Can Circle’s plan to become a federal bank help it win the stablecoin war?

Can Circle Win the Stablecoin Wars?

Source: Decrypt

By Jeff John Roberts

Compiled and edited by Chen Zou

In a blog post this week, Circle CEO Jeremy Allaire revealed his company’s big plans for the future of its stablecoin, USDC. Allaire wrote that Circle intends to become a federal bank, and that he expects USDC to grow to “hundreds of billions of dollars” in circulation.

USDC has long been the darling of the cryptocurrency trading market, existing as a medium between crypto positions and fiat currencies, and now the traditional financial system has begun to accept stablecoins, which institutional users believe is a more effective funding tool that can provide higher liquidity. But so far, the market is still dominated by Tether's stablecoin. Many competitors have also rushed to join this blue ocean market. Allaire believes that USDC, which is currently ranked second in market value, has the opportunity to overtake at a time when US regulators are reviewing Tether's abnormal accounting behavior. However, Circle itself has regulatory and business concerns, which makes Allaire's plan to make USDC a top stablecoin more risky than it seems.

How stable is Circle’s stablecoin?

Stablecoins are popular with users because they offer the same convenience as other blockchain-based currencies like Bitcoin, but without the volatility. And for the dozens of companies that issue them, stablecoins offer an easy way to make money. When people buy stablecoins with their dollars, companies like Tether and Circle don't pay any interest. Instead, they use those dollars to create reserves to back new stablecoins, which apparently also earn the companies a profit. Circle, for example, says it expects to make $40 million from its USDC business this year.

But the question also arises: How should stablecoin companies properly and effectively invest these reserve funds? Putting reserves in things like bonds or commercial paper means higher yields, but it also means that stablecoins may not be as stable as the company says because it includes the volatility of these investments.

When Circle revealed last month that USDC was not backed 1-to-1 by cash as the company had long promised, competitors quickly smelled blood. One of its competitors, Paxos, published a graphic blog post directly criticizing USDC for not being a true stablecoin.

Circle is partially backing its stablecoin with assets such as bonds and commercial paper, which are not cash or cash equivalents.

“They are seeking the highest possible yield,” Dan Burnstein, a top lawyer at Paxos, told Decrypt. “The question is, do they have the right to put consumer assets at risk in pursuit of that yield?”

Dante Disparte, Circle’s chief strategy office, hit back, saying in an interview: “We will not respond to the Paxos article with dignity." According to Disparte, the entire stablecoin industry is ready to be strictly regulated, and Circle will ensure that USDC complies with any rules issued by the U.S. Treasury or other agencies. However, he declined to say whether Circle plans to change its reserve composition.

This again raises the question of whether Circle is really putting consumer assets at risk, as Burstein claims. At first glance, it seems that Burstein is exaggerating the situation. The non-cash assets that Circle uses to back USDC are relatively safe - after all, these investments are not junk bonds, altcoins, or assets that could go to zero at any time.

But that doesn’t mean there are no risks. According to JP Koning, a former bank analyst who writes about stablecoins, “What happens to these so-called ‘safe’ assets if a financial crisis strikes? In such a crisis, consumers might rush to exchange their USDC for cash, in turn forcing Circle to sell its assets to meet redemption requests. Once a ‘bank run’ occurs, Circle may be forced to sell these assets at a price below market value (capital depreciation) or not be able to sell these assets at all (liquidity crisis). This would cause the price of USDC to fall below $1, or it would simply not be able to continue to deliver on its promises.”

If a new crisis emerges, a run on stablecoins could also be faster and more severe than in traditional markets. As a recent paper points out, this is because in the case of stablecoins, users can redeem their money in minutes or even seconds, while in the traditional financial system these take days or even longer. At the same time, such a crisis could also be triggered by another systemic risk - vulnerabilities in the stablecoin programming architecture.

These are only theoretical concerns at the moment, but tellingly, Circle’s partner Coinbase has quietly removed from its website the description that each USDC is “backed by one dollar and held in a bank account.” This change in wording is likely a remedial action taken by Coinbase to avoid litigation, but it also indirectly reflects that USDC is not as “stable” as Circle promised.

Circle's tough road ahead

Circle is in the process of going public, which means it must convince investors that its USDC business is secure and growing. This may be one of the reasons why the company announced its intention to become a federally chartered bank, as this federal endorsement will help eliminate potential investors' concerns about regulatory risks.

Currently, Circle operates through a state-based payment operator license, which is a business model used by many other financial companies, including PayPal. Other stablecoin issuers have taken different legal strategies. For example, Paxos and Gemini rely on the stablecoin regime established by New York State, while Tether adopts a "wildcat bank" model involving overseas operations.

What all these models have in common is that they require stablecoin issuers to hold only minimal additional capital thresholds on top of their reserves. This is very different from traditional banks, which typically must have 8% of additional capital for a “buffer” and often require much more. The purpose of the “buffer” is to allow a bank to absorb the loss of some of its assets but still have enough funds on hand to meet redemption requests in the event of a crisis.

If Circle goes ahead with its plan to become a national bank, it will likely be asked to provide such a capital buffer demonstration, too. This is obviously a tall order, especially since Circle will have to replace the commercial paper and bonds in its existing reserves with Treasury bills that pay virtually no return.

Where does Circle get the cash to create that 8% buffer? The company raised $440 million in outside investment this spring, part of which could be used to build a capital buffer. But in the long run, it’s unclear how Circle will make enough money from its stablecoin business to maintain that buffer and cover its day-to-day operating expenses.

But Circle executive Disparte expressed confidence in the company's future business prospects, noting that USDC is just one of its money-making tools. Circle also operates a "trading and finance" business that is expected to bring in $60 million in revenue this year, and also has a profitable crowdfunding platform called Seed Invest. Disparte also pointed out that obtaining a banking charter will enable Circle to apply for the Federal Reserve's discount, providing it with a reliable source of cheap liquidity.

In addition, Circle already enjoys partnerships with payment giants Visa and Mastercard, which also means that the traditional financial world will also provide impetus for its development.

However, uncertainty still hangs over Circle, especially its plan to become a bank — which is just a plan at this point. The company has only announced its intentions; it has not yet filed documents, which could mean that the company doesn’t have the paperwork ready. Meanwhile, the Federal Reserve is planning to release a major report on stablecoins next month, which could drastically change how Circle and other stablecoin issuers operate and could force them to change their reserve structures.

This doesn’t mean that Circle’s plan to win the stablecoin war won’t succeed. It just means that Circle still has a lot to do to win this war.