Author: Matt Levine, Bloomberg columnist and former Goldman Sachs vice president; Translated by: Chris, Techub News
Cryptocurrency is repeating the path of traditional finance at a very fast pace.
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 2008 global financial crisis, but that is very complicated; the 2022 cryptocurrency crisis is more like a simplified version of it, everything happened faster and more openly, and some participants even shared 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, like a vivid textbook.
I once wrote that "cryptocurrency is the result of smart, ambitious interns at traditional financial firms taking control of a simulated market." This statement illustrates 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 teaches us 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 if it were a dollar in a cryptocurrency environment like 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.
Meanwhile, the issuer of the stablecoin will keep your $1 and invest it, trying to make a profit from these investments, which is used to pay for operating costs and management salaries, etc. You (or anyone holding a stablecoin) can usually return the stablecoin to the issuer at any time in exchange for $1. At that time, the stablecoin issuer must raise the $1 to return it to you.
This process illustrates the operating logic of stablecoins: they are both like currency and an abstract form of bank. Their core is to gain trust by promising to peg $1 to the equivalent value of stablecoins, 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. If you know anything about how banks work, you know a few ways these systems can go wrong. Here are two famous examples:
Bank’s venture capital:
The stablecoin issuer (like a bank) holds your funds and has the right to invest them and make a profit. The more profit the issuer makes, the more they get to keep. However, if the investment fails and the funds are lost, most of the losses will ultimately be borne by the depositors (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.
A bank run could happen
Even if the stablecoin issuer has all its funds invested 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 itself is well known, so it has self-reinforcing properties: if you think a run might happen, then you should get your money out as quickly as possible (before the issuer runs out of funds), and if everyone thinks and acts this way, it will eventually lead to a run.
These two problems (bank risky investments and runs) are often related, and a common cause of runs is that banks make bad investment decisions with depositors' money.
Sometimes a bank loses so much money on its investments that before anyone realizes it, it is bankrupt. In such cases, even if there is no run, the bank may fail because of bad investments.
On the other hand, a run can also occur without investment losses, simply because of a liquidity mismatch at the bank. That is, the bank may have enough assets to repay all depositors, but these assets are long-term or not easily liquidated, while the funds requested by depositors are "immediate liabilities" that are available at any time. When too many people request to withdraw funds at the same time, the bank may not be able to liquidate enough assets quickly to meet these demands, causing a run, even if the assets themselves are not loss-making.
There are two main countermeasures to banks’ investment risk:
1. Prudential Supervision : Regulators closely monitor banks’ investment behavior to ensure that they do not make high-risk or inappropriate investments. This supervision helps banks avoid making serious investment mistakes.
2. Capital Regulation: Banks are required to maintain a certain percentage of additional funds (i.e., capital buffer) to ensure that even if investments suffer losses, 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 bank run problem:
1. Liquidity Regulation: Banks are required to keep enough cash or other highly liquid assets to be able to pay depositors when they request 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 fail, they will compensate depositors for their losses (usually within certain limits). This protection gives depositors peace of mind and prevents them from worrying about a bank failure and triggering a large-scale run on their bank.
The stablecoin space is largely lacking the protections found in traditional banking. While there are various proposals to introduce some of these, overall, stablecoin issuers generally do not have the same regulatory framework or safeguards as banks.
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 report even showed that its capital adequacy ratio was only 0.2% (it later improved), which meant that it had almost no additional capital buffer to absorb potential losses.
Another example is TerraUSD, whose investment strategy can basically be described as a highly concentrated risk investment. This strategy caused TerraUSD to decouple during a run in 2022.
A regulatory solution for stablecoins might look something like this:
The most direct solution is to impose similar regulatory requirements on stablecoin issuers as on banks. 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 to truly implement this, many details need to be resolved.
Another bolder idea is to give stablecoin issuers access to a bank-like backing mechanism.
In short, a good regulatory program should include the following aspects:
1. Safe investment policy: Ensure that stablecoin issuers invest their clients’ funds in low-risk, highly liquid assets.
2. Capital requirements: Issuers are required to hold sufficient equity capital as a buffer to cope with potential losses.
3. Liquidity management: Ensure that the issuer has sufficient liquidity to meet users’ redemption needs and prevent situations similar to 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 stablecoin issuer Circle Internet Financial. 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 arguments is that stablecoins are more transparent than banks in many ways. This transparency may be seen as an advantage for cryptocurrency enthusiasts who are skeptical of the opacity of the traditional financial system. But the opacity in the traditional financial system has its reasons.
Liao, Fishman and Fox-Geen point out in the paper that while this transparency may seem attractive to supporters of 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 certain 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 the belief that other people will run to the bank to withdraw their money. How do you know if there will be a run? This belief is usually rooted in rumors, bad financial reports, panicked TV interviews, etc. A bank's stock price drop may indicate that something is wrong with the deposits.
However, in the world of stablecoins, 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 for people 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 prices fall, they are more inclined to sell or redeem further, causing prices to continue to fall, thereby exacerbating market instability. Although 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 solution to this problem is that stablecoin issuers should maintain high liquidity for most of their funds.
Stablecoins and traditional banks need to adopt different strategies when managing financial risks, especially when facing a higher risk of coordinated runs.
Specifically, stablecoins backed by fiat currencies 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 stablecoin runs is much higher than that of traditional banks, so they need to maintain a high level of asset liquidity to quickly respond to redemption demands.
Because the pool of assets held by stablecoins is generally more resilient and is segregated specifically for the benefit of token holders, stablecoins typically require less capital buffers (funds to absorb financial losses) than banks. In other words, because the asset pool is robust enough and the risk of a run 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 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 be intended to emphasize the central role of blockchain technology in stablecoins and its impact on the unique properties of stablecoin systems.
Tokenization and the use of distributed ledgers not only pose financial risks, but also introduce 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 encryption, 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. Such risks are often referred to as operational risks in traditional banking.
The difficulty in assessing these operational risks lies in the following:
1. Lack of sufficient historical data: Since blockchain technology is relatively new, there is little 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 required loss-absorbing capital. This dependency becomes more prominent with the rapid development and continuous upgrading of infrastructure.
3. Rapid changes in infrastructure: In an evolving technology environment, assessing and managing these operational risks becomes more challenging. Technology choices and changes may significantly impact 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 because they are based on blockchain technology, which is transparent, traceable, and digitally native. The blockchain's public ledger and encryption protection allow every transaction to be recorded and verified, theoretically reducing the risk of losing funds.
On the other hand, it is also conceivable that stablecoin issuers are more likely to lose funds precisely because of these same technical characteristics. Reasons could include:
Technical Complexity: The complexity and novelty of blockchain technology may lead to operational errors or system vulnerabilities, especially in a rapidly evolving environment.
Dependence on technical infrastructure: Stablecoins are completely dependent on digital infrastructure. If there is a problem or attack on the system, it may lead to failure of fund management.
Lack of mature operational procedures: Compared with traditional banks, stablecoin issuers may lack sufficiently mature operational procedures and emergency mechanisms to deal with potential technical failures or errors.
The United States experienced a small banking crisis last year, which forced me to spend some time rethinking the banking industry. I once wrote:
The essence of a bank is a way for people to collectively take on long-term, risky investments without having to pay special attention to those risks. By spreading the risk among many depositors, banks make everyone safer and more profitable.
When you and I deposit money in a bank, we think of it as being very safe, money in the bank that we can withdraw at any time to pay the rent or buy a sandwich. But in reality, the bank is using that money to make long-term, fixed-rate, 30-year mortgages. Homeowners can’t borrow money directly from me for 30 years because I might need that 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 make loans to small businesses that might otherwise fail. These businesses cannot borrow from me directly because I am unwilling to take the risk of losing money, but they can borrow from us collectively because banks reduce the risk to individual depositors by spreading the credit risk among many depositors and borrowers.
The opacity of the traditional banking system has given banks more power to make risky investments with their customers' money. This opacity once helped banks operate in a relatively stable environment, as the complexity behind it made it difficult for customers to fully understand what the bank was doing. However, last year's regional banking crisis partially demonstrated that this opacity is no longer as effective as it used to be.
Today, the public can more easily access information about banks due to the widespread dissemination and digitization of information. Rumors and panic can spread rapidly around the world through the Internet, and people's expectations of banks are increasingly inclined to be market-based, that is, more concerned with real-time market performance rather than long-term stability.
As a Federal Deposit Insurance Corporation (FDIC) regulator said last year, the game is still the same game, it just got 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 vulnerable in the new information environment. Banks therefore need to manage risks more carefully to cope with more complex and rapidly changing market sentiment.
The magic of traditional banks is their ability to pool together a range of risky investments and then issue senior claims on them, which are represented by dollars: $1 in a bank account is $1, even if it is backed by a bunch of risky assets. This arrangement allows customers to trust that their deposits are safe and can be used without risk when needed.
However, stablecoins abandon this "magic". Although $1 of a 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 closeness 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 operate, but may also indicate the future development direction of traditional banking.
In the future, as financial markets become more digital and transparent, traditional banks may face similar challenges. Banks’ asset risks 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 may reshape our understanding of banking and financial stability and force regulators and market participants to adjust their risk management strategies.
