Could Stablecoins Topple the Crypto Industry?

We can't continue to ignore Tether's reserve issues.

It could be said that Tether (USDT) has been crypto's dirty secret for several years. Like other stablecoins, it avoids the volatility of ordinary cryptocurrencies by pegging its value to another commodity -- in this case, the U.S. dollar.

Crypto traders use stablecoins to move in and out of crypto positions without having to move their funds off crypto exchanges altogether, which can be time consuming and expensive. Stablecoins are also a cornerstone of the booming decentralized finance (DeFi) industry. In short, they promise the benefits of cryptocurrencies, such as cheap and speedy money transfers, without the price volatility.

But the truth is that some stablecoins are anything but stable, which is why regulators are keen to put more controls in place. So it's a good time to consider the risks they pose -- both to cryptocurrencies and to the wider economy.

What if people want to withdraw all their money?

The premise of a fiat-backed stablecoin like Tether is that every USDT that's minted is supported by a dollar that's held outside the crypto markets.

There are $68 billion USDT in circulation -- that's $68 billion that traders have given to Tether on the understanding that when they want to trade it or convert it into U.S. dollars, they'll be able to. But let's imagine for a minute that rumors of new regulation make investors nervous and many people start withdrawing their USDT. That could trigger a run on Tether.

The problem? Only 2.9% of Tether's reserves are held in cash. Almost half is held in commercial paper, which is a type of short-term debt. And Tether has not been transparent about what types of commercial paper it has issued.

This may sound like fear-mongering. But an investigation by the New York Attorney General's office has already shown the need to question Tether's practices. In February, New York Attorney General Letitia James told press, "Tether's claims that its virtual currency was fully backed by U.S. dollars at all times was a lie."

If there was a run on Tether and lots of people wanted to withdraw their funds, there is no guarantee they could. And it isn't an exaggeration to say that the ripple effect from that could topple the crypto industry. Here's why:

• Popular cryptocurrency exchanges could collapse
• The bottom could fall out of the DeFi market
• Consumer confidence in cryptocurrencies could be destroyed

Most importantly, billions of crypto investors around the world could lose money. And it wouldn't stop there. In July, Fitch Ratings warned of the possible impact on wider credit markets. The credit rating agency said in July that, "A sudden mass redemption of USDT could affect the stability of short-term credit markets."

We've been here before

Cryptocurrency investors are no strangers to risk. Most articles on the subject contain warnings about volatility and potential coin failure. But the risk presented by certain stablecoins is harder to see -- a lack of transparency about assets means we don't always know what's happening behind the scenes.

But just because we can't see the danger, it doesn't mean it doesn't exist. A look at recent history shows us why commercial paper is concerning. Before 2008, people thought that money market funds were safe investments. It turned out they weren't as safe as many had assumed.

Like stablecoins, money market funds pledged to maintain a share value of $1. But when Lehman Brothers declared bankruptcy, it caused the share value of a well-known money market fund to fall below $1. That fund had some exposure to Lehman Brothers debt. When it was unable to maintain its value, even more investors then tried to withdraw their money, pushing the value down even further.

In the instability and panic that followed, the government had to step in to stop a run on several other money market funds. And, in 2016, the Securities and Exchange Commission introduced new rules to protect investors from a recurrence.

This is one reason why regulators want stablecoins to follow stricter regulations. The logic is that if they behave like money market funds, they should be regulated in the same way.

Tether is not the only stablecoin

Tether is the biggest stablecoin on the market, but there are a growing number of alternatives. And some, such as USD Coin (USDC), have trumpeted their reserve credentials loud and clear. Coinbase, one of the partners involved in USDC says, "Each USDC is backed by one dollar or asset with equivalent fair value, which is held in accounts with U.S. regulated financial institutions." As of July, USDC held 9% of its funds in commercial paper and 61% in cash and government money market funds.

There are also several types of stablecoins that are not backed by fiat currencies. For example, Cardano (ADA) recently announced the launch of an algorithmic stablecoin called Djed. This maintains its price with a preprogrammed algorithm that buys or sells assets as needed.

Regulation aside, the best thing that could happen is that investors gradually move their funds out of Tether and into more transparent alternatives. Right now, a run on the biggest stablecoin by market cap could do significant damage to the whole market. But as Tether's size and influence diminish, so does the risk -- as long as the stablecoins that replace it have less exposure to risky assets like commercial paper.