When I started my career in finance, one of the first realizations I had was that almost nothing was new. A “new” product in finance was almost always a resurrection of an old product or a retrofitting of an existing product to a new application. Truly new products were exceptionally rare.
One observation I’ve had as crypto markets evolve is that many of the products have the exact same set of flaws as financial products that have come before. Or, when they do not have the exact flaws, they have similar ones. History may not always repeat itself, but it does rhyme.
With today’s release of the Lummis-Gillibrand bill, together with other recent proposals to address governance of dollar-pegged digital assets called stablecoins, I want to take this opportunity to review the old and the new as applied to stablecoins. In doing so, I will look to the 2008 financial crisis for lessons learned.
What is Stable?
Form is Function
The first lesson of the crisis is that product structure and legal relationships matter. There are a few key best practices:
Segregated and bankruptcy remote funds, in practical terms, means that your assets are held in trust for you. In the case of a stablecoin that means that if they are not segregated you are a general creditor of the company and junior to its secured debt holders in a race for recovery. To be clear, that means that your dollar may not be redeemable for a dollar.
As an oversimplification, having a primary prudential regulator means operating within an authorized set of products and services and within a defined risk framework. In the case of a stablecoin, if the issuer of the coin is not approved by a prudential regulator, they do not necessarily have to invest the reserves or manage the stablecoin in a way where the primary goal is the preservation of underlying principal and value for the end users of the coin. Remember, you give an issuer a dollar and they are supposed to return you exactly a dollar – no more and no less. If they are not constrained in how they manage your dollar, then the issuer’s desire to earn higher returns on your dollar may drive them to expose you to risks that may undermine the safety of your dollar.
The second lesson of the crisis is that many traditional financial assets that claimed to be stable were not. There are entire books on this, but a quick overview of how they performed in the financial crisis is as follows:
The single most obvious stable instrument in traditional markets is actual physical currency. The $20 bill in your pocket. I’m as confident as I can possibly be that it will continue to be worth $20 (inflation notwithstanding). This seems trivial, but it raises an important point: the goal of all other products in the price stability space is to get as close to parity with currency as possible and maintain parity. It is the ideal1 that other products aspire to.
Unsurprisingly, cash continued to be worth the amount printed on the front of the bill in 2008.
After physical cash, FDIC-insured bank deposits are the most secure. In the United States, to prevent runs on banks during times of economic stress, the FDIC was created to provide deposit insurance to regulated banks. At current levels, what this means is that if you have $250,0002 or less at a bank as of the current insurance levels, you will be made whole on your deposits even if the bank itself were to fail.
Bank deposits are not themselves cash; banks take deposits, make loans, and attempt to make interest income on the loans greater than what they pay on the deposits while not having too many of the loans go bad. This mostly works, historically. When it doesn’t, banks can fail. During the financial crisis there were many lenders without primary prudential oversight, or shadow banks, who failed as liquidity withdrew from markets. When a stablecoin issuer uses customer assets to earn returns but is not subject to oversight by a primary prudential regulator, they are acting as a shadow bank and subject to a higher likelihood of liquidity runs.
In 2008 the US did not experience significant bank runs by depositors.
However, it should be noted that the picture here is not perfect: 2008 did reveal that bank deposits above FDIC limits could be at risk in the event of another credit crisis. Uninsured deposits, which are deposits above the FDIC limits, have experienced losses in the past. The historical loss rate for such deposits is very low, but not zero.
US Treasury Bills
T-Bills are short-term debt obligations of the US government itself, backed by the full faith and credit of the United States. As of yet, there has not been a default in the history of US Treasury markets, and short-dated US government debt is THE global safe haven asset in times of financial turbulence. T-Bills under 90 days in maturity also fall under the definition of “cash equivalents” in the United States.
Unsurprisingly, in 2008, these instruments were one of the most preferred in terms of safety. This is a common pattern across various financial downturns in recent US history (including 2020 when COVID began as well), and post-crisis reforms in the money market fund space have enshrined government money market funds (which are funds typically composed of T-Bills and other short dated agency debt) as the instrument of choice for net asset value (NAV) stability and liquidity.
Overnight Repurchase / Reverse Repurchase Agreements
Repo is one of the most basic forms of lending or borrowing in financial markets, taking the form of a pre-agreed buy and sell. In short, the lender sends cash, buying securities, and the borrower agrees to repurchase those securities at a future date, at a higher price, which reflects the interest that is paid on the loan plus the original sale price of the securities. These are almost always overnight. In the interim, the lender of the cash holds securities that generally over collateralize the loan.
In the case where these securities are US Treasuries, such as is the case with the Paxos-issued stablecoins USDP and BUSD, the ultimate source of loss, even if the borrower were to default, is the credit risk of the US Treasury itself. However, in the cases where the securities can be credit exposed instruments or if a bilateral repo counterparty fails, there is risk of loss on the collateral due to default.
Commercial Paper / Short-Term Debt
These instruments are highly rated, short-term obligations of corporate and other non-government issuers in the cash equivalents space. They include commercial paper, corporate debt that has run down and has less than 1 year to maturity, bank notes, and other forms of short-term debt and loans. Also in this category are certain forms of Agency debt (not quite government guaranteed) and municipal bonds with appropriately short maturities.
Historically, the main holders of these types of exposures are prime funds and other short-term investment vehicles, along with insurance companies and some banks. The short duration characteristics of most prime funds3 are nearly identical to government funds, yet the credit exposure to corporate and other non-government debt has proven disruptive in the past and limited their ability to be used as a flight to quality instrument, most notably when the Reserve Fund broke the buck in 20084.
Thus, while the majority of these instruments survived 20085, there were some notable failures and losses in the market, including those caused by the collapse of Lehman.
Now, having left the realm of purely vanilla bonds, we enter into the dark reaches of the financial system. When people talk about things like shadow banking or invisible derivatives exposure, off balance sheet financial guarantees are one of the things that they are talking about. In 2008, if you were to look at financial markets, a key form of financial guarantee was stable value wraps, covering approximately $400B of funds in retirement markets.
Stable Value Funds, which were a form of NAV stability product, were typically bond funds with a relatively conservative underlying portfolio (2-4 year duration, investment grade, etc.). These funds then purchased a limited form of financial guarantee called a stable value wrap, where if the funds were ever forced to be unwound and the securities liquidated, shortfalls to the stable NAV were then covered by the wraps in most cases6.
However, stable value wraps were also uncollateralized exposures. This meant, in the depths of the crisis, there were significant doubts about the sufficiency of some of the wraps depending on the counterparties in those trades. While none of them ultimately failed7, post-crisis derivatives reform is slowly moving most forms of derivatives to fully collateralized forms to address this issue.
Drawing Parallels: Stablecoin Ideal Design
With a clear view of both financial structures and the dangers of 2008 evaluated, the next question becomes a simple one: what would a truly stable tokenized dollar look like?
At Paxos, we believe all properly constructed stablecoins should have the following aspects:
- Clear matching of tokens to reserves, where all stablecoins are at least 1:1 backed by cash and cash equivalent reserves at all times
- Transparency of reserves, so that holders of a stablecoin have complete and total knowledge of the specific assets backing the coin
- Availability, such that creation and destruction of a stablecoin, as well as the commensurate sending of dollars via traditional rails, is easily achieved
- Controls and oversight, with a primary prudential regulator ensuring there are attestations, audits, and examinations of controls such that a stablecoin issuer’s operations are at or above the standard of traditional financial institutions handling fiat
- Reserve management practices, including binding investment guidelines, that limit reserves to conservative assets that would perform well in periods of genuine financial stress, such as 2008
- Fiduciary duty to ensure that the issuer places the customer’s interest ahead of their own
- Segregation of funds to insure that they are bankruptcy remote and never leave legal possession of the customer.
Learning from 2008, the reserves should be composed of T-Bills, or government money market funds primarily composed of T-Bills, bank deposits (with prudent and limited use of uninsured deposits as necessary to facilitate liquidity), and Overnight Repo secured only by US Treasuries. Introducing other instruments simply introduces credit risk, and transforms the stablecoin into something more like a traditional fixed income or equity exposure, depending on the underlying instrument.
Even this framework, of course, is not a guarantee of performance – such a thing is unfortunately not possible – but the goal of any proper stablecoin is to have a USD stablecoin that achieves constant parity with the USD in all market and economic environments.
At Paxos, we believe that properly designing and implementing these features into our products, at the outset, weigh the odds in your favor.
1 Minus the whole being destroyed, lost, or stolen bit
3 Prime Funds are typically governed by SEC rule 2a-7 like government money market funds, but own credit-exposed instruments like commercial paper and bank notes
5 In each of these cases, while there was not a failure or the product, there were massive outflows of liquidity that initially led to significant discounting before eventual recovery.
6 In each of these cases, while there was not a failure or the product, there were massive outflows of liquidity that ultimately led to investor losses and significant discounts to price.
7 In each of these cases, while there was not a failure or the product, there were massive outflows of liquidity that ultimately led to investor losses and significant discounts to price.