Stablecoins in a Time of Crisis

Photo by Elena Mozhvilo on Unsplash

Stablecoins are often misunderstood, as the sad reality is that many people only pay attention to the details once things begin to break, not before. I’ve been asked over the past few days which of the current crop of stablecoins would be “safe” in the current environment, so I want to step in to give some first principles views about what works and what does not in the moment.

What Makes a Good (as in, stable) Stablecoin?

There are three primary vectors on which stablecoins should be evaluated:

1. Ease of conversion
2. Transparency
3. Safety of Reserves

There are several elements to each of these points, but I want to start by laying out the core issue that from a safety and soundness perspective, if you don’t understand those attributes for a specific stablecoin, you do not understand if it is stable or not.

Ease of Conversion

This one is simple: can you actually, you know, get dollars out of your stablecoin?

I know this sounds like a trivial point, but it actually matters. Can you have a bank account in a local place, where you can cash in and cash out? Can you do it easily on an exchange? Or do you have to go to an OTC desk on Telegram and then pay a solid fee in order to get in and out, with some rate of speed that is less than ideal?

If you are a user of a stablecoin, make sure you know how you could get back out of it. Thinking in terms of multiple redundancy, you ideally want more than one place (e.g. more than one exchange) where you could do this, either in the form of liquid markets to trade into cash, or where you can get directly out of your crypto and into USD you can send to a bank.

The bridge between Tradfi and crypto is key.

Transparency

The second major question about the stablecoin, and likely one of the most misunderstood, is transparency.

There are two layers to this problem:

The first is if the holders of the stablecoin knows what the reserve is composed of. Does the stablecoin issuer publish reports on a periodic basis? Are they reviewed by an auditing firm and publish attestations on that basis? Are those specific about the assets or very generic? In short, best practices here are that you publish a complete list of all holdings on a monthly basis, and that those statements are reviewed by an auditing firm and there is confirmation over time that they are correct. Why do I say this is the standard? Because trillions (not a typo) of dollars of money market funds can do this on a monthly basis in traditional finance. If a stablecoin issuer is not doing this, it’s not because they can’t, it’s because they won’t and they are hiding something from you. Proceed accordingly.

The second is if you know the reserves are what you think they are. Not in terms of transparency of composition, but rather, in terms of claims. The concept of bankruptcy remoteness is incredibly important here (and relates to the recent collapse of FTX): are the reserves segregated, identifiable, and for the benefit of only the holders of the stablecoin? Or are they on the corporate balance sheet and exposed to other creditors? Lent out in some fashion where the lenders have a claim? Commingled with corporate funds so that even if there were claims of remoteness a bankruptcy proceeding will not likely find that to be the case?

I know for most people in crypto that is a very granular, crunchy, and tradfi-based discussion to have, but it’s exceptionally important. This is a really misunderstood problem even in tradfi (see people thinking bank deposits at a bank are just cash held in a vault, which is very very very not true). But if you don’t understand the holding structure of the stablecoin (it should be either a segregated investment fund, trust company with segregated accounts, or single-purpose bank entity), you don’t know if your money is actually your money if you hold the stablecoin.

Safety of Reserves

The last question is another basic but undervalued one: are the reserves in safe instruments, and just as importantly, what restrictions exist about investing them in unsafe instruments in the future?

One of the lessons of finance in general is that trust in people eventually fails, but trust in systems, structure, and incentives, when properly designed, is more durable. Not perfectly durable, of course, but the track record is significantly better.

To that end, one should ask if the reserves underlying the stablecoin are safe. Here is a quick back of the envelope ranking of how I think about the safety of USD stablecoin reserves (this question would be different for non-USD stablecoins):

1. T-Bills — these are short term obligations of the US Treasury itself, with de-minimis exposure to interest rate risk given how quickly they mature. Put differently, these are only going to materially lose money if the Treasury itself defaults, at which point the stablecoin is probably the least of your worries.
2. ON Reverse Repo secured by USTs — these are marginally less safe than T-Bills in the extreme sense, in that you have longer dated treasuries as collateral in most cases. That’s not the end of the world; those usually rally when things go wrong. But there are some extra steps, either operationally or functionally, to close these trades out if the repo counterparty defaults, and perhaps some small amount of execution risk. With that said, again, still extremely high on the stack of safety and I personally prefer them as an instrument for the daily liquidity.
3. Agency Debt — again, only short dated stuff. This is basically the safest of US gov’t paper outside of the T-Bills. While most of the agencies are not explicitly backed by the government, the implicit guarantee is real, and the market trades it that way. It’s another instrument that historically does not dislocate wildly in a crisis.
4. Bank Deposits — these are necessary for stablecoins, so I list them here. Most of the time, there will not be effective FDIC coverage, and while there can be private insurance, that introduces some amount of credit risk to the insurer. A necessary evil to run a fast payments network (otherwise we are talking about something that will settle slowly for redeeming from the stablecoin), speaking as someone who has done this with my hands. Even so, most US banks are decently regulated, but failures do occur. These are low risk but not risk free.
5. Commercial Paper — this is exposure to private credit. At the very high end of the stack (systemically important US Banks, for instance), I think you approach bank deposits and maybe agency debt for the truly SIFI-designated banks like JPM. These could fail, but if you own that end of the stack, failures here again indicate systemic failure. Moving down from that gets wild fast, as CP to less systemically important institutions or those outside the US is going to be highly credit exposed, so likely to be failing at the same time the stablecoin needs to be able to pay out redemptions.
6. Everything else — if there’s anything else in there, run away.

Some other quick points that one should know the answer two: is leverage permitted? (“No and please leave” is the correct answer) Are the assets be used for anything outside the 1–4 items on the list above? Can they be used for those in the future, even if they are not now (e.g. are there binding guidelines or not?)? Lastly, are the people managing this capable of moving large volumes in times of stress, and do they have a track record of doing so in the stablecoin or other equivalent financial products?

Trust, but Verify

In the end, there are people who play games with these things. If you are going to own a stablecoin, look closely at these three different vectors and ask if you trust the issuer on that basis. Right now is not a time to take risk, especially not with the flight to safety instrument in the portfolio.

Good luck out there.