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Risks Stablecoins Pose to the Cryptocurrency Market

On Tuesday September 21st, Securities and Exchange Commission Chairman Gary Gensler made clear his view of stablecoins, describing the cryptocurrency conduit as ‘poker chips at the casino’ and a ‘danger to investors with questionable long-term viability.

On Tuesday September 21st, Securities and Exchange Commission Chairman Gary Gensler made clear his view on stablecoins, describing the cryptocurrency conduit as ‘poker chips at the casino’ and a ‘danger to investors with questionable long-term viability’. 

Despite the chairman’s comments, we at Sia Partners expect the trend of decentralized finance (DeFi) to continue to grow in the future as investors push for increased sovereignty over their finances and seek protection from inflation. However, as this trend continues, financial services representatives need additional insight into the implicit risks and lack of transparency around the growing DeFi environment. We believe that understanding the risks associated with this market is necessary before recommending cryptocurrencies to investment clients and CFOs.

What are Stablecoins?

  1. Stablecoins: The Digital Currency

Stablecoins are a type of digital currency that help to facilitate transactions in popular cryptocurrencies such as Bitcoin and Ethereum, which combine for almost $1.5 trillion in market cap alone. Stablecoins such as USDC, Tether, and Dai mirror outside stable assets such as the U.S. dollar and other fiat currencies, but in digital form. In total, there are over 200 active stablecoin projects, which together process more transaction volume than Venmo and PayPal's P2P payment platforms. 

Stablecoins aim to have a 1:1 relationship to their equivalent asset in reserves, such as $1 in reserves per every 1 USDC. However, stablecoins are private money and are not government-issued, and thus should not be viewed with the same amount of security, trustworthiness, or collateralization as a central bank treasury. 

Investors considering converting Bitcoin into U.S. Dollars may elect instead to convert that Bitcoin into USDC, a U.S. dollar-denominated stablecoin. USDC and other stablecoins pay higher interest rates on deposits than traditional FDIC bank accounts and yet still mirror stable currencies. Electing stablecoins over fiat can also reduce the number of transactions, fees, and overall processing time for investors.

  1. Risks of Stablecoins

Many stablecoin issuers do not provide full transparency about where or how their reserves are held. The lack of certainty makes it difficult for investors to determine the level of risk associated with the investment. If the stablecoin operators are domiciled in a sanctioned region or do not have a license, regulators could freeze the issuers' underlying funds, rending the investment virtually worthless. Additionally, some stablecoins are not collateralized 1:1 with stable assets, even if they represent that they are. Certain stablecoins are collateralized by other cryptocurrencies or swaps, instead of cash, thereby making the stablecoin fundamentally unstable. 

  • Stablecoin company Maker operates normally at a 150% collateral ratio.
  • On February 23rd, cryptocurrency firms Tether and Bitfinex agreed to pay an $18.5 million fine to end a New York probe into whether they covered up to $850 million in losses after not having enough funds in reserves.
  • On October 6th, USDC stablecoin company Circle announced that they received an SEC “investigative subpoena” in July from the SEC requesting “documents and information regarding certain of our holdings, customer programs, and operations”.

Without concrete laws concerning stablecoins and cryptocurrencies in the United States and abroad, large institutional investors are fearful of entering the industry for fear of liquidation or severe fines. 

For retail investors, who have higher risk tolerances, investing a large portion of their savings into cryptocurrencies whose collateralization is murky is a barrier to entry. For the cryptocurrency industry to advance, the proper guardrails and investor protections need to be introduced and enforced.

A Call to Action from Regulators

  1. Regulators and Their Role

As a result of these recent transgressions, regulators have begun to take a deeper look into stablecoins. At the forefront of their examination is making sure investors are protected and aware of the risks present in this nascent market. 

  • On June 9th, in an interview on CNBC, ex-CFTC chairman Timothy Massad called for more regulation of Tether and other stablecoins. He said stablecoins should be more transparent and that "we need a better framework of regulation for tether and other stablecoins." 
  • On June 14th, the Financial Times reported that the Bank of England has warned that stablecoins may face more regulation. Officials noted that "banks would likely have to have reserves in place that would let stablecoin holders redeem them for cash on a one-to-one basis."  "The prospect of stablecoins as a means of payment ... [has] generated a host of issues," said BoE Governor Andrew Bailey.  "It is essential that we ask the difficult and pertinent questions when it comes to the future of these new forms of digital money." 
  • According to a Bloomberg report on June 15th, Biden administration officials warned stablecoin makers that "many consumers are not aware that the dollar-linked tokens are not federally insured and could result in losses on their investments."  The report also said regulators fear "stablecoins can be used to sidestep the formal banking system, letting criminals launder money with impunity." 
  • On July 16th, CNBC reported that Treasury Secretary Janet Yellen plans to meet with the President's Working Group on Financial Markets, the Office of the Comptroller of the Currency, and FDIC to discuss the role and risks of stablecoins in the U.S. financial system. 
  • On August 18th, Federal Reserve officials discussed the potential threats stablecoins pose on financial markets' financial stability and security. According to the meeting minutes, officials said these "new financial arrangements" appear to have structural maturity and liquidity transformation vulnerabilities and little transparency. 
  • On September 21st, Securities and Exchange Commission Chairman Gary Gensler made clear he is no fan of stablecoins, describing the cryptocurrency conduit as ‘poker chips at the casino’ and a ‘danger to investors with questionable long-term viability’.
  1. Smart Regulation

As the cryptocurrency market continues to grow from its infancy, regulators will need to establish basic rules and regulations for all market participants, including retail investors, institutions, exchanges, and cryptocurrency operators. Regulators will likely focus their initial efforts on ensuring cryptocurrency service providers and investment vehicles adhere to U.S. KYC and risk policies surrounding investment offerings, as well as checking compliance with U.S. anti-money laundering (AML) laws. Another check should be that stablecoins treasuries are indeed backed 1:1 in reserves, and that the assets pledged for reserves are stable. 

Of the many looming questions plaguing cryptocurrencies, the largest is whether U.S. regulators will consider cryptocurrencies and stablecoins as securities. This treatment will have major impacts on all aspects of the cryptocurrency market, including tax, among other considerations. 

Basic regulations will not impede stablecoins and cryptocurrencies, but rather bolster investor confidence in the market and pave the way for increased retail and institutional investment. Successful regulatory policy should include insight from all parties, including leading market operators. Because the industry is developing so rapidly, consultation with leading market operators will help to ensure regulations are fair, current, and accommodating for future business growth and investor participation.

How Sia Partners Can Assist Your Firm with Cryptocurrencies

  1. Strategic Support

Given the rapid development of decentralized finance, it can be challenging to keep pace while mitigating any potential risks. Sia Partners' multidisciplinary capabilities in Change Management, Digital Transformation, Governance, Risk Management, Audit, Compliance, AML, and KYC can support your team through these uncertain times. Specifically, we can help your firm develop:

  • Its journey to crypto-assets understanding
  • A strategic roadmap and business plan
  • A well-developed and complete risk management plan
  1. Technical Implementation 

Sia Partners has capabilities to support its clients across the decentralized finance ecosystem. Among other things, Sia Partners can help your firm developing and integrating decentralized networks or applications, introducing crypto-related projects to market, managing the risk associated with those offerings, and navigating current laws and regulations through our compliance, KYC, and AML capabilities.

  1. Security and Risk Management

Security is the cornerstone of any application handling crypto assets. Our team supports its clients in choosing their partners, counterparties, and vendors to assure asset and sensitive information protection when it comes to security. We have well-developed risk-management capabilities that can aid you and your firm understand the risks of these developing and uncertain markets.

  1. Training

As a pioneer of Consulting 4.0, Sia Partners is a thought leader in emerging technologies and Consulting For Good. Our financial services consulting professionals can help educate you and your firm on all aspects of the emerging trends of FinTech, cryptocurrencies, DeFi, and blockchain technology across these various employee groups:

  • C-Suite
  • Operations
  • Finance
  • Compliance
  • Risk Management
  • IT
  • HR