Fed warns on crypto risks as major stablecoin breaks peg

The US Federal Reserve warned of the risks posed from stablecoins in its latest financial stability report, which was published the same day as a major stablecoin broke its peg to the US dollar.

TerraUSD, the fourth-largest stablecoin by market capitalisation, plunged in value on May 9 amid a widespread sell-off in the crypto market and broader financial markets. The stablecoin is down around 7% in the past day, having recouped some of its earlier losses.

TerraUSD’s inability to maintain a stable peg underscored the risks highlighted in the Fed’s report. The central bank noted how stablecoins tend to promise liquidity while being backed by illiquid assets, making them subject to runs in a similar way to money market funds.

“These vulnerabilities may be exacerbated by a lack of transparency regarding the riskiness and liquidity of assets backing stablecoins,” the Fed said.

The US central bank said the risks were even higher due the growing use of stablecoins to meet margin requirements in leveraged crypto lending. This may amplify volatility and raise redemption risks.

Stablecoins, particularly those linked to the US dollar, have grown rapidly in the past year, reaching a value of around $180 billion in March 2022. Over 80% of stablecoin market cap is accounted for by the top three coins, Tether, USD Coin and Binance USD.

All three of the largest stablecoins maintain their value on the basis of a pool of dollar-denominated assets. For example, Tether mentions holdings of assets including commercial paper, fiduciary deposits, cash, repos and Treasury bills.

Each of the top three stablecoins claims they have a 1:1 backing with dollar assets, though there have been questions raised over Tether’s accounting practices.

By contrast, TerraUSD operates as an “algorithmic stablecoin”, using computer code to run what it describes as “monetary policy”. By varying the supply of an underlying asset – itself a crypto asset – the operator of the stablecoin claimed it could achieve a stable peg to the dollar. However, selling pressure across the crypto market seems to have overwhelmed the algorithm.

The Fed noted how a “wave” of technological advances in finance had created a boom in financial products and new digital assets. “The proliferation of new types of digital money, including stablecoins, could present risks to both individual users and the financial system as a whole,” it said.

In this context, it suggested a central bank digital currency (CBDC) could promote financial stability. “A CBDC could provide the public with broad access to digital money that is free from credit and liquidity risk,” it said.

CBDCs might also “level the playing field” for fintech firms wanting to provide innovative services, the report said. Digital money could underpin “new access services, distribution methods, and related service offerings”.

Research by the Bank for International Settlements has highlighted a growing trend among central banks towards the issuance of CBDCs. Over two-thirds of central banks now say it is “possible” they will issue a retail CBDC in the medium term, the highest proportion the BIS has recorded since it began its annual CBDC surveys in 2017.