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Understanding Key Risks Associated With Stablecoins

Merkle Science· 5 min read

Stablecoins — pegged to a dependable fiat currency such as the US dollar — were set to become a cornerstone of the crypto ecosystem; however the failure f the algorithmic peg mechanism fixing the price of Terra’s USD stablecoin (UST) and the unmooring of Tether from its USD peg highlight some of the risks associated with stablecoins. TerraUSD (UST), which used to be one of the largest stablecoins, shed light on market run risks associated with stablecoin when it completely lost its dollar peg, earlier this month. UST is still struggling to regain its dollar peg despite initiating multiple remedial measures. Further, on May 19, 2022, the world’s largest stablecoin, Tether, momentarily lost its dollar peg and dropped to 95 cents, much below the $1 threshold it is supposed to maintain. The fallout from Tether’s brief dip from its peg resulted in investors withdrawing more than $7 billion from Tether, once again raising fresh questions about the reserves underpinning the stablecoin.

On May 9, 2022, the Federal Reserve released its semi-annual Financial Stability Report, which highlighted the run risks of stablecoins. U.S. Secretary of Treasury Janet Yellen echoed The Federal Reserve’s concern over stablecoins. On May 10, 2022, in testimony before the Senate Banking Committee, she observed that “we see run risks, which could threaten financial stability, risks associated with a payment system and its integrity and risks associated with increased concentration if stablecoins are issued by firms that already have substantial market power.” In light of UST losing its peg, she further warned that “these risks are not hypothetical, they are playing out in real-time.” The U.S. Department of Treasury is soon set to release a comprehensive report on crypto and stablecoins. This is not the first time that stablecoins have come under regulatory scrutiny. In December 2021, the U.S. States Senate Committee on Banking, Housing, and Urban Affairs held a hearing on stablecoins, in which it discussed the possible impact of stablecoins on financial stability. On November 1, 2021, the President’s Working Group (PWG) on Financial Markets released its highly-anticipated report on stablecoins. The PWG listed loss of value due to market runs as one of the major prudential risks associated with stablecoins. Further, following up on a hearing held by the U.S. House Committee on Financial Services, in February 2022, the U.S. Department of Treasury, in order to ensure investor protection and maintain financial stability, called for stablecoins to fall under the remit of federally issued depository institutions.  

Some of the prudential risks attached to stablecoins include loss of value, payment systems risks, and risks of scale, it also highlights other important risks such as market integrity and investor protection, illicit financing, and DeFi risks. Some of the risks outlined in the report include:

Major Prudential Risks Associated with Stablecoins

Some of the prudential risks attached to payment stablecoins such loss of value, payment systems risks, and risks of scale, it also highlights other important risks such as market integrity and investor protection, illicit financing, and DeFi risks. Some of the risks outlined in the report include:

Loss of Value: These are the risks related to stablecoin users in case of a run. Increased use of stablecoins may lead to increased prudential concerns such as the use of reserves assets that may fall in price or become illiquid, failure to appropriately safeguard reserve assets, lack of clarity regarding the redemption rights of stablecoin holders, and operational risks related to cybersecurity and the collecting, storing, and safeguarding of data.

Further, the mere prospect of a stablecoin not performing as expected could result in a “run” on that stablecoin, which may occur when many stablecoin holders try to liquidate their holdings, resulting in a “fire sale” of reserve assets. Fire sales of reserve assets are especially detrimental as they may lead to disruption of critical market functions, depending on the type and volume of reserve assets involved. The report warns that runs could rapidly and contagiously spread from one stablecoin to another.

Payment System Risks: Payment stablecoins can also face the same basic payment systems risks plaguing traditional payment systems. These risks include credit risks, liquidity risks, settlement risks, and risks arising from improper governance systems. However, unlike traditional payment systems that are centralized, some types of stablecoins, such as algorithmic stablecoins, may be decentralized. This means that no single entity is responsible for risk management and operational resilience of the entire arrangement. As a result, payment system risks of stablecoins would also include operational risks and stablecoin arrangement risks. 

Operational issues caused due to factors such as reduction, deterioration, or breakdown of services that can disrupt the ability of users to make payments fall under underpayment risks. These risks have the ability to disrupt payment activities.

Stablecoin arrangement risks are caused by those stablecoin arrangements that do not clearly define the point at which settlement is final in their rules and procedures pose heightened uncertainty and create credit and liquidity pressures for arrangement participants.

Risks of Scale: Rapid scaling from the increase in demand for an individual stablecoin will lead to three sets of policy concerns. 

Firstly, stablecoin issuers or key participants such as custodial wallet providers could cause systematic risks. For example, if the custodial wallet provider fails, the financial stability of the market can be adversely affected. Secondly, the combination of stablecoins held by a stablecoin issuer or wallet provider and a commercial firm could lead to an excessive concentration of economic power. Thirdly, stablecoins that become widely adopted as a means of payment could present concerns about anti-competitive effects. For instance, users of a stablecoin may face undue frictions or costs in the event they choose to switch to other payment products or services. 

Other Important Risks Affecting Consumer and Investor Protection

Market Integrity and Investor Protection: These risks encompass possible fraud and misconduct in digital asset trading, including market manipulation, insider trading, and front running, as well as a lack of trading or price transparency. Further, digital asset trading platforms and other market participants such as custodians or exchanges play a key role in providing access to stablecoins and liquidity in the market for stablecoins.

Illicit Financing Risks: Stablecoins also pose illicit finance concerns and risks to financial integrity, including concerns related to compliance with rules governing AML/CFT activities.

DeFi Risks:  Digital asset trading platforms and DeFi arrangements present risks of particular focus to the agencies, and most notably to the SEC and CFTC. Among others, these risks include increased reliance on stablecoin arrangements on digital asset trading platforms and vice versa. Potential AML/CFT risks and risks may arise from unique aspects of distributed ledger-based arrangements. These include governance issues, interoperability, scalability, protocol and smart contract vulnerabilities, cybersecurity, and other operational issues.

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