How to insure against the risk of stablecoin runs

The news that TerraUSD, one of the largest algorithmic stablecoins with a market cap once above $18bn, broke its peg to the dollar has reverberated throughout financial markets. Although the variety of mechanics behind algorithmic stablecoins may be difficult to understand, and can vary from one stablecoin protocol to another, what happened to Terra, as US Treasury Secretary Janet Yellen told the Senate banking committee, is that it ‘experienced a run and declined in value’.

Given the growing importance of the stablecoin market, which has experienced a remarkable increase in total supply over the past two years to approximately $180bn, the Biden administration recently issued an executive order on ensuring responsible development of digital assets. This charges numerous government agencies with the task of formulating policies and measures designed to mitigate risks, while supporting innovation that can improve efficiency, reduce costs and increase financial inclusion.

This is a complex and important issue that cannot be solved easily. Many government agencies and industry groups will play a role. However, one agency that was expressly created to bolster public confidence amid the banking runs of the great depression springs to mind in particular – the Federal Deposit Insurance Corporation.

As Washington looks for ways to ensure responsible development in digital assets, now is the time to consider tasking the FDIC with analysing the possibility of a new federal stablecoin insurance programme to help mitigate the risk of stablecoin-related runs.

Although a federal stablecoin insurance programme seems implausible at first, it isn’t that different from the deposit insurance we have today. Commercial banks that want to have their deposits covered must pay a fee to the FDIC, based on various metrics. These fees go into a deposit insurance fund, which is only used in the event of a bankruptcy. The deposits covered by this programme are actually commercial bank money, not central bank money. In effect, this government programme helps insure private money, avoiding the harm that bank runs could inflict.

An optional programme similar to deposit insurance could be created for dollar stablecoins. Any provider that wanted to opt in could be required to submit documentation related to their stablecoin’s stability mechanism and reserve portfolio. This would be similar to the supervisory evaluations the FDIC uses to assess a bank’s overall condition, though it would take into account stablecoin specific criteria.

Once the structure of the stablecoin was evaluated and its potential risks were better understood, the FDIC could assign the stablecoin to one of a number of risk groups, which would determine the fee needed to be paid.

Since stablecoins are built on blockchains, the FDIC should consider utilising similar technology for its insurance programme to improve efficiency, reduce costs and increase transparency. As such, the FDIC could issue a stablecoin insurance token on a private, permissioned blockchain and only allow access to SITs to stablecoin providers that have completed a risk assessment.

Different stablecoin providers use different stability mechanisms. Some are collateralised with high quality liquid assets and might, for example, pay 30 basis points per SIT. Others that are overcollateralised with cryptocurrency assets might pay a higher rate. A purely algorithmic stablecoin may be required to pay significantly more.

Similar to deposit insurance, the money collected could be placed in a stablecoin investment fund to maintain public confidence and resolve failed stablecoin projects. Those stablecoins that didn’t join would be ineligible, helping to mitigate potential moral hazard problems.

Currently, the designated reserve ratio for the deposit insurance fund is set at 2%, with bank assessments calculated each quarter, but the FDIC could increase the reserve ratio and/or frequency of assessments for stablecoins should the need arise.

There are still lots of questions that need to be answered about how much is insured per account, especially given the global nature of the asset. In the beginning, such an amount could be kept relatively low and still be effective.

Analysing address data from The Block and CoinMarketCap for Tether and USD Coin, the two largest stablecoins, more than 90% of related addresses hold less than $1,000 in stablecoins. Although a more thorough analysis of address-level data is likely to be needed to determine the optimal limit, $1,000 is a useful benchmark.

Importantly, the programmable nature of stablecoin technology could help strengthen the legal claim for the end user in the event of bankruptcy, improving consumer protection. One unit of SIT could be linked to one stablecoin, such that the SIT reverts to the stablecoin holder should a bankruptcy trigger an insurance payment. After confirming the holder’s identity, SIT could be returned to the FDIC until the $1,000 cap was reached.

The idea of creating a federal stablecoin insurance programme may be unorthodox, but it also represents a unique opportunity to achieve many of the objectives laid out in President Biden’s executive order.

Stablecoin insurance could bolster public confidence, mitigate systemic risk by helping to avert runs and provide a better risk assessment framework for stablecoins. Additionally, it would support technological advances that are helping to lower costs, increase efficiency and improve transparency, promoting safe and affordable access to financial services.

Just as the creation of the FDIC helped reinforce the leadership of the US in the global financial system following the great depression, implementing a new federal stablecoin insurance programme could boost US credentials as digital asset technology dramatically alters the financial landscape.

Biden is, of course, still free to explore the development of a central bank digital currency as part of his strategy, but he would do well to remember that when President Franklin Roosevelt was contemplating the ‘readjustment of our financial system’, he noted that ‘there is an element… more important than currency… and that is the confidence of the people’.

Many questions are yet to be answered and many avenues to be explored as part of the financial landscape’s digital revolution. But stablecoin insurance could provide a boost of confidence as more and more regular consumers take part in the blooming digital currency market.

This article was originally published on www.omfif.org

This article was prepared by the author. The views expressed in this article are the author’s own and do not necessarily reflect the views of the Digital Euro Association.