equivalent of Treasuries, have of late, thanks to rock-bottom interest rates and low yields, been treated by some investors as the near-equivalent of safe securities.

Today, over US$100 billion is in stablecoins, and while that’s a big financial footprint, it’s not enough to destabilize the financial system in and of itself.

It’s where that money gets deployed that becomes problematic.

It’s How You Use It

Extrapolating from Tether’s disclosures, the stablecoin holds some US$30 billion of commercial paper, which makes it the 7th largest investor in this asset class globally, not far behind the massive funds run by the likes of Vanguard and BlackRock.

And if the commercial paper market was to come under pressure, it wouldn’t take much for a “run” on Tether to collapse it altogether, taking with it the commercial paper market.

With an estimated leverage of 383-to-1, a loss of just 0.26% on its commercial paper holdings would cause Tether to be unable to honor all of its USDT obligations.

But the reality is that it’s highly unlikely USDT holders will demand all of their USDT be swapped to dollars at the same time, or is it?

Policymakers have criticized stablecoins, comparing them to the period in U.S. history where “free banking” was common — privately issued banknotes of uncertain value, circulated in the American economy in the 19th century.

But a perhaps more useful analogue would be to compare the likes of Tether and other stablecoin issuers to massive money market funds, which were created in the 1970s to circumvent the rules limiting the interest banks could pay to depositors.

Despite pledging to maintain the value of their shares at a dollar (the stability fallacy) money market funds blew up in the aftermath of the 2008 Financial Crisis forcing American taxpayers to step in to forestall a fire sale of money market fund assets and prevent a crash in the market for commercial paper, on which the real U.S. economy depends.

The same thing could happen for stablecoins.

A Crack in the Dam

A chain is only as strong as its weakest link.

As interest in cryptocurrencies grows, the demand for stablecoins, which serve a variety of uses, has also grown alongside.

Stablecoins are often used in cross-border payments, facilitating self-executing smart contracts and providing a temporary rest stop when traders are trading out of other cryptocurrencies.

But stablecoins are also largely unregulated, and typically don’t publish their balance sheets — Tether is the exception after running into issues with the New York Attorney General, requiring it to make such disclosures.

And we’ve all seen what happens when things that look and act like banks start burying assets in their balance sheets.

To be sure, US$100 billion isn’t a lot of money in the global financial system, but that’s precisely why it poses the biggest risk — because nobody thinks enough to watch it.

While authorities globally obsess over the alleged money laundering and illicit flows facilitated by cryptocurrencies, it’s actually the small sector carved out by stablecoins that are the US$12 light bulb that could potentially destabilize the entire financial system.