Stablecoins are entering a period of great uncertainty following the U.S. Securities and Exchange Commission labeling BUSD an “unregistered security” and ordering Paxos to stop minting new tokens.
Do these moves signal a wider war by U.S. regulators on stablecoins? Could the SEC declare all stablecoins securities, or is BUSD a special case?
Independent crypto reporter Amy Castor, who has been covering cryptocurrencies since 2016, believes the BUSD crackdown is aimed squarely at the world’s largest crypto exchange, Binance:
“Going after Paxos-issued BUSD is part of a much broader crackdown on crypto. They are going after the jugular, and they plan to cut off the blood supply.”
She continues, “They want to kill BUSD because BUSD is critical to Binance, which is the largest offshore crypto casino. Binance auto-converts every U.S. dollar and stablecoin to BUSD (the pegged version). Now they’ll have to find something else to auto-convert to… probably Tether. So, maybe the authorities will target Tether next, something that has been a long time coming.”
Even before these regulatory moves on BUSD, various indicators showed a large redemption of stablecoins between September 2022 and February 2023. Could a bank run on redemptions lead to a significant stablecoin depegging event? Some think so, pointing to convoluted cash reserves held by stablecoin treasuries, the need for third-party audits, and the uneasy relationship between stablecoins and the U.S. Treasury.
So, how stable are stablecoins?
Types of stablecoins
A stablecoin is just a token pegged to the value of an asset, an algorithm or a fiat currency. They’re hugely popular as a de facto working capital for traders or as a safe haven to cash out, with the total value settled using stablecoins last year hitting $7 trillion — that’s more than Mastercard.
As of Feb. 10, the three big dollar-denominated fiat-collateralized stablecoins (USDT, USDC and BUSD) represent almost 12% of the total crypto market cap and account for 91.58% of the entire stablecoin supply.
Given that the U.S. dollar is the global reserve currency, stablecoins gravitate toward it as a peg, but there are other categories. Asset-collateralized stablecoins use real-world assets, such as gold, for collateral to maintain stable price levels, like with Paxos’ PAXG.
Stablecoins collateralized by baskets of cryptocurrencies are backed by other cryptocurrencies and stablecoins, which might themselves be asset-collateralized or fiat-collateralized. MakerDAO’s Dai invented this model. Dai is an algo-stablecoin backed by various other stablecoins, Ether and wrapped Bitcoin.
Most controversial, algorithmic stablecoins combine a decentralized minting mechanism with economic incentives to maintain their peg to a target value, usually the dollar. Automated processes — in theory — keep their value close to that target. Clearly still experimental, price peg algorithms let traders mint and burn coins as needed to maintain their price.
In May 2022, Terra’s algorithmic stablecoin, UST, famously depegged because of its circular dependency design. Multiple wallets exploited vulnerabilities in the Terra ecosystem and its automated procedures. The UST stablecoin — and its collateral token, LUNA — collapsed, dragging the market into another winter.
The bad news is that fiat-collateralized stablecoins can also depeg in a bank run.
Depegging and cash reserves
Stablecoins move up and down with their dollar pegs constantly, within a predefined range of normal movement. A small range of fluctuations is normal, but significant movement for a sustained duration leads to depegging concerns.
“The real problem is the actual pegging itself,” says Sinclair Davidson, an economist at RMIT University. “Creating a fixed exchange rate regime is tried and tested. Nation-states have failed, and now, the private sector is trying to do the same. Almost all pegged exchanges in human history have been subject to attacks.”
Bank runs are a self-fulfilling prophecy, as customers race to withdraw funds in a panic before others beat them to it. Stablecoins can depeg and potentially collapse at hyperspeed, as they are sold on hundreds of crypto exchanges and traded 24/7.
Some collateral is less liquid, and valuations of stated collateral may change based on the price of the underlying assets and the costs of converting it to cash. Even USDT, USDC and BUSD face risks that are hard for seasoned crypto investors to see.
For example, USDT’s collateral incorporates secured loans (8.7%) and other investments (4%), with unknown information on their maturity details or underlying security. USDT also lists corporate bonds and precious metals (5.1%) in its audited reports.
The USDT report dated December 2022 shows only 58.5% of cash reserves in U.S. Treasurys, with an average maturity date of fewer than 60 days. By comparison, USDC and BUSD have 100% of their collateral with the U.S. Treasury Department as bonds and also strong cash deposits.
So, as fiat-collateralized stablecoins grow in market cap, third-party audits verifying “proof of collateral” will become a crucial part of the industry. They are already a topical issue since the FTX collapse and for DAO treasuries, whose native tokens might be highly volatile. So, a bank run depeg is plausible.
Recent redemption depeg threats
Whale Alert — a blockchain analytics system reporting token burns and mints for USDT, USDC and BUSD — records that from late 2022 to early 2023, there was a significant increase in stablecoin redemptions, predominantly in BUSD.
The declining market caps of these stablecoins confirm this. Since their all-time supply highs in November 2022 until Feb. 10, 2023, a combined $9.8 billion — or 7.23% of stablecoins — were redeemed and exited the crypto market. Before Feb. 13’s SEC actions, BUSD already represented over 31% of redemptions.
Crypto investors might not have noticed the decrease in stablecoin dominance in the crypto market. Stablecoins slid down from a 16.5% market cap to 12.9% over the past three months, removing almost $10 billion of liquidity from the market.
Large-scale redemptions have meant reduced liquidity for stablecoins. These fiat-collateralized or Treasury-collateralized stablecoins might stress-test the current cash-on-hand ratios (the 20% range in the case of USDC, 6% for BUSD, and an unknown ratio for USDT).
So, “fiat-collateralized” may be a misnomer, as up to 80% of the collateral is held in 30-day fixed-maturity Treasury bills, with only 20% held in liquid cash deposits.
Stablecoins are likely to remain relatively stable during a market crash. However, large withdrawals of stablecoins on centralized exchanges to self-custody wallets or into fiat may cause delays. CEXs, the fiat on- and off-ramps, may not have sufficient stablecoins to meet withdrawals, or the volume of stablecoin redemptions may be larger than the cash on hand for instant redemptions.
The latter example is untested but possible. On Dec. 13, 2022, Binance paused over $1.6 billion in USDC withdrawals, as the exchange didn’t have the USDC on hand to fund said withdrawals.
The delay was around eight hours, but these redemption delays have the potential to temporarily depeg a stablecoin.