Stablecoins and Risk. How stable are stablecoins? - Olaf Ransome

22 March, 2024 

This is the second in a monthly series on things liquidity. Stablecoins are the initial focus. Last week, I covered some of the basics. This week, we’ll talk about risk.

Stablecoins vs. holding Bitcoin

With Bitcoin at an all-time high, the only thing you might be worried about is being able to get and out of the market quickly. An understandable view might be: “I don’t care whether I hold Tether or USDC, I just want to be able to buy and sell BTC without any delay.” Fine, keep trading and put this aside to read when you have a moment.

If you want to know about risk and are not trading BTC, then just keep reading.

Functions of Money

There are four functions of money:

1. Store of value 

2. Medium of exchange

3. Unit of account

4. Means of payment

If a Stablecoin helps you trade BTC, then you are dealing with #2, #3 and #4. Is the Stablecoin a store of value? Maybe. Here’s why.

If you have a £50 pound note in your pocket, you are pretty sure you can use it to buy goods in England for up to £50 pounds. Pound notes tick all four functions. If you have a balance of £5,000 pounds in “commercial bank money” in your Lloyds Bank account, same thing. You probably realise that you have some risk; the risk that Lloyds Bank goes bankrupt and you lose your money. You know too that there is a deposit protection scheme with the Financial Services Compensation Scheme covering the first 85k.

You also know that if you have more than £85k you are on your own. So, you chose your bank carefully and you might even split up your cash amongst several banks. Less risk. Good.

Accounting: unsecured receivables

If you use the services of JP Morgan (JPM) in US dollars, you might have heard that JPM has something called JPM Coin. JPM Coin has some very clever capabilities which allow you to do some more sophisticated things when making payments. Let’s call that “programmability”; pay 100 to X, but only if my balance is greater than Y, or only pay after 12:00 on Friday. And JPM Coin runs on some new internal systems (or 'rails,' if you prefer) which will let you do things internally at JP 7 x 24 x 365.

Wonderful, lots of new possibilities. A big step up from the typical legacy platforms. From a risk perspective though, it does not matter whether you have an account in USD with a balance of $1 million or the same amount in JPM Coin; in accounting and risk terms you have an unsecured receivable. If something happens to JP Morgan, you are a creditor of JPM. There are no specific assets pledged to clients who hold JPM Coin. So JPM Coin or fiat US dollars in an account don’t change anything; you still want to manage your balances and not have all your eggs in one basket.

If you have an account balance with an e-money provider such as Monerium, then the operator has to keep assets equal to 103% of the deposits. The same will apply when DWS sets up AllUnity and provides another EUR denominated Stablecoin. That might be money at a central bank or it might be money at commercial banks. E-money providers typically aren’t allowed to do any lending. So, you don’t have to worry about the e-money provider not having assets, but you do have to worry about how well the operator manages the quality of those assets. Again, you don’t want all your eggs in that one basket.

The layer cake of risk

If you buy and hold either Tether or USDC, the picture changes slightly. You end up with what I call a 'Layer Cake' of risk. First, where are you holding this asset? If it is at an exchange and not in a self-custody wallet, you have counterparty risk with that institution. Are your assets properly segregated? Regulated financial institutions have to follow lots of rules on this. Unregulated ones don’t. Lots of FTX customers found out all about this.

Is the operator sound?

Now let’s look at Tether. Your next risk is Tether as an issuer and operator of a Stablecoin. Do they really operate on a sound basis? Tether has not been very transparent and has been in troube with regulators for making dodgy loans to other group companies. USDC is more regulated and arguably has better governance. Again, this is counterparty risk.

Where is the cash?

The next layer of risk is all about where Tether holds the underlying USD or other sound investments.  At some point, Tether held USD with a Caribbean bank, which in turn held its money with a correspondent bank in the US; yet another layer. Tether also held some securities. USDC also does the same. Holding these instruments is like holding a money market mutual fund. It is a collective investment vehicle. Again, this is counterparty risk, with some market risk on top. Again, you don’t want all your eggs in that one basket.

Payment Systems

The risk profile changes significantly when we look at new forms of payment like Fnality with its Sterling Finality Payment System (£FnPS). Users have a balance with a payment system and Fnality has all those GBP as reserves with the Bank of England. So, no commercial bank risk, no market risk.

What about if Fnality goes bankrupt, what do account holders have a claim on? Remember with JPM Coin, you have a claim on JPM. There would be lots of preferred creditors, such as employees and the tax man, ahead of you in the queue. Fnality has a special construction which makes the cash balances held with the Bank Of England bankruptcy remote from the operations of Fnality; in other words, the clients collectively have a collective, direct claim on the reserves at Bank Of England. There is no risk that some bad management by Fnality means your claim cannot be met. It is as good as cash.

This is an institutional grade solution. You are no longer worried about counterparty risk or market risk. You can be confident in the store-of-value.

What’s in it for Tether and USDC vs. others like Fnality?

Interest. If they can arrange to be paid interest for holding cash, or for buying some short-term money market instrument, they keep it all because they are not paying you interest on your balances in their Stablecoin. Fnality is different; their clients are banks and other FIs, all of whom won’t settle for zero interest.

How to think about the risk of Stablecoins

Start with the Fnality model in your head. Is what you are thinking about getting into “as good as cash”? If it is, you have as near as damn it no risk. You can hold it as a store-of-value for as long as you want.

Where are your Stablecoins held? Is that institution licensed and regulated? If there is no other reason to keep the relationship, find a regulated provider.  

Is the Stablecoin operator running a treasury, so holding cash and short-term investments? Then, you need to think about both who the operator is and secondly where you have your holdings. At a simple level, a wise person would not be putting too big of an egg in any one basket.

Is the Stablecoin operator licensed by a recognised regulator and do they have to back the coin in cash, i.e. like e-money? If the answer is yes, then check for the deposit insurance coverage. If the operator is covered, then you have a level up to which you are comfortable. Beyond that, think about distributuing the holdings.

Thanks for reading. Please do let me know what you think of these notes. Feedback via the comments would be great.

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Olaf is a liquidity ad financial services expert. He is the founder of 3C Advisory  You can message Olaf directly here.