Stablecoin Report: Greater Risks Posed by Stablecoins Using Only Fractional Reserves or Higher-Risk Asset Allocations

The dramatic growth of stablecoin issuance may eventually have implications for the overall functioning of short-term credit markets, according to Fitch Ratings.

The statement by Fitch follows comments late last month by Boston Federal Reserve President Eric Rosengren stating that Tether is a looming risk for the economy.

Fitch Ratings notes in a recent update that potential asset contagion risks “linked to the liquidation of stablecoin reserve holdings” might increase pressure for stricter or tighter regulation of the emerging sector.

Contagion risks are mainly associated with collateralised stablecoins, and may vary based on the size, liquidity and riskiness of their asset holdings, as well as “the transparency and governance of the operator, among other things,” the Fitch Ratings team noted.

They also mentioned that fewer risks are posed by coins that may be “fully backed by safe, highly liquid assets.” However, regulatory authorities might still be concerned that if the footprint is “potentially global or systemic.”

For instance, USD Coin (USDC), the world’s second-largest US dollar-pegged stablecoin, is backed by USD on a 1:1 basis “held in custody accounts.” Whereas stablecoins that use fractional reserves or “adopt higher-risk asset allocation” may face a “greater run risk,” Fitch Ratings added.

For example, Tether (USDT), the world’s largest stablecoin issuer, has disclosed that as of 31 March 2021 it “held only 26.2% of its reserves in cash, fiduciary deposits, reverse repo notes and government securities, with a further 49.6% in commercial paper (CP).”

Tether’s CP holdings amounted to $20.3 billion as of 31 March, while its consolidated assets totaled $41 billion, and “may be rising rapidly”; total assets associated with its USD pegged  stablecoin (USDT) reached almost $63 billion by June 28, 2021.

As noted by Fitch Ratings, these figures indicate that its CP holdings could be larger than those of most “prime money market funds (MMF) in the US and EMEA.” A sudden mass redemption of USDT might impact the overall stability of short-term credit markets “if it occurred during a period of wider selling pressure in the CP market, particularly if associated with wider redemptions of other stablecoins that hold reserves in similar assets,” Fitch Ratings added. It also mentioned that the run risks were “highlighted when a partially collateralized stablecoin, Iron, broke its peg in June.”

Fitch Ratings further noted:

“The Diem US-dollar stablecoin, which the Facebook-backed Diem Association plans to issue in partnership with Silvergate Bank, proposes to hold at least 80% of its reserves in low-risk short-term government securities. The remaining 20% will be held in cash, with overnight sweeps into MMFs that invest in short-term government securities with the same risk and liquidity profiles.”

The company added that projects that might quickly become systemic, like Diem (previously Libra), have “drawn the attention of regulators and could lead to tighter regulation of stablecoins.”

US regulators have also noted that entities with asset allocations “similar to that disclosed by Tether may not be stable if short-term credit spreads widen significantly, as has occurred in times of financial stress in 2020 and 2007-2008. This contrasts with the way stablecoins are marketed to the public,” the Fitch Ratings team noted.

They also mentioned:

“Tighter regulation is proposed under the Stablecoin Tethering and Bank Licensing Enforcement (STABLE) Act in the US, introduced to Congress in December 2020, and the Markets in Crypto-Assets Regulation in the EU, though the timetable and details of planned changes remain unclear or subject to change.”

Increased and tighter regulations might enhance transparency and could potentially force a migration of stablecoin collateralization reserves to “less risky assets,” Fitch Ratings claims while noting that the process may impact – or be “influenced by” – regulatory authorities’ “promotion” of central bank digital currencies (CBDCs) and instant payment services, such as the FedNow Service in the United States.

Fitch Ratings added:

“We believe authorities are unlikely to intervene to save stablecoins in the event of a disruptive event, partly owing to moral hazard. Authorities could step in to support dealers and prime MMFs should stablecoin redemptions lead to or amplify a wider CP sell-off, pressuring market liquidity and impeding new CP issuance.”

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