Should stablecoins be backed 100% by cash? Connecting to the banking system does not equal zero risk.

When it comes to the risks of stablecoins, many people intuitively think of the transparency of the underlying reserve assets and the issue of a bank run when systemic risks occur. However, Steven Kelly, an assistant in financial stability research at Yale University, has a different perspective on this. He believes that using 100% cash as reserve assets for stablecoins is not as safe as imagined.

Stablecoin Reserve Asset Issue

The President's Working Group on Financial Markets (PWG) released the long-awaited stability report earlier this month, once again addressing the liquidity discrepancies behind stablecoin reserve assets. Stablecoins backed by non-cash and illiquid assets could pose significant risks to financial stability during periods of significant redemption pressure.

In response to the above views, Steven Kelly believes that while stablecoins supported by non-cash assets may be more vulnerable to losses, this is distinct from broader financial instability. Here is his perspective.

At the turn of the century, during the bursting of the dot-com bubble, the U.S. stock market lost $8 trillion in value, fifty times the total market capitalization of stablecoins. However, this did not lead to systemic financial uncertainty. In contrast, during the 2007 subprime mortgage crisis, a $22 billion French fund with one-third of its assets in high-rated subprime bonds, including a large amount of U.S. subprime mortgage securitized products, halted redemptions, triggering a run on all financial institutions and their high-rated assets used as collateral, ultimately sparking a global financial crisis.

Unlike the dot-com bubble burst confined to the stock market, the French fund's issue involved assets at the core of the banking system, leading to catastrophic financial panic. In contrast, stablecoins currently have no direct association with such assets, although the cryptocurrency market experienced a $470 billion drop in May, roughly 20%. However, the market quickly recovered afterward, demonstrating the independent development of the cryptocurrency market.

A Case Study: Tether

Steven Kelly further explains the differences between stablecoins and traditional funds using the example of Tether.

Most investors are aware that Tether's reserve assets are opaque and insecure, including Chinese commercial paper, borrowings endorsed by other exchanges with cryptocurrencies, and significant deposits in Bahamian banks, leading to regulatory scrutiny and fines.

However, from another perspective, if a typical money market fund had any of the above scenarios, investors would lose trust and withdraw their investments. Yet, Tether has continued to grow over the years, dominating the stablecoin market share and multiplying its market value, without any professional cryptocurrency traders expressing concerns about Tether redeeming USDT below $1.

Based on the examples above, Steven Kelly believes that Tether has created its own ecosystem and remains popular due to its transaction execution, significant network effects, and extensive chain-to-chain interactions.

Keeping Risks within the Crypto Sector

Steven Kelly's viewpoint does not suggest that Tether and other stablecoins will never face crises, especially considering their ties to the cryptocurrency market. In fact, factors such as sharp cryptocurrency price drops, margin calls, hacking attacks, and exchange operational failures can have an impact.

However, if any of the above situations occur and lead to redemption problems, the worst-case scenario would involve stablecoin issuers holding large amounts of cash, rapidly maturing repurchase agreements, or any borrowings related to the core banking system. It is best to keep stablecoins within the crypto sector for now, rather than connecting these risky assets to the heart of the financial market.

"Legislation similar to bank guarantees proposed by the PWG is definitely a necessary step before stablecoins are widely adopted. However, the 'temporary solution' of having stablecoins backed by safe assets may backfire," stated Steven Kelly.

While Steven Kelly's viewpoint may go against intuitive thinking, government-backed fiat currencies are undoubtedly the most shock-absorbing assets during redemption risks. However, until stablecoins are considered part of the banking system and subject to comprehensive regulation, keeping them as independent as possible from the banking system may be another way to mitigate risks in the cryptocurrency market.