# Too Big To Fail: Current Stablecoins Hurt Decentralization As They Grow

Stablecoins are the blockchain industry’s most important product. They are the medium for P2P payments and account for how a majority of transactions on the blockchain are processed. After the collapse of UST, Tether’s unclarity on reserve backing and gaping flaws with other stablecoins, USDC is the de facto trusted stablecoin. However, recently, it depegged drastically to below 88 cents causing the failure of four of five top stablecoins by market cap, several DeFi protocols, and damage to users’ long term savings. This depegging event has demonstrated USDC’s systemic importance in the blockchain markets and its fragility as a store of value.

Failure of USDC and its creator Circle Inc. is a single point of failure for most other stablecoins and the blockchain industry as a whole. Other major stablecoins, DAI and Frax are critically dependent on USDC with over 50% of MakerDAO’s DAI reserves in USDC. Similarly, Tether, the market leader in stablecoins, is nontransparent about its backing. They have yet to submit adequate proof of reserves. It has yet to be proven that every issued Tether is backed 1:1 by reserve equivalents. There is high suspicion among the blockchain community that a substantial amount of Tether has been minted without any backing.

Following FTX’s collapse, Binance and BUSD is facing regulator scrutiny. Paxos, the issuer of BUSD was forced to discontinue issuing new BUSD by New York regulators. Frax is significantly exposed to USDC, through direct holdings of USDC and also liquidity provider tokens in USDC and DAI. A large portion of Frax’s backing is algorithmic. Algorithmic backing has been proven it will absolutely fail during a bank run and was the cause of UST’s failure. Currently, 10–20% of outstanding Frax is backed using the exact same mechanism as UST, which means in the event of a bank run Frax’s intrinsic value is 80–90 cents without considering possible losses on its LP token holdings, which comprise over 50% of holdings. This is priced into the price of FRAX, which rarely trades at its pegged price of $1.

## Centralized Counterparties
Silicon Valley Bank’s failure due to the bank’s incorrect management of long term assets and short term liabilities caused 3.3B of USDC’s 32B net backing to be frozen pending government liquidation. The U.S. government froze Silicon Valley Bank’s assets, leaving it unclear whether any of USDC’s backing held at the bank was ever to be released. This forced Circle to disable redemptions of USDC, triggering a steep price drop in USDC and most other major stablecoins. The bank’s assets were eventually unfrozen and USDC regained its peg.

Frax peg highly unstable due to partial algorithmic backing

BUSD peg unstable due to Binance solvency concerns

USDT often depegs due to accounting opaqueness \& solvency concerns

DAI peg broken due to USDC depeg, where more than 50\% of DAI’s assets held in USDC

USDC peg broken due to Silicon Valley Bank failure

## Size Leads to Centralization

Initially, DAI was collateralized by BTC and ETH, decentralized currency, at a high 140% collateralization ratio. However, as the usage of DAI grew, it became important to also back DAI by another stablecoin to increase capital efficiency and lower DAI’s collateralization ratio. USDC was chosen as the most trusted stablecoin & one of the few that could support DAI’s $40B net outstanding balance. This caused centralization of DAI’s backings into Silicon Valley bank through Circle and to a few other large banks.

Circle must bank with just a few partners which means that if any of its partner banks fail, most of USDC’s value goes with it. As stablecoins grow in market capitalization, they increasingly must bank with just a few large partners. Thus as they grow, they become more centralized by necessity; they become more censorable and less valuable as a blockchain native transaction medium. We believe there needs to be more stablecoins available on the blockchain so that each is less censorable and more distributed.

Existing major stablecoins do not properly disclose the holdings of their treasuries, its unclear to a holder of a stablecoin the counterparty risk a holder of the stablecoin is taking at any given point in time. During the USDC crisis, it was unclear to holders of USDC what amount of Circle’s deposits were held in Silicon Valley Bank. Of the stablecoins with over a billion in market capitalization, TrueUSD does the best job of showing its deposits in real time.

## Transparency

The key to maintaining the stablecoin peg is to make it easier to redeem the stablecoin for the underlying. We suggest introducing distributed banking such that the deposit on each stablecoin is limited to the Federal Deposit Insurance guaranteed maximum of $250,000. There’s over 4,200 federally insured banks in the United States, which allows for $1 billion worth of stablecoin to be issued and FDIC insured. Though this may seem unwieldy, there exist aggregator tools that allow you to claim up to $100M of FDIC insurance simply via bank splitting. Germany, France, Japan, Dubai, and other jurisdictions also offer banks. insurance and solutions favorable to blockchain.

An alternative solution could be holding 100% of customer deposits in cash and short term treasuries, posting this data on the asset breakdown publically via a proof-of-reserves protocol. A similar approach is taken by TrueUSD, we believe we can add a better user interface and a more detailed reserve asset breakdown.

TrueUSD is the most transparent stablecoin due to its live attestations to the amount in its reserves. It uses ChainLink and a live attestation service to prove its reserve status to its users. The platform keeps its USD funds in third party bank accounts without direct access by TrueUSD.

## Interoperability with Existing Stablecoins

Current stablecoins present a risk of anti-competitive effects given the absence of interoperability standards for stablecoins and stablecoin arrangements. Greater interoperability would allow users to Tether has partnerships with most major exchanges while Circle and Coinbase enjoy a close relationship. In order for a stablecoin to achieve prominence it must attain distribution through integrations with other protocols. Part of the major stablecoins’ growth has been fueled by the number of integrated protocols. Exchanges, DeFi Protocols and others use USDC as the main traded against asset. Fragmentation of stablecoins causes poor user experience because trading pairs are defined across multiple stablecoins rather than just a few. This can be resolved by denominating tokens against USD rather than a trading pair. The user can cash out in the stablecoin of their choice after the trade is completed.

According to the treasury department, regulators in the United States are most concerned with User Protection \& Run Risk, they’d like to require stablecoin issuers be subject to regulation at the depository institution and holding company level. They would prefer any entity that performs activities critical to the functioning of the stablecoin arrangement meet appropriate risk-management standards. They would also prefer stablecoins issuers comply with restrictions that limit affiliation with commercial entities, and implement standards to promite interoperatbility among stablecoins.

## Liquidity

The friction between owning a token and redeeming the token for USD is the difference between the token price its peg. USDC’s primary sources of liquidity are Circle accounts, which allow for direct bank balance to USDC conversions. On chain liquidity includes Curve’s 3Pool.

## Regulatory Environment

In the United States, there’s currently an effort by the Biden Administration to cut off cryptocurrency firms from the banking system. Cryptocurrency firms are regularly denied bank accounts and unbanked by existing providers. Regulatory clarify around cryptocurrency is unclear. A 2020 Bill issued would have restricted stablecoin issuance to FDIC insured depository institutions [3]. Texas has taken the position that stablecoins are regulated by its money transmission laws because they may be considered a claim that can be converted into currency and thus fall within the definition of money or monetary value under Texas Law.

Facebook attempted to launch Libra, a group of corporations aiming to create a global stablecoin aimed at retail payments. It appears the primary concern of regulators was Facebook’s authority over the project. Libra’s goal was to Libra’s secondary goal was to create a decentralized identity on the blockchain.

CBDCs have faced delays as government officials are unable to find qualified teams to run their CBDC programs. We are open to white labelling and assisting government agencies in launching their own stablecoins. Sophisticated stablecoin tracking, freezing, reversion, and other mechanisms can be implemented as needed. Certain users may benefit from totally decentralized stablecoins while others, who may be newer or susceptible to fraud might need a tool where transactions can be reversed. We see an array of stablecoins in the market ranging in various degrees of centralization.

## Benefits of Stablecoins

Stablecoins are the cryptocurrency product with the greatest real world utility. They provide widely distributable, low cost globally transferrable currency. Remittances, global payments, business banking, and a store of value. Moreover, it is universal programmable money, providing a universal api to which any financial application can plug into. Stablecoins will become crucial and ubiquitous as a payment method.

## References

[1] https://www.jonesday.com/en/insights/2022/08/what-the-federal-government-is-doing-about-stablecoins-realclearmarkets

[2] https://home.treasury.gov/system/files/136/StableCoinReport\_Nov1\_508.pdf

[3] https://www.congress.gov/bill/116th-congress/house-bill/8827/text

[4] https://crsreports.congress.gov/product/pdf/LSB/LSB10754

[5] https://www.elibrary.imf.org/view/journals/063/2022/008/article-A001-en.xml

[6] https://www.banking.senate.gov/newsroom/minority/toomey-introduces-legislation-to-guide-future-stablecoin-regulation

[7]https://www.globallegalinsights.com/practice-areas/blockchain-laws-and-regulations/08-the-regulation-of-stablecoins-in-the-united-states