Stablecoins and Bank Failure — The Risk of Fiat-Backed Tokens

About the author: Ranjeet Sodhi is the CEO and Co-Founder of Vault. He is also a fintech entrepreneur with over 19 years of experience leading and turning around key regulatory risk management initiatives for global top tier investment banks and financial services firms, including JPMorgan Chase, Citi, Deloitte, and E&Y. You can follow him on Twitter at @ranjeetsodhi.

Recently news broke that Noble Bank, one of the early banks associated with safeguarding Tether’s backing, is likely insolvent and will be available for sale for as little as $5 million dollars (any cryptowhales want a bank in Puerto Rico?).

While updated versions of the story clarify that this insolvency is the result of the loss of key clients – including Tether – from their network, it highlights a critical issue that affects nearly all fiat-backed stablecoin projects, one that very few people in the cryptocurrency community are taking note of:

Banks fail.

They fail at an alarming rate.

Small banks (i.e. the only ones willing to work with crypto projects) fail most often.

This should be of particular concern to the cryptocurrency community because of the number of emerging fiat-backed tokens that have launched, leveraging singular storage of fiat currency in these types of institutions.

Regional Bank Failures in the United States

Since 2008, there have been over 500 bank failures in the United States. Most of these of these were smaller, regional banks (the FDIC keeps a running list here), that were poorly capitalized and not subject to the same capital requirements as the tier one players, but there are some surprising names on that list as well.

These banks fail for a principal reason: Credit and Operational Risk.

Simply put, these banks had outstanding liabilities that they could not meet, were not capitalized well enough to meet their outstanding obligations, and therefore imploded when it came time to meet their obligations.

This was seen most clearly in the 2008 financial crisis, in which a number of banks took on exposure to risky assets, leveraged them to purchase liabilities, and then were forced into insolvency when the market conditions changed resulting in these purchases becoming unprofitable.

Dodd Frank is a Partial Remedy that Doesn’t Improve Small Banks

To remedy this issue, Basel III and Dodd Frank legislations were implemented to ensure stricter capital reserve requirements in the US. The idea was that banks that want to take on riskier positions must have commensurately sized capital reserves to act as a buffer in case these investments failed and to prevent the insolvency of the banks, thus avoiding the “too big to fail scenario.”

However, these stricter capital requirements that were enacted to prevent bank failure only affected banks that had assets under management above $50 Billion dollars – and virtually all of the bank failures reported by the FDIC were underneath this threshold and therefore not subject to these updated requirements.

In other words, there’s an inherent risk in cryptocurrency projects that leverage traditional banking infrastructure – the small banks that are willing to work with cryptocurrency projects are also the riskiest because they are not subject to the same capital reserve requirements.

The World is Obsessed with Fiat-Backed Tokens

Ever since the launch of Tether, the cryptocurrency world has been obsessed with the concept of fiat-backed stablecoins. While there are many decentralized projects that tout algorithmic stability, the appeal of a token with a centralized store of value is clear – if you issue a token that’s worth a dollar, and you have a dollar ‘backing’ it, conceptually the token will probably be worth a dollar.

While Tether specifically has come under criticism, numerous tokens have since emerged that leverage the same basic model with incremental improvements – improved audits, redeemability, fiduciaries, etc. But all these fiat-backed entrants into the space effectively have their own take on the same model – issue a token, put a dollar in a bank account.

And these fiat-backed projects have gone on to raise significant capital, and achieve a total market cap of over $2.9 billion claimed to be sitting in bank accounts backing tokens.

A 2.9 Billion Dollar Liability for Small Banks

Here’s where things get interesting – dust off your accounting 101 textbooks, we’re going back to the basics.

For a bank to be solvent, it must have enough assets to cover its liabilities.

To a customer, the balance of their bank account represents an asset – they have money in the account, that they assume they can withdraw whenever they want.

To a bank, the balance of a customer account is… a liability! When a customer gives the bank money, the bank then OWES the customer that amount of money.

In normal circumstances, banks will use these funds to generate revenue for the bank – usually by issuing loans and mortgages to other customers.

The problem here is – the more liquid the bank account, the greater the risk associated with loaning out the money. A responsible bank is not going to use money from a checking account to issue a 30-year mortgage because the checking account owner might come and ask for their money at any time. However, the capital reserve requirement for systemically important financial institutions (SIFI’s) in the United States is on the average less than 10%, and for small banks this ratio is much lower. This means that many of these banks have poor/almost no capital reserves to protect against defaults or bad investments, and can become insolvent with just a handful of bad investment choices – this seems to be what happened with Noble Bank.

So, here we can clearly see the fundamental issue with the established fiat-backed stablecoin model. Storing hundreds of millions of dollars in liquid bank accounts in a regional bank represents an unmitigated risk for all parties involved. (And, before we get too excited about “FDIC Insurance,” let’s note that it typically covers deposits of up to $250,000 per beneficiary).

In Summary – There’s Significant Unmitigated Risk in Fiat-Backed Tokens, and No One Seems to Care

There’s a latent risk in fiat backed stablecoin projects that extends beyond Tether to seemingly every token with this model – banks are not designed to hold hundreds of millions of dollars in liquid accounts.

Recent projects have taken meaningful steps towards regulation, but in the press release announced by the New York Department of Financial Services, regulation is not aimed at addressing the risks outlined here.

Decentralized tokens do not have these issues, but instead place the reliability of the peg on algorithms and central-bank-like structures that have yet to be proven, and without a central store of collateral, token holders don’t have a claim on any underlying assets in the event of token collapse.

As the market evolves, other solutions will continue to emerge – fiat-backed tokens may find more established and credit-worthy counterparties, more sophisticated insurance options could arise to protect token holders, and alternative stores of value can be used that don’t rely on the traditional banking system – such as gold bullion backing.

Clearly, each stablecoin has its fallbacks and benefits, and it’s likely that a number of projects will find their footing to appeal to different segments of the market. But as this space evolves, one thing is becoming clear – holding enormous sums of capital as collateral for a fiat-backed stablecoin project is risky business.

Disclaimer: The views expressed in the article are solely that of the author and do not represent those of, nor should they be attributed to CCN.

Images from Shutterstock

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