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Stablecoin Depegging Highlights DeFi's Exposure To TradFi Risks

S&P Global Ratings believes that the temporary depegging of two major stablecoins following SVB's failure demonstrates inherent risks in these assets. Stablecoins are crypto assets that are intended to maintain their value relative to a fiat currency. Yet after SVB's collapse, U.S. Dollar Coin (USDC) and DAI temporarily lost their peg to the U.S. dollar by 13%, before subsequently rebounding. Meanwhile, regulators closed down Signature Bank, a key lender to crypto businesses, which followed the liquidation of Silvergate Bank on March 8, 2023. In our view, these events highlight the interconnectedness between the traditional and decentralized financial systems (TradFi and DeFi), and that contagion of risks has the potential to go both ways. It remains to be seen whether the failure of these three banks will have a broader effect on the crypto ecosystem, particularly if other banks are not ready to step in to serve it.

TradFi Risks Spill Over To DeFi

On March 10, 2023, the Federal Deposit Insurance Corporation (FDIC) took over SVB, a major lender to technology companies in the U.S. and across the globe. SVB's failure stemmed from a combination of significant unrealized losses on its securities portfolio driven by rising interest rates and an acceleration of deposit outflows.

U.S. authorities took action to reduce contagion risk, protecting all deposits at SVB and Signature Bank (see "The Fed's Plan For U.S. Banks Should Reduce Contagion Risk," published March 13, 2023). Before this plan was announced, USDC and DAI--two major stablecoins--depegged from the U.S. dollar. Circle, the issuer of USDC, confirmed that $3.3 billion of the cash reserves backing USDC were held at SVB (see chart 1). Investors lost confidence in USDC, driving its value to a low of $0.88 on March 11, until Circle's CEO, Jeremy Allaire, stated that Circle would cover any shortfall in the USDC reserves from corporate funds. Because SVB's depositors were ultimately protected, the USDC reserves suffered no loss, and USDC regained its peg on March 13. Meanwhile, Coinbase, a crypto exchange that partners with Circle in the Centre Consortium that operates USDC, also temporarily halted exchanges between USDC and fiat U.S. dollar over the weekend, until reinstating them on March 13.

Chart 1

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In turn, the depreciation of USDC affected the value of DAI, because USDC holdings and related instruments represent over half of the collateral reserves backing DAI (according to data published by DefiLlama). However, not all stablecoins were affected in the same way. Tether, for example, had no exposure to SVB; its value increased slightly above $1 before returning to parity on March 13 (see chart 2).

Chart 2

image

What Risks Does This Highlight In Major Stablecoins?

Timely convertibility of stablecoin to fiat may not always be possible.  A key purpose of stablecoins is to provide a bridge between the fiat and crypto ecosystems, by allowing on-chain payments with the stability of a fiat currency. In order to fulfil this purpose, they must not only maintain their peg to a fiat currency, but also be convertible to fiat currency in a timely manner. While conversion of USDC to U.S. dollars has remained possible through some exchanges, it is notable that Coinbase halted conversions temporarily. Coinbase partners with Circle in the Centre Consortium that operates USDC, and to date has promised to convert USDC to U.S. dollars at a rate of 1:1, including at times when the price has fluctuated on other exchanges. Although Coinbase has reinstated exchanges at a rate of 1:1, this interruption highlights the risk that a stablecoin may not be convertible at all times in a timely manner. As DeFi market participants explore use cases for DeFi protocols in financing fiat assets in the real economy--such as through lending or securitization-focused protocols, where stablecoin funding is raised to finance fiat-denominated assets--it is critical to consider the risk that a stablecoin may not be convertible when needed to meet fiat obligations (see "DeFi Securitizations: A Credit Risk Perspective," published Feb. 7, 2023).

Investor confidence can also affect a stablecoin's value. If investors lose confidence in the sufficiency of reserve assets, the stablecoin's value will fall from its peg. The fiat-based reserves that back stablecoins are subject to market-value risk (particularly in a rising-interest-rate environment), as well as potential credit and counterparty risks. An increase in these risks--whether actual or perceived--can result in a depegging.

Centrally issued stablecoins depend on their issuer to manage and cover risks.   The issuer of a centralized stablecoin is responsible for maintaining sufficient reserves to back the outstanding balance of its stablecoin. The issuer may need to contribute capital to cover declines in the value of collateral reserves in a rising-interest-rate environment, or to cover credit losses in the collateral reserves. In the case of USDC, reserves are held in short-dated treasuries, and cash held at regulated U.S. financial institutions, with monthly attestations to the sufficiency of collateral published by Grant Thornton.

Contagion risks exist between USDC and DAI.   DAI is a collateralized stablecoin created by the Maker protocol. It is not issued by a centralized entity. Unlike USDC, DAI is backed primarily by crypto collateral, and uses an overcollateralization threshold and automated liquidation mechanism to maintain its peg. However, its value is ultimately driven by market confidence; in particular, by confidence in the value of the collateral backing its U.S. dollar peg. This collateral includes a material exposure to USDC, creating a transmission channel for risks affecting USDC or its issuer Circle to materially affect the value of DAI, as highlighted by recent developments. With the recovery of the value of the USDC, DAI's value has also stabilized.

What Does This Mean For The Future Of Stablecoins And The Broader DeFi Ecosystem?

Stablecoins remain necessary to the growth of DeFi.   We do not expect central bank digital currencies (CBDCs) to be issued by most major central banks in the near future. Therefore, privately issued stablecoins will be a necessary tool to enable use cases for DeFi.

Regulation will be key to the industry's development.   Regulatory efforts related to crypto assets have so far particularly focused on stablecoins as a potential risk transmission channel between the crypto and DeFi ecosystem and the real economy. In our view, it is likely that regulation will lead to the development of stablecoins that are issued by regulated financial institutions. Recent events may also increase regulators' focus on the stablecoin issuer's obligations, particularly in terms of loss coverage and timely redeemability.

A shortage of TradFi partners may hold DeFi back.   Three of the banks that were most active in serving the crypto industry have failed in recent weeks. Meanwhile, regulators are becoming increasingly assertive in their warnings to banks around crypto risks, particularly in the U.S. It remains to be seen how the relationship between the rapidly evolving crypto ecosystem and the traditional banking system will develop.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Andrew O'Neill, CFA, London + 44 20 7176 3578;
andrew.oneill@spglobal.com
Secondary Contacts:Alexandre Birry, London + 44 20 7176 7108;
alexandre.birry@spglobal.com
Lapo Guadagnuolo, London + 44 20 7176 3507;
lapo.guadagnuolo@spglobal.com
Mohamed Damak, Dubai + 97143727153;
mohamed.damak@spglobal.com
Cristina Polizu, PhD, New York + 1 (212) 438 2576;
cristina.polizu@spglobal.com

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