Regulators have raised concerns in recent years that decentralized finance (DeFi) could pose risks to the traditional financial (TradFi) services industry. Those concerns were compounded by events such as the collapse of the algorithmic stablecoin terraUSD (UST) and the failure of the FTX crypto exchange in 2022, which had relatively limited spillover effects on established financial institutions.
Cristiano Ventricelli is the associate vice president of decentralized finance and digital assets at Moody’s Investors Service.
But a new realization has emerged after the recent failures of Silicon Valley Bank and Signature Bank: Distress from established financial institutions could also spread to the DeFi sector.
In fact, that’s what happened this year when Circle’s USD currency (USDC) lost its peg to the dollar on March 10, the day US banking authorities stepped in to take over Silicon Valley Bank (SVB). The fiat-backed stablecoin dipped below 90 cents after announcing that Circle had up to $3.3 billion in exposure to SVB, which had undergone a deposit run.
Other smaller circulation stablecoins also lost their pins, including BUSD, released by Paxos, and crypto-backed stablecoin DAI, released by MakerDAO. Only USDT seemed to benefit from the turmoil, briefly breaking above $1, most likely as investors moved out of deep-pegged stablecoins.
The depeg event was relatively short-lived. After the US banking authorities announced that uninsured depositors at Silicon Valley Bank would be fully covered, the USDC price started to climb towards $1, and USDC, DAI and BUSD remain at their $1 peg as of April 2, 2023.
But according to Moody’s, the risks have now been exposed. What the depegging highlighted is that stablecoin issuers’ reliance on a relatively small number of off-chain financial institutions limits their stability. And wider awareness of these risks could actually exacerbate the situation for stablecoin issuers.
In the wake of the USDC depeg, Circle was able to onboard new banking partners, reducing concentration risk. Nevertheless, TradFi financial institutions may decide to rethink partnering with stablecoin operators, and the reduction in the available pool of financial institution partners could make it even more difficult for fiat-backed stablecoins to maintain stable exchange rates.
In light of these recent events, regulators may tighten their scrutiny of stablecoins. Last year, Terra’s collapse raised concerns about stablecoin reserves, leading regulators to recommend additional liquidity and transparency requirements. Now, the depeg of USDC and other stablecoins points to another set of governance risks related to reserve asset custody. The European Union’s Crypto Assets Regulation (MiCA) briefly addresses this, but leaves the precise regulatory standards to European banking authorities.
Moody’s expects the defaults of Silicon Valley Bank and Signature Bank to lead to additional regulatory requirements, particularly in the area of counterparty diversification. As TradFi and DeFi become more intertwined, particularly through tokenization of real-world assets, the risk of system failure increases, highlighting the need for effective regulation, transparency, and risk management.
There is also a growing interest in exploring alternative solutions to address the shortcomings of stablecoins. One possible alternative is tokenized bank deposits, which allow users to hold digital tokens representing ownership of underlying bank deposits. Tokenized bank deposits would be subject to the regulatory standards of the banking industry, which would provide greater confidence in the safety of the underlying assets, although the credit risks associated with traditional banking would of course remain.
Another potential alternative is central bank digital currencies (CBDC), which are digital representations of fiat currencies issued by central banks. CBDCs could eliminate the need for an external custodian and provide direct access to central bank reserves. In our view, CBDCs are probably years away from large-scale implementation.
Stablecoins are likely to play an important role in the digital asset ecosystem for the foreseeable future, meaning regulators should continue to monitor and address the associated risks.