12/04/2023 Alexander

How are stablecoins different to CBDCs in terms of risk?

Joined by Carol Van Cleef, Pawel Kuskowski speaks from the 9th Compliance & AML Conference in Warsaw about the global and crypto perspective for stablecoins and CBDCs.

When the agenda for the conference programme was put together, picking FTX as a focal point was a great idea, but in the few weeks leading up to the conference, significant events shook up the crypto banking industry.

Firstly, there were 3 bank closures – one of them being a voluntary orderly wind down where the shareholder values would be protected to some extent. This was followed by a very well publicised bank failure that was a real run on deposits which caused the regulator to move very quickly. The third failure followed within 48 hours which employed a different element of US law and involved a different set of issues. A bank run had started on the entity but the closure was due to what the federal reserve said was systemic risk issues which raised a lot of eyebrows.

Regarding stablecoins and CBDCs, Carol says that we have all been on edge regarding stablecoins for almost three years now. She adds that the President of the Federal Reserve Bank in the US raised the issue of systemic risks associated with stablecoins in a presentation back in June 2020.

The presentation highlighted the fact that stablecoins could present systemic risks. Almost two years later, the US Secretary of Treasury Janet Yellen has named Tether (also known as USDT) a stablecoin concern. The sort of principles surrounding stablecoins were the ones that really acted as the catalyst for the series of banking closures which unfolded in the US in March 2023.

Basically, stablecoins are cryptocurrencies created by entities like the United States Dollar Coin (USDC), Tether and each of the entities have a different set of viewpoints regarding the word “stablecoin”. However, stablecoins involve different sets of risks as well – one being the US-based Circle and the other one being Bitfinex.

Why is USDC specifically different?

Tether was created out of the turmoils of trying to get fiat money into crypto. Back in 2016, US was going through one of those debanking and de-risking periods that they have been experiencing periodically for over the last twenty years. In that period, banks were becoming less comfortable with their clients moving fiat into crypto exchanges and were closing accounts of those clients who had crypto involvement. Stablecoins were supposed to be the solution to avoid having multiple conversions of fiat to crypto and then crypto to fiat when the value of the crypto appreciated in fiat terms.

However, Carol adds that stablecoins were supposed to be stable.

Carol then shares that when she worked for a digital currency that was 100% backed by gold, with gold bars sitting behind a gold repository, she oversaw the sale of $100 million worth of gold when they unwound in 2008.

The definition of stablecoin today could be backed by different vehicles, not just gold. However, the one that is most relevant today is fiat backed, where fiat is turned into a stablecoin and then the fiat is put into a bank account. The critical point is that it is going into a bank account.

What is Tether backed by?

This became a point of controversy which the New York State Attorney General looked into in 2018/19. The composition of the Tether (USDT) backing was a combination of fiat, government securities, as well as commercial paper. This is where the systemic risk came in as it became clear that if banks invest in commercial paper, it had to be of a certain rating – AAA rating in the case of Silicon Valley Banks.

What was that commercial paper and how good was it?

This became a big issue back in 2018 when there was some problem in the Chinese real estate market and a rumour that Tether had commercial paper from a troubled entity spread. They essentially made a loan with their dollar backing into this company that might go bankrupt and that is what raised the concerns of the Federal Reserve in 2020.

Where is USDT actually created from?

The New York State Attorney General had taken issue with the fact that USDT was backed by a combination of fiat plus government securities plus commercial paper rather than the 100% fiat backing it claimed to have.

Watch the whole discussion:

What is the level of regulatory overlay?

Circle and Coinbase have been the organising parties and issuer, and both of them are regulated at the state level as money transmitters. It’s more or less under the guise of that authority or regulatory supervision that these coins are being overseen. Moving beyond that though, there does not seem to be another, except for Paxos which also has a regulatory structure. Regulatory scrutiny from the European-US perspective however is much lower. In any case, the more blockchains we use for stablecoins, the more difficult it is to trace.

What is the function of USDT?

Pawel says that the crypto currency market is putting much more trust in USDT as opposed to USDC. Carol explains that USDT has the first mover advantage because it was available sooner so it helped to fill a void in the marketplace with their instant settlement capability available 24/7.

Attitudes towards Central Bank Digital Currency

Everyone in the libertarian world dislikes the idea of Central Bank Digital Currency (CBDC) but at the same time, we are starting to face the problem with rails into crypto, on-ramping and off-ramping, in a secure way. A lot of people are asking “where can we open a bank account?” because it’s a systemic risk for them to be cut off from the on/off ramping.

Pawel says that people believe CBDCs will be easier to trace by the government who will be able to switch on/off people’s crypto wallets or at least control the number of things people can spend it on within a limited timeframe. As it is programmable, there are several issues for people to be concerned about, one of which is privacy since the government can basically see you.

Carol adds that this might encourage spending through private channels. In the US, there is a long history of private currencies including community based and company based currencies like Disney Dollars.

Where are we in terms of CBDC?

The US Government moved in to ensure all deposits regardless of size would be protected, whereas previously there was a limit of $250,000. The question is, at what point does it make more sense instead of just giving that guarantee out and allowing and/or encouraging risky behaviour with our money by entities that may not be as qualified as we think they are to manage our money, move it into a safe haven and sit at a bank? Is this a step towards the Federal Reserve System being the ultimate bank and holding deposits to prevent the next crisis? However, the barriers to this is firstly, the maturity of the technology considering hacks are happening in blockchains and wallets and secondly, the issue of adoption.

How big is the crypto world?

As of now, only around 2% of the world population can be labelled as part of the crypto community. However, millennials and Gen Z are expected to adopt crypto much faster than those who have already retired in the 90s and want nothing to do with technology. To gain adoption in the older generation, incentives such as government benefits and social security may encourage baby boomers to get more involved.