Fitch Ratings Report: The continued issuance of stablecoins may bring new short-term credit market risks

The recent rapid growth in stablecoin issuance could, over time, have an impact on the functioning of short-term credit markets. Potential asset “contagion risk” associated with the liquidation of stablecoin reserve assets could increase regulatory pressure on this nascent industry.

Contagion risk is primarily associated with collateralized stablecoins, which vary based on factors such as their asset size, liquidity and riskiness, as well as the transparency and governance of their operators.

Tokens fully backed by safe, highly liquid assets pose less risk, but regulators may still increase their attention because their financial footprint may be global or systemic. For example, USD Coin, the second largest stablecoin pegged to the US dollar, is backed 1:1 by US dollars in custodial accounts. Stablecoins that use partial reserves or adopt higher-risk asset allocations may pose greater operational risks. For example, Tether, the largest stablecoin issuer, disclosed that as of March 31, 2021, it only held 26.2% of its reserves in cash, trust deposits, reverse repurchase bills and government securities, and another 49.6% was commercial paper (CP).

As of March 31, Tether's commercial paper holdings were $20.3 billion, while its total consolidated assets were $41 billion, and may be increasing rapidly; on June 28, total assets of the dollar-pegged stablecoin (USDT) reached $62.8 billion. These figures suggest that its CP holdings may be larger than those of most high-quality money market funds (MMFs) in the United States and EMEA. If a sudden large-scale redemption of USDT occurs during a period of general selling pressure, especially if it is associated with broader redemptions of other stablecoins holding similar asset reserves, it may affect the stability of short-term credit markets.

The Diem USD stablecoin, which the Facebook-backed Diem Association plans to issue in partnership with Silvergate Bank, proposes to hold at least 80% of its reserves in low-risk, short-term government securities. The remaining 20% ​​will be held in cash, with overnight interest invested in MMFs with short-term government securities of the same risk and liquidity.

Projects that could quickly become systemic, such as Diem, have already attracted the attention of regulators and could lead to stricter regulation of stablecoins. U.S. regulators have also noted that entities with asset allocations similar to Tether’s disclosures may not be so “stable” if short-term credit spreads widen significantly, a phenomenon that has occurred during periods of financial stress in 2020 and 2007-2008. This is in contrast to the way stablecoins are marketed to the public.

Under the Stablecoin Custody and Bank Licensing Enforcement Act (STABLE), submitted to the U.S. Congress in December 2020, and the European Union's Crypto-Asset Market Regulation, a stricter regulatory framework is proposed, although the planned timelines and details remain unclear or subject to change. But tighter regulation could increase transparency and force the gradual transfer of stablecoin collateral reserves to less risky assets. This process could also influence — or be driven by — the authorities' support for central bank digital currencies and instant payment services such as the FedNow Service in the United States.

We believe that the authorities are unlikely to intervene to rescue stablecoins in the event of a disruptive event, in part due to moral hazard. If stablecoin redemptions lead to or amplify a broader CP sell-off, weighing on market liquidity and hindering the issuance of new CPs, the authorities could step in to support dealers and major MMFs to resolve the problem.