USDC’s Depeg exposed the risks that traditional finance poses to Stablecoins

In recent years, regulators have expressed concern that decentralized finance (DeFi) may pose risks to the traditional financial (TradFi) services sector. These concerns were compounded by events such as algorithmic stablecoin terraUST’s collapse and the failure of the FTX crypto exchange in 2022, which had relatively limited ripple effects on established financial institutions.

Cristiano Ventricelli is Assistant Vice President of DeFi and Digital Assets at Moody’s Investors Service.

But a new realization has emerged following the recent failures of Silicon Valley Bank and Signature Bank: distress from established financial institutions can also spill over into the DeFi sector.

That’s actually what happened this year when Circle’s USD coin (USDC) lost its peg to the dollar on March 10, the day US banking authorities stepped in to take over Silicon Valley Bank (SVB). The fiat-backed stablecoin fell below $0.90 after the announcement that Circle had up to $3.3 billion in exposure to SVB, which had been on a deposit run.

Other smaller-circulation stablecoins also lost their pins, including BUSD, issued by Paxos, and crypto-backed stablecoin DAI, issued by MakerDAO. Only USDT seemed to benefit from the turmoil, briefly surpassing $1, most likely due to investors moving out of the depegged stablecoins.

The Depeg incident was relatively short-lived. After US banking authorities announced that uninsured depositors at Silicon Valley Bank would be fully covered, the USDC price began to rise towards $1, and USDC, DAI and BUSD remain on the $1 peg as of April 2, 2023.

But in Moody’s view, the risk has now been exposed. What the depegging highlighted is that stablecoin issuers’ reliance on a relatively small set of off-chain financial institutions limits their stability. And wider awareness of these risks may actually make the situation worse for stablecoin issuers.

In the wake of the USDC depeg, Circle was able to bring in new banking partners, thereby reducing the concentration risk. Nevertheless, TradFi financial institutions may decide to reconsider cooperation with stablecoin operators, and the reduction in the available pool of financial institution partners will make it even more difficult for fiat-backed stablecoins to maintain stable exchange rates.

In light of these recent events, regulators may increase their scrutiny of stablecoins. Last year, the Terra/LUNA collapse raised concerns about stablecoins’ reserves, leading regulators to recommend additional liquidity and transparency requirements. Now, the depeg of the USDC and other stablecoins highlights a different set of governance risks associated with holding reserve funds. The EU’s Crypto Asset Regulation (MiCA) briefly touches on this, but leaves precise regulatory standards to be set by European banking authorities.

Moody’s expects that the failures at Silicon Valley Bank and Signature Bank may trigger further regulatory requirements, particularly regarding counterparty diversification. As TradFi and DeFi become more intertwined, particularly through the tokenization of real-world assets, the risk of systemic failure increases, underscoring the need for effective regulation, transparency and risk management.

There is also growing interest in exploring alternative solutions to address the shortcomings of stablecoins. A potential alternative is tokenized bank deposits, which allow users to hold digital tokens that represent ownership of underlying bank deposits. Tokenized bank deposits will be subject to the regulatory standards for banking, giving greater confidence in the safety of the underlying assets, although credit risk associated with traditional banking will of course remain.

Another potential alternative is central bank digital currencies (CBDC), digital representations of fiat currencies issued by central banks. CBDCs can eliminate the need for a third-party custodian and provide direct access to central bank reserves. However, in our view, CBDCs are likely still years away from being implemented on a large scale.

Stablecoins are likely to play a significant role in the digital asset ecosystem for the foreseeable future, which means regulators must continue to monitor and address their associated risks.