Stablecoins Add ‘Novel Vulnerabilities’ to Crypto, Financial Stability: Bank of New York

The rapid growth of decentralized finance (DeFi) sector is full of several challenges, including run risk among large stable coinsaccording to a new report from the Federal Reserve Bank of New York.

Entitled “The Financial Stability Implications of Digital Assets”, the report provides an overview of stablecoins as part of the wider crypto ecosystem, pointing out, among other things, several features that “introduce new vulnerabilities” to the stability of both crypto and traditional finance.

These include ongoing risks arising from Circle’s USDC stablecoin, which, based on self-disclosure, is higher-quality collateral than, say, Tether (USDT), the industry’s largest stablecoin by market capitalization. While this security may be more stable than, say, crypto-native backing, Bank of New York argues that these traditional assets are still subject to volatility.

Researchers highlighted the “significant financial stability implications” that liquidations and fire sales of even these traditional assets would have for fast-growing stablecoins. Examples of these assets include cash, bills, U.S. Treasury bonds, and corporate bonds.

Pointing to the events surrounding the TerraUSD collapse in May of this year, when USDT lost over $7 billion in market capitalization in contrast to USDC, which saw over $4 billion of new inflows over the same time period, the paper says, “this replacement from Tether in USDC illustrates a larger concern – namely that resilient stablecoins can amplify risk from more fragile ones, as they provide a convenient instrument to run to.”

Essentially, researchers argue that as stablecoins grow, any risk to their underlying security becomes even more important to monitor. The current macro environment has also highlighted how even the safest assets, such as bonds, are still subject to large market movements.

The report concluded that a run on a stablecoin “could create negative feedback loops” via its relationships with DeFi applications and crypto-asset prices. For example, USDC and USDT are highly integrated through the leading decentralized exchanges, lending platforms and derivatives protocols.

“Because stablecoins are supposed to be the safest asset in the crypto ecosystem, problems with them pose the biggest systemic risk in crypto,” the paper said.

More stablecoin interoperability is needed

To mitigate these risks and address additional concerns about systemic risk, regulators “should have the authority to implement standards to promote interoperability between stablecoins,” the Bank of New York argued.

One potential way to achieve greater interoperability, according to the report, is the use of so-called “bridges,” which allow tokens designed to be used on one blockchain to be distributed on another, expanding access to new protocols and assets.

However, bridges have certain trade-offs, as they can also “become a transmission channel for stress,” researchers warn.

“For example, users can resolve a loss of liquidity on one blockchain by transferring funds from another, leading to overlapping contagion across multiple networks,” the paper said. “Bridges have also proven to be a key source of technical weakness targeted by many successful cyber attacks.”

Several cross-chain bridges fell victim to attacks this year, including the $100 million hack of the Horizon Bridge in June. About 69% of all stolen crypto funds this year – amounting to as much as $2 billion – came from hacking protocols that bridge different blockchains, according to a recent Chainalisys report.

Other ways to mitigate the above risks, according to the Bank of New York, include legislation that “should require stablecoin issuers to comply with activity restrictions that limit affiliation with commercial entities.”

“In addition, Congress may consider other standards for wallet storage providers, such as limits on affiliation with commercial entities or on the use of users’ transaction data,” according to the report.

The bank’s paper came out almost simultaneously with the “Report on Digital Asset Financial Stability Risks and Regulation” published by the Financial Stability Oversight Council, the federal government organization charged with identifying risks to the financial stability of the United States

In the 124-page paper, government regulators and advisers warned of the risks digital assets could pose if their scale or interconnection with the traditional financial system were to grow without compliance with “appropriate regulations”.