Frances Coppola: Stablecoins Rely on Shadow Banking

We often talk about central banks creating fiat money. In fact, most fiat money is not created by central banks but by commercial banks. In addition, not all banks that create and hold fiat money are regulated banks. Many are what we know as “shadow banks”. There’s a whole shadow banking industry on the cryptocurrency network that creates and holds fiat money, or something that looks very similar.

Shadow banks are financial institutions that do banking-like things but are not subject to banking regulations. These include investment banks, non-banks, money market funds, private equity and hedge funds, and insurance companies. This also includes Special Purpose Vehicles (SPVs), subsidiaries that were established by regulated banks to do unregulated things. This includes banks headquartered outside of the US, especially in offshore countries.

Frances Coppola, a CoinDesk columnist, is a freelance banking, finance, and business speaker and writer. Her book “The Case for People’s Quantitative Easing” explains how modern money creation and quantitative easing work and advocates “helicopter money” to help economies out of recession.

The “shadow dollars” created and held by shadow banks are known as Eurodollars. “Euro” here does not refer to the euro currency and has little to do with Europe. Eurodollars these days usually live in places like the Cayman Islands and the Bahamas.

Because Eurodollars are held outside of the US regulated banking system, they have no FDIC insurance and the institutions in which they are held have no Federal Reserve support. Really, they are “faux dollars”.

For their users, however, Eurodollars are indistinguishable from real dollars created by the Fed and US-regulated banks. And when Eurodollars flow from the shadow banking system into the regulated system, they become real dollars. Conversely, dollars created by the Fed and US regulated banks become Eurodollars when sent to offshore or overseas locations. The system works as long as the implicit 1: 1 exchange rate between Eurodollar and real dollar applies. But when the pen fails, there is chaos.

See also: Questions about tether just don’t go away. Is the crypto market interested?

Tether’s bank, Deltec, is part of the shadow banking network. Located in the Bahamas, an offshore jurisdiction beyond the reach of US regulations, it holds US dollar deposits. Deltec Bank is not covered by the Federal Reserve, and the US dollars it holds do not have FDIC insurance. Tether’s deposits with Deltec Bank, including cash reserves that Tether says return USDT tokens, are Eurodollar deposits.

Deltec Bank may hold cash reserves with one or more US regulated banks. However, these reserves may not be sufficient to secure all Eurodollar deposits. And even if it does, dollars are not “held” in regulated bank deposit accounts. They are loaned to the bank and only insured up to the FDIC limit of USD 250,000 per customer and institution. In any case, the FDIC insurance only applies to deposits at regulated banks, not to deposits at offshore shadow banks, even if these shadow banks are customers of the regulated banks. If Deltec Bank failed, there would be no FDIC insurance for its depositors. Tether’s guarantee that 1 USDT = 1 USD is therefore entirely dependent on the remaining solvency of Deltec Bank.

See also: Pascal Hügli – Hyper-Stablecoinization: From Eurodollars to Crypto-Dollars

It’s not just Tether who relies on shadow banking. In a recent interview, Paolo Ardoino, Tether’s Chief Technical Officer, said that not only Tether itself, but also the cryptocurrency exchanges that are its main customers have US dollar accounts with Deltec Bank.

Some of these exchanges may use Deltec Bank as their settlement bank. However, others may simply have accounts with Deltec to make paying Tethers more convenient. Instead of transferring US dollars to Deltec Bank every time they need to top up their cables, they can simply top up their Deltec account whenever it suits them and use the balance to pay for more cables. Whichever approach they use, the money they deposit with Deltec Bank is not FDIC insured and is not covered by the Fed. And if their own settlement banks are shadow banks too, then any money they have with them is neither FDIC insured nor backed by the Fed.

The collapse of the Reserve Primary money market fund … shows how disastrous it can be to break such an implicit exchange rate peg.

Tether and its Crypto Exchange customers not only rely on the Fiat Shadow Banking Network, but are part of it themselves. And so are other stablecoin issuers. Just as Tether guarantees 1 USDT = 1 USD, other stable coin issuers guarantee that their coins are equal to US dollars. They even call them US dollars: USDT means “USD Tether”, USDC means “USD Coin” and so on. However, with a few exceptions, stablecoins are created by unregulated financial institutions that do not have FDIC insurance or Fed support. Stallcoins are really “faux dollars”.

See also: Frances Coppola – The Stablecoin Surge is based on smoke and mirrors

Whether stable coins such as USDT and USDC can be exchanged 1: 1 for US dollars depends entirely on the existence of adequate US dollar reserves and the solvency of the banks that hold these reserves. If there aren’t enough actual dollars to pay all of those who want to withdraw their money, the 1: 1 exchange rate peg is broken and coin holders cannot get all of their money back.

The collapse of the Reserve Primary money market fund during the 2008 financial crisis shows how catastrophic it can be to break such an implicit exchange rate peg. Investors in a money market fund pay US dollars in exchange for shares in the fund. Until 2008, money market funds marketed as high yield versions of insured US bank deposits. It was widespread that shareholders would always be able to withdraw their deposits and that no fund would “break the money”. So 1 share = 1 USD. Sounds a lot like a stablecoin, doesn’t it?

Reserve Primary MMF did not have 100% cash reserves on its shares. It had invested in commercial papers issued by the shadow bank Lehman Brothers, among others. When Lehman Brothers failed in September 2008, the value of its commercial papers plummeted to zero and Reserve Primary MMF could no longer guarantee the 1: 1 bond. It announced to its shareholders that it could only return 97 cents for every dollar invested.

The announcement by Reserve Primary MMF, shortly after the failure of Lehman Brothers and the collapse of insurance company AIG, sparked shock waves in the financial system. Huge sums of money flowed from the shadow banking network into regulated banks and US treasuries. To stop the run, the Fed rescued the shadow banking network, reestablished the broken peg, and restored confidence in Eurodollars.

See also: JP Koning – What tether means when it says it’s “regulated”

Like the shareholders of Reserve Primary MMF, cryptocurrency traders simply treat stable coins as a variety of US dollars. Of course, traders know that the exchange rate is not guaranteed and that not all stable coin issuers have 100% cash reserves. But hey, the Fed has bailed out shadow banks before, right? Why shouldn’t it save stablecoins?

Unfortunately for crypto traders, stablecoins and their banks are nowhere near as dangerous to the global financial system as Lehman Brothers, AIG, Reserve Primary MMF and the rest of the shadow banks that crashed in 2008. If Tether falls, the crypto market will be seriously disrupted, but the rest of the world will hardly notice. And few people will lose sleep over a small Bahamian bank failure.

Neither the Fed nor the FDIC have any reason to ensure that crypto traders can get their US dollars out of the stable coins and exchanges on which they have deposited them. The credibility of the promises made by crypto shadow banks therefore depends solely on the adequacy of their reserves. Unfortunately this seems to be hugely variable. So we could say “reservation depositors”. Choose your stable coin carefully.

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