XREX | Examining the Stablecoin Industry Development from USDC's Perspective

This article is excerpted from a live discussion on stablecoins by XREX. It is written by Wayne Huang, co-founder of XREX.

Some of the world's largest stablecoin issuers, such as Tether issuing USDT, Circle issuing USDC, MakerDAO issuing DAI, have faced significant pressure due to the recent bank clearings and closures of banks like Silvergate, SVB, Signature in the US. In particular, USDC temporarily unpegged. These events indicate that for stablecoins to have long-term development and widespread application, there are aspects that need attention, optimization, and improvement.

I believe it can be discussed in four main points:

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1. Special bank-like closure and clearing mechanism
2. Introduction of insurance mechanism
3. Higher quality reserves
4. Lender of Last Resort system

A Special Bankruptcy Liquidation Mechanism Similar to Banks

We have seen the evolution of traditional finance over hundreds of years. Banks, as "special financial institutions," have a meticulous and detailed design in their bankruptcy liquidation process, which accelerates the repayment to depositors in the shortest time possible. This process is very different from the bankruptcy liquidation process of regular companies. It is designed to quickly repay depositors while minimizing the spread of market doubts and panic, and is a highly optimized mechanism.

Currently, almost all stablecoin issuers have the same liquidation bankruptcy mechanism as ordinary commercial institutions, where depositors and general creditors queue up together. Ahead of them are liquidation fees, employee salaries, shareholders, and other entities that receive repayment priority. If banks were to operate under such a mechanism, who would be willing to deposit money in banks? This is why banks are designed with a special bankruptcy liquidation procedure, and stablecoin issuers also need such a mechanism.

Introduction of Insurance Mechanism

This time, we see that the US Federal Business Bank has the FDIC insurance mechanism behind it, and there are also other choices of insurance providers, making it a multi-level structural financial ecosystem.

However, the blockchain finance sector currently does not have such an ecosystem. Stablecoin issuers have not yet been insured because accounting audits, regulatory mechanisms, and insurance providers are not yet fully developed. Recently, Circle briefly had about 7% (US$3.3 billion) of reserves stuck in SVB (Silicon Valley Bank). Although it was only for a few days, it still caused market panic, leading to the second largest stablecoin in the world facing an unhooking crisis.

If stablecoin issuers have insurance mechanisms, one or more insurance companies can immediately inject capital (similar to Credit Default Swaps) to cover this 7%, stabilizing market confidence and avoiding a run. Of course, in extreme situations, it is likely that no one will dare to lend funds, but having a certain mechanism can still enhance stability to some extent.

Higher-Quality Reserves

Compared to the multiple US banks that went bankrupt this time, stablecoin issuers have evidently been more conservative in asset allocation. Circle and Tether's reserves consist of over 75% short-term US bonds, and MakerDAO also continues to increase the proportion of short-term US bonds in its reserves.

Why aren't they 100% short-term US bonds? On one hand, the operational cost of short-term US bonds' liquidity is relatively high. On the other hand, issuers have multiple commercial bank accounts that can provide services to users and maintain good relationships with banks, significantly improving user experience and convenience in converting between fiat and stablecoins.

Therefore, Circle and Tether currently maintain approximately 25% to 30% as commercial bank deposits.

However, the bankruptcy turmoil of multiple US banks this time has shown us that commercial banks are not strong in the face of sudden market panic and a run. They are susceptible to liquidity problems during financial storms, leading to insolvency and temporary closure or bankruptcy liquidation procedures.

Because commercial banks have these risks, we must recognize that stablecoin issuers' deposits in commercial banks are considered broad money, not high-quality reserves. Deposits are not equivalent to cash; they are more like lending to the bank. It may be manageable to temporarily recover all the money lent to the bank in small amounts, but it can be challenging for large amounts.

So, what reserves can offer the convenience and speed of commercial bank deposits while being safer than commercial bank deposits?

That could be reserves that are more closely tied to the underlying currency, such as deposits in systemically important financial institutions (a few of the most crucial banks), Federal Reserve deposits, or Central Bank Digital Currency (CBDC).

Stablecoin issuers like Circle, MakerDAO, and Frax have been advocating for direct access to accounts at the Federal Reserve, similar to commercial banks. However, as they currently do not have Federal Reserve licenses or FDIC coverage, the chances of successfully obtaining them are not high.

If stablecoin issuers still cannot access Federal Reserve accounts in the coming years, perhaps Central Bank Digital Currency (CBDC) could create a new high-quality, high-liquidity "backdoor" for them. Holding CBDC positions would be closer to the underlying currency, offering higher-quality reserves than commercial bank deposits while maintaining high liquidity.

Lender of Last Resort System

This chain reaction of bank liquidation turmoil starting from Silvergate this time prompted the US Federal Reserve and Treasury Department to intervene quickly. They not only made an exception to protect all depositors' funds but also provided special short-term loans to relieve all banks' liquidity issues, effectively suppressing runs.

Currently, stablecoin issuers lack such a lender of last resort system due to incomplete regulatory mechanisms and their integration. A more feasible short-term route in the future is to expand the application scope of FDIC to protect new financial companies like stablecoin issuers such as Circle. Another route, which requires more time and negotiation, is for stablecoin issuers to first obtain a banking license and then join the FDIC under the existing framework.

From the current perspective, financial regulatory authorities do not support blockchain financial activities. It is very challenging for blockchain financial entities to obtain a deposit account at the Federal Reserve. Therefore, it is even more difficult to persuade US legislators and regulatory authorities to expand protection for stablecoin issuers. This is also related to a predicament where blockchain finance is not yet significant or influential enough in the overall financial system to have the opportunity to access a lender of last resort mechanism.

Alipay has reached the balance sheet of the People's Bank of China and obtained a reserve fund deposit account. We believe this will be a critical task that blockchain finance must prove in the next three to five years.

Acquiring a lender of last resort mechanism may not be feasible in the short term. Therefore, establishing a stablecoin issuer-specific fund and becoming a major client of a government-backed monetary fund may be a more practical approach.

During a live broadcast with Winston Hsiao and Ethan Yang yesterday, many participants asked us about our views on the future development of stablecoins. I believe stablecoins are essential payment tools that will bring higher efficiency and better services, whether in accounts receivable and cross-border payments for listed companies and SMEs, or international remittances for the general public.

(Special thanks to Nathan Yu, An-Tsu Chen, Ethan Yang, Jason J. Lai, Winston Hsiao, Matt Huang, and You Zhiwei for their guidance.)