Author: Matt Levine, Bloomberg columnist and former Goldman Sachs vice president; Translated by: Chris, Techub News
Cryptocurrency repeats the path of traditional finance at a very fast speed.
Compared to the complex and chaotic financial crises in the traditional financial world, the financial crises of cryptocurrency are often more intuitive and simple. You can understand the credit crisis by analyzing the global financial crisis in 2008, but that is very complicated; and the cryptocurrency crisis in 2022 is more like a simplified version of it, everything happens faster and more publicly, and some participants even share their experiences in real time on Twitter and YouTube. Although these crises of cryptocurrency are simple, they can help us understand similar financial phenomena more clearly, as if they were a vivid textbook.
I once wrote a sentence: "Cryptocurrency is the result of smart and ambitious interns in traditional financial companies taking control of a simulated market by themselves." This sentence explains why the world of cryptocurrency is so educational. It puts young, bright minds in an environment without too many constraints, allowing them to explore, make mistakes, and learn from them. This process is not only fun, but also allows us to learn a lot about finance.
Stablecoins are a bit like an abstract form of bank in the cryptocurrency world. Here's how it works: you give $1 to the stablecoin issuer, and they give you a "receipt" which is a stablecoin, which represents "$1". You can then use this stablecoin as a dollar in a cryptocurrency environment such as a blockchain or a cryptocurrency exchange. It can be used for trading, you can use $1 of stablecoin to buy $1 of Bitcoin, and then the person who sells you Bitcoin owns your stablecoin.
At the same time, the stablecoin issuer will keep your $1 and invest it, trying to make a profit on these investments, and these profits are used to pay operating costs and management salaries, etc. And you (or anyone holding a stablecoin) can usually return the stablecoin to the issuer at any time in exchange for $1. At that point, the stablecoin issuer must come up with the $1 to return to you.
This process illustrates the working logic of stablecoins: it is both like money and an abstract form of bank. At their core, they are based on trust by promising to peg $1 to the equivalent of the stablecoin, and to maintain and operate the entire system by investing these dollars.
Stablecoins work in a similar way to bank deposits, but there are some key differences between them. If you know anything about how banks work, you will know several ways that these systems can go wrong. Here are two famous examples:
The stablecoin issuer (like a bank) holds your funds and has the right to invest these funds and make a profit from them. The more profit the issuer makes, the more they can keep. However, if the investment fails and the funds are lost, most of the losses will eventually be borne by the depositors (that is, the stablecoin holders). Because most of the funds actually belong to the depositors, if the issuer loses all the money, they will not have enough funds to compensate the depositors. This gives the issuer an incentive to take risks: if the venture is successful, they can make a lot of money; if it fails, the loss is mainly other people's money.
Even if the stablecoin issuer invests all its funds in very safe assets, some of these assets may be long-term investments. If everyone demands their money back today, the issuer may not be able to redeem these long-term investments immediately and may have to sell them at a loss, resulting in insufficient funds to repay everyone's demands. This dynamic is well known, so it has a self-reinforcing nature: if you think a run might happen, you should get your money out as quickly as possible (before the issuer runs out of money), and if everyone thinks and acts this way, eventually a run will actually happen.
These two problems (bank risky investments and runs) are often related, and a common cause of runs is that the bank made some bad investment decisions with depositors' money.
Sometimes, a bank may lose so much money on investments that before anyone realizes it, the bank is bankrupt. In this case, even if there is no run, the bank may fail because of bad investments.
On the other hand, a run can also happen without investment losses, simply because the bank has a liquidity mismatch. That is, the bank may have enough assets to repay all depositors, but these assets are long-term or not easily liquid, while the funds required by depositors are "demand liabilities" that are available at any time.
When too many people demand to withdraw their funds at the same time, banks may not be able to liquidate enough assets quickly to meet these demands, leading to a run, even if the assets themselves are not losing money.
There are two main responses to banks' investment risk problems:
1. Prudential Supervision: Regulators closely monitor banks' investment behavior to ensure that they do not make high-risk or improper investments. This supervision helps banks avoid making serious investment mistakes.
2. Capital Regulation: Banks are required to maintain a certain proportion of additional funds (i.e., capital buffers) to ensure that even if investments lose money, the bank still has non-depositor funds to absorb these losses. This regulation reduces the risk that investment failures will directly affect depositors.
There are also several common solutions to the problem of bank runs:
1. Liquidity Regulation: Banks are required to keep enough cash or other highly liquid assets so that they can pay depositors when they ask to withdraw funds. This regulation ensures that banks can meet customers' withdrawal needs in the short term.
2. Lender of Last Resort: If a bank holds good but illiquid assets, and at a certain moment all depositors want to withdraw their funds, central banks such as the Federal Reserve will provide loans to banks to ensure that the banks can temporarily tide over the difficulties and wait for the assets to be liquidated. This mechanism prevents banks from going bankrupt due to temporary liquidity problems.
3. Deposit Insurance: The government promises that if a bank does go bankrupt, they will compensate depositors for their losses (usually within a certain limit). This guarantee gives depositors peace of mind and prevents them from triggering a large-scale bank run due to concerns about bank failure.
The stablecoin space largely lacks those protections found in traditional banking. While there are various proposals to try to introduce some of these, in general, stablecoin issuers generally do not have the regulatory framework or security measures that banks have.
Take Tether, one of the largest stablecoin issuers. Tether got into trouble in 2019 for using customer funds for extremely risky investments. At the time, its public financial statements even showed that its capital adequacy ratio was only 0.2% (it later improved), meaning it had almost no additional funding buffer to absorb potential losses.
Another example is TerraUSD, whose investment strategy can basically be described as highly risky investment. This strategy caused TerraUSD to depeg in a run in 2022.
A regulatory solution for stablecoins might look like this:
The most straightforward solution is to impose bank-like regulatory requirements on stablecoin issuers. That is, "stablecoin issuers should invest funds in fairly safe assets that should have high liquidity, and they should hold a certain percentage of their own capital to ensure that even if these assets suffer losses, there is still enough money to repay users holding stablecoins." This is a relatively simple answer, but there are many details to be worked out to really implement this.
Another bolder idea is to give stablecoin issuers access to a bank-like support mechanism.
In short, a good regulatory solution should include the following aspects:
1. Safe investment policy: Ensure that stablecoin issuers invest customers' funds in low-risk, highly liquid assets.
2. Capital requirements: Require issuers to hold sufficient equity capital as a buffer to cope with potential losses.
3. Liquidity management: Ensure that issuers have sufficient liquidity to respond to user redemption needs and prevent bank runs.
4. Systemic support: Consider providing stablecoins with support mechanisms similar to traditional banks, such as deposit insurance or emergency liquidity support.
This is a very interesting paper written by Gordon Liao, Dan Fishman and Jeremy Fox-Geen, who are employees of Circle Internet Financial, a stablecoin issuer. The paper explores "Risk-based capital requirements for stable value tokens", and Circle obviously has some interest in loose stablecoin regulation, but the paper does raise some important points about the relationship between stablecoins and banks.
One of the points is that stablecoins are more transparent than banks in many ways. For cryptocurrency enthusiasts who are skeptical of the opacity of the traditional financial system, this transparency may be seen as an advantage. But there is a reason for the opacity in the traditional financial system.
Liao, Fishman and Fox-Geen point out in their paper that while this transparency may appear attractive to supporters in the cryptocurrency world, in fact, some of the opacity of the traditional banking system is to protect the stability and effectiveness of the system. The complexity and some degree of opacity of banks help maintain confidence and stability during market fluctuations, while excessive transparency may exacerbate market panic in times of crisis.
In the traditional banking system, the main reason for a bank run is usually that people think that other people will run to the bank to withdraw money. How do you know if everyone will run? The root of this idea is usually because of rumors, bad financial reports, panicked TV interviews and other signals. A bank's stock price drop may indicate that something is wrong with the deposits.
In the world of stablecoins, however, the situation is more direct and transparent. Because stablecoins are traded on the open market, their prices directly reflect the market's confidence in them. If a stablecoin is trading at $1.0002, it may mean that there is no risk of a run at the moment; but if its price drops to $0.85, it almost certainly means that a run is happening in the market.
This transparent price signal makes it easier to judge market sentiment, but it also means that stablecoin price fluctuations can quickly convey market panic and may accelerate the occurrence of a run. This public market reaction is not only a reflection of the fundamentals of the stablecoin, but can also become a self-fulfilling prophecy, that is, when people see the price drop, they are more inclined to sell or redeem further, causing the price to continue to fall, thereby exacerbating market instability. While this transparency helps the dissemination of market information, it can also become a trigger point for a chain reaction in times of crisis.
The main way to solve this problem is that stablecoin issuers should keep most of their funds highly liquid.
Stablecoins and traditional banks need to adopt different strategies when managing financial risks, especially when facing a higher risk of coordinated runs.
Specifically, fiat-backed stablecoins usually hold highly liquid assets, avoid excessive maturity mismatches (i.e., the maturity dates of assets and liabilities are inconsistent), and have relatively low credit risk. This is because the risk of runs on stablecoins is much higher than that of traditional banks, so they need to maintain a high degree of asset liquidity to quickly respond to redemption demands.
Since the pool of assets held by stablecoins is usually more resilient and is segregated specifically for the benefit of token holders, the capital buffers (funds used to absorb financial losses) required by stablecoins are usually smaller than those of banks. In other words, because the asset pool is sufficiently robust and the risk of runs is low, stablecoins do not need as much capital as banks to cope with potential losses.
However, for those tokenized deposits that are backed by traditional loans and fractional reserves, they may require more capital than traditional deposits, even if the asset backing is the same, because tokenization increases the risk of runs. The reason is that tokenized deposits inherit the asset-liability mismatch problems inherent in bank balance sheets, so similar capital and solvency regulatory mechanisms may need to be applied to manage these risks.
The term "blockchain blockchain blockchain" may emphasize the central role of blockchain technology in stablecoins and its impact on the unique nature of stablecoin systems.
The use of tokenization and distributed ledgers not only brings financial risks, but also introduces additional risks related to technology, infrastructure and operations. These non-financial risks have been highlighted in public consultations and proposals by regulators.
Specifically, the use of cryptographic technology, permanent record keeping and traceable transactions can reduce certain security and compliance risks to a certain extent. However, these technologies also bring new challenges, especially when assessing the capital required for these risks. This type of risk is often referred to as operational risk in traditional banking.
The difficulties in assessing these operational risks are as follows:
1. Lack of sufficient historical data: Due to the relative novelty of blockchain technology, there is less historical data on operational losses, which makes risk assessment more complicated.
2. Dependence on technology choice: The technology choice adopted by the issuer can have a significant impact on the loss absorbing capital required. This dependency becomes more prominent as the infrastructure is rapidly developing and constantly upgraded.
3. Rapid changes in infrastructure: In an evolving technology environment, how to assess and manage these operational risks becomes more challenging. Technology choices and changes may significantly affect the issuer's ability to respond to potential risks.
On the one hand, it is conceivable that stablecoin issuers are less likely to lose your funds than traditional banks due to the transparent, traceable, and digitally native nature of blockchain technology. The public ledger and cryptographic protection of blockchains allow every transaction to be recorded and verified, theoretically reducing the risk of losing funds.
But on the other hand, it is equally conceivable that stablecoin issuers are more likely to lose funds precisely because of these same technical characteristics. Reasons may include:
The United States experienced a small banking crisis last year, which forced me to spend time rethinking the banking industry. I once wrote a sentence:
The essence of a bank is a way for people to collectively undertake long-term and risky investments without paying special attention to these risks. Banks make everyone safer and more beneficial by spreading risks among many depositors.
When you and I deposit money in a bank, we think that this money is very safe, it is money in the bank, and we can withdraw it at any time to pay rent or buy a sandwich. But in fact, banks will use these deposits to issue long-term, fixed-rate 30-year mortgages. Homeowners can't borrow money from me directly for 30 years because I might need the money tomorrow to buy a sandwich. But they can borrow from us collectively because banks reduce liquidity risk by spreading it among many depositors.
In the same way, banks lend to small businesses that might go bankrupt. These businesses can't borrow money from me directly because I don't want to take the risk of losing money, but they can borrow from us collectively because banks reduce the risk to individual depositors by spreading credit risk among many depositors and borrowers.
The opacity of the traditional banking system gives banks more ability to take risks with their customers' money. This opacity once helped banks operate in a relatively stable environment because the complexity behind it made it difficult for customers to fully understand what the bank was doing. However, last year's regional banking crises partially demonstrated that this opacity is no longer as effective as it used to be.
Today, the public can more easily access relevant information about banks because of the widespread and electronic distribution of information. Rumors and panic can spread quickly around the world through the Internet, and people's expectations of banks are increasingly inclined to be marked to market, that is, to pay more attention to real-time market performance rather than long-term robustness.
As a Federal Deposit Insurance Corporation (FDIC) regulator said last year, the game is still the same game, but it has become more intense. This sentence points out the new challenges facing the modern banking industry: although the basic operating logic of banks has not changed, the transparency and speed of information dissemination have made the market react more quickly and intensely. The risk management advantages that traditional banks have gained by relying on opacity have become more fragile in the new information environment, and banks therefore need to manage risks more carefully to cope with more complex and rapidly changing market sentiment.
The "magic" of traditional banks lies in their ability to pool a series of high-risk investments together and then issue senior debt claims on these investments, which are expressed in US dollars: $1 in a bank account is $1, even if it is backed by a bunch of risky assets. This arrangement allows customers to believe that their deposits are safe and can be used without risk when needed.
However, stablecoins abandon this "magic". Although a $1 stablecoin is almost equivalent to $1 in most cryptocurrency scenarios, its market price fluctuates. When market conditions are good, it may trade at $1.0002 or $0.9998, but in unfavorable conditions, it may fall to $0.85. Stablecoins are a form of banking that does not have the "$1 is $1" guarantee of traditional banks, but instead reflects its proximity to $1 through a 24-hour real-time market.
This situation raises new regulatory issues. Because stablecoins do not have the implicit guarantees and opacity of traditional banks, market prices directly reflect the risk status and market confidence of the assets behind them. This real-time market feedback not only changes the way stablecoins work, but may also indicate the future direction of traditional banking.
In the future, as financial markets become further digitized and transparent, traditional banks may also face similar challenges. Banks’ asset risk and market confidence may be more directly reflected in market prices than they are now, rather than relying on safeguards within the banking system. This shift could reshape our understanding of banking and financial stability and force regulators and market participants to adjust their risk management strategies.
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