STABLECOINS, TOO BIG TO FAIL

Throughout history, the main options for sending money from one country to another have included Western Union, which started as a telegraph service in 1871 and later expanded its operations to money serrvice business. Additionally, SWIFT (Society for Worldwide Interbank Financial Telecommunication), established in 1973, has been fundamental for the exchange of financial transactions, such as payments, guarantees, and information between entities globally. These two platforms have dominated the international transfer landscape for decades.

This duopoly ended with the first transaction of Bitcoin, which occurred in 2009 between Satoshi Nakamoto and cryptographer Hal Finney. This new system allows for the electronic transfer of funds from person to person without intermediaries, leveraging the benefits of blockchain technology. However, the problem of Bitcoin's volatility became evident, leading to the search for alternative solutions. Thus, the concept of stablecoins was born, designed to offer stability in a market where value can be unpredictable. In this article, we will focus on those stablecoins whose issuance is conducted by private companies, structured to maintain a stable value relative to the dollar (“USD”) or any fiat currency, meaning that the issuance of a stablecoin is backed by a dollar or another fiat currency, which is considered low risk and easily liquidated.

The first stablecoins were Tether, launched in 2014 by entrepreneur Reeve Collins, along with Omni Foundation executives Brock Pierce and Craig Sellars. Later, in 2018, USDC was introduced, created by Centre, a consortium co-founded by Circle and Coinbase. Both stablecoins were established with the goal of addressing the issue of volatility in the market. Thanks to blockchain technology, all transactions are nearly instantaneous and secure, facilitating both domestic and international payments. Additionally, mobile applications have been developed to allow for quicker access, reducing friction and significantly improving the customer experience.

"Not everything is hunky-dory." When looking at the big picture, it’s important to note that, in most countries, banks offer a “deposit insurance” that guarantees customers' savings and deposits up to a certain limit. This insurance is activated automatically and free of charge when opening a bank account, providing protection in case the bank faces financial difficulties. However, as of now, there is no equivalent entity to a "Federal Stablecoins Insurance Corporation." This means that the companies issuing stablecoins, as the only clients receiving fiat deposits from banks, would benefit from insurance only for those amounts. It is absurd to think that this coverage limit could encompass the total volume of deposits from all those possessing stablecoins in their wallets. This situation poses a systemic risk that regulators must tackle, particularly in countries where there is no clear regulation.

In the market, some VASP (Virtual Asset Service Providers) directly offer a “deposit insurance” for the cryptocurrencies that clients hold in their wallets. Could this be a potential solution to the existing systemic problem? The reality is that issuers of stablecoins lack visibility over the individuals who have their assets in custody; they only know the amount of coins that are in circulation.

These operations are global and require standardization, an objective that BASILEA III aims to achieve through measures from the Basel Committee on Banking Supervision of the Bank for International Settlements (BIS). These regulations will significantly impact stablecoins and can be summarized in three key points:

• Redemption Risks: There is a focus on addressing the redemption risks during periods of extreme stress, when issuers of stablecoins may face massive withdrawal claims. The regulator suggests limiting exposures to these stablecoins to longer maturities by introducing a maximum maturity for individual reserve assets.

  
  

• Over-Collateralization: Should long-term assets be allowed as reserves, the committee recommends these should be over-collateralized. This means that the amount of additional collateral should be sufficient to cover potential decreases in the value of the assets, ensuring that the stablecoin remains redeemable at its fixed value, even during difficult times and volatile markets.

  
  

• Credit Quality Criteria: It is suggested that stablecoin issuers rely on a list of high credit quality assets for their reserves. These assets could include reserves from central banks, government-backed securities with high ratings, and deposits in high-quality banks.

It is important to highlight that these measures apply to banks but are not binding for stablecoin issuers. To put this into perspective, recall that the adoption of BASILEA II took three years, and the information generated by these new regulations will remain in the banks' hands for communication to financial authorities. Historically, banks and autorithies have not been quick to prevent a financial crisis.

There are several concerning similarities between the 2008 financial crisis and the issuers of stablecoins. Below are some of the most notable comparisons:

• Lack of Transparency in Risk Assessment: During the 2008 crisis, the methodologies used for assessing credit risk were poorly understood, and only a few had access to this information. In the case of stablecoins, there is no fixed limit on the amount that can be minted according to the smart contract governing them, leading many to be unaware of the conditions and terms of their programming.

  
  

• Trust in Auditing Entities: In 2008, rating agencies provided information about credit portfolios; today, it will be auditing firms that are responsible for validating the “Proof of Reserve” of stablecoins. However, doubts arise about the reliability of these auditors, and the reality is that little can be done about trust in this regard.

  
  

• Potential Domino Effect: Lehman Brothers had strong ties with other banks, especially in the realm of investment and financial intermediation. Its collapse triggered a domino effect in the financial system. Currently, stablecoin issuers are forming significant alliances with major players like Blackrock, Robinhood, Visa, and Mastercard. Such partnerships could create an even broader domino effect, given the global nature of these platforms.

  
  

• Incentives for Regulatory Laxity: High fees for loan placements and minimal oversight led to the creation of toxic assets for banks in 2008. Today, the money that banks will receive as collateral from stablecoins is extremely attractive. This could result in a lack of control and a lax approach toward issuing companies, as these entities represent valuable clients for banks with multiple investment opportunities.

In conclusion, the landscape of stablecoins is continuously evolving and presents both significant opportunities and challenges. As the use of these backed cryptocurrencies continues to grow, and in light of concerns regarding volatility, lack of regulation, and transparency, it is imperative that both issuers and regulators remain vigilant.

With regulations such as MICA (Markets in Crypto Assets) in the European Union and the Genius Act and the Stable Act in the United States, set to come into effect by 2025, a regulatory framework is being established to legitimize and protect this new financial ecosystem. However, the global nature of blockchain transactions demands greater agility in the implementation and oversight of these regulations.

Those managing substantial amounts of stablecoins, due to the nature of their businesses, must be particularly attentive to their reporting and transparency obligations of the companies that mint or create stablecoins.

Moreover, it is crucial that authorities not only focus on formalizing these regulations, but also address the systemic risks that emerged during the 2008 financial crisis, which could resurface in the context of stablecoins. With the insights gained from past crises, it is vital that the financial sector and regulators collaborate to create a safe and efficient environment, protecting users and stabilizing the financial system as a whole.

This task is not easy, but a proactive approach and cooperation among all involved parties can help mitigate risks and maximize the benefits of this innovative way to send and receive money.

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By Jorge Tavares.

Co-Founder en Legal & Compliance Advisors, con experiencia de 15 años en el sector financiero, los ultimos 7 años asesorando a los principales proyectos de crypto en México Seleccionado como abogado líder por la revista los mejores 100 abogados de México. Diplomado en Banca Digital y Fintech por la Universidad Internacional de la Rioja España. Master en Blockchain Esden, Escuela de Negocios, Madrid España.

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