Fitch Ratings Report: Continued increase in stable currency issuance may bring new short-term credit market risks

The study shows that the incremental issuance of stablecoins may have an impact on the functioning of short-term credit markets.

The recent rapid growth in stablecoin issuance could, over time, have an impact on the functioning of short-term credit markets. The potential asset “contagion risk” associated with the liquidation of stablecoin reserve assets could increase regulatory pressure on this nascent industry.

Contagion risk is primarily associated with collateralized stablecoins and varies depending on factors such as the size, liquidity and riskiness of their assets, as well as the transparency and governance of the operator.

Tokens backed entirely by secure, highly liquid assets pose less risk, but regulatory authorities may still increase their focus due to the potentially global or systemic nature of their financial footprint. For example, USD Coin, the second largest stablecoin pegged to the U.S. dollar, is backed by a 1:1 ratio of U.S. dollars in a custody account. And stablecoins that use fractional reserves or employ higher-risk asset allocations may pose greater operational risk. For example, Tether, the largest stablecoin issuer, disclosed that as of March 31, 2021, it held only 26.2 % of its reserves in cash, fiduciary deposits, reverse repurchase notes and government securities, and another 49.6 % in commercial paper (CP).

Fitch Ratings Report: Continued increase in stable currency issuance may bring new short-term credit market risks

As of March 31, Tether’s commercial paper holdings stood at $20.3 billion, while its total consolidated assets stood at $41 billion and may be increasing rapidly; total assets of the U.S. dollar-linked stablecoin (USDT) reached $62.8 billion on June 28. These figures suggest that its CP holdings may be larger than those of most prime money market funds (MMFs) in the U.S. and Europe, the Middle East and Africa. A sudden massive redemption of USDT could affect the stability of short-term credit markets if it occurs during a period of general environmental selling pressure, especially if it is associated with more widespread redemptions of other stablecoins holding similar asset reserves.

The Diem USD stablecoin, which is planned to be issued by the Facebook-backed Diem Association in partnership with Silvergate Bank, proposes to hold at least 80% of its reserves in low-risk, short-term government securities. The remaining 20% would be held in cash, with overnight interest invested in an MMF of short-term government securities with the same risk and liquidity.

Projects that could quickly become systemic, such as Diem, have caught the attention of regulators and could lead to stricter regulation of stablecoins. U.S. regulators have also noted that entities with asset allocations similar to those disclosed by Tether may not be as “stable” if short-term credit spreads widen significantly, a phenomenon that has already occurred in 2020 and during the financial stress of 2007-2008. This is in contrast to the way stable coins are marketed to the public.

According to the Stablecoin Escrow and Banking License Enforcement Act (STABLE), which was submitted to the U.S. Congress in December 2020, and the EU’s Crypto Asset Market Regulation, which proposes a stricter regulatory framework, the timeline and details of the plan remain unclear or subject to change. But tighter regulation could improve transparency and force a gradual shift in collateral reserves for stablecoins to less risky assets. This process could also influence — or be driven by — authorities’ approach to central bank digital currencies as well as instant payment services such as the FedNow service in the United States.

We believe authorities are unlikely to intervene to save stablecoins in the event of a disruptive event, in part because of moral hazard. If redemptions of stablecoins lead to or amplify a broader CP sell-off, putting pressure on market liquidity and preventing new CP issuance, authorities could step in to support dealers and major MMFs to resolve the problem.

Image credit: Fitch Ratings, Internet

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