A dozen years ago, during the 2008 financial crisis, it occurred to me that the best way to make a financial system safe, amid wild innovation, was for investors and regulators to suffer regular, small “wake-up” calls. These events, like the porridge in the Goldilocks tale, would be just “hot” enough to hurt, but not so scorching that they created permanent burns.
Sadly, this did not happen before that crisis; or not to a degree that might have punctured investor (and regulator) euphoria and complacency. However, an interesting question to ponder today, amid another wild bout of financial innovation around cryptocurrencies, is whether we might yet see a version of that Goldilocks moment at work?
Consider the intriguing story of the cryptocurrency called Tether. In recent years, the Tether company, which is controlled by the owners of a crypto exchange called Bitfinex, has issued $69bn of so-called “stablecoins” — digital tokens pegged to other assets such as dollars.
This sum, which has expanded rapidly this year, means that Tether represents about half the total stablecoin universe. And since the coin is widely used as a convenient way to transfer digital assets into fiat currency (and vice versa) and conduct transactions between different platforms it is often described as the reserve currency of the crypto world.
Yet its reputation is not as stable as its name suggests. Before February 2019, the company claimed the token was backed by holdings of dollars, enabling it to maintain a one-to-one exchange rate. However, earlier this year the group paid an $18.5m fine to the New York attorney-general’s office as part of a settlement, following allegations by the AG that Tether had “obscured the true risk investors faced” with its reserves before February 2019.
The company has added a note to its website to say that the token is backed by safe, dollar-like assets, such as $30bn of US commercial paper (a claim that implies it is the seventh largest global operator in this sector).
Last week a Bloomberg article claimed that part of Tether’s assets were sitting in Chinese bonds, amid unusual financial flows between offshore bank accounts. In response, the company issued a vehement denial that anything was untoward, arguing “that quarterly assurance attestations (as recently as June 30, 2021) confirm that all Tether tokens are fully backed” and “the vast majority of the commercial paper held by Tether is in A-2 and above rated issuers”.
Some crypto investors do not seem concerned (perhaps because they assume Tether will hold its value as long as everyone else uses it). While crypto prices initially fell following Bloomberg’s story, they have since rebounded. But rumours keep flying and, last week, international policymakers pledged more oversight. If nothing else, that makes the Tether story a wake-up call.
Should the mainstream financial world care? Some seasoned performers might argue not. After all, stablecoins currently act somewhat like the poker chips of a cyber casino.
While the tokens are used to make trades within the confines of crypto-land, they can only be used there. As a result it should not matter if they turn out, say, to be part of a pyramid scheme, as long as that casino is self contained — or so the optimistic argument goes.
Yet that idea seems more and more naive. For one thing, mainstream investors and institutions are increasingly being pulled into the crypto-world, for investment purposes, if nothing else. For another, the market now has tentacles into other parts of finance, as Tether’s holdings of US commercial paper shows. This might create contagion risk, as Fitch ratings noted in July, particularly if these products are combined with the type of leverage that might spark margin calls in a crunch (which they increasingly are).
While stablecoins are currently used in a “walled” casino, companies such as Facebook hope to create versions of these tokens in the future that will have mass-market, real-world use. Precedents matter.
So regulators and investors need to heed the wake-up calls. One obvious step that any mainstream investors and institutions tiptoeing into this world must take is to demand better, audited policies around reserves. In China, the reserves backing fintech products are held at the central bank; in Kenya, a product such as M-Pesa holds reserves in a trust account. Something similarly transparent is needed for Tether and other stablecoins.
A second step is that regulators need to increase co-ordinated global oversight. This will not be easy, given the mobile, flighty nature of cyber space. Moreover, as Klaas Knot, the vice chair of the Financial Stability Board noted last week, financial regulators face a tricky silo problem: although bodies such as the FSB are skilled at sharing data about cross-border financial flows, they have “no counterpart” in digital sphere. This matters, given that many crypto companies describe themselves as being in “software”.
It is good news that regulators have pledged to increase their scrutiny and it is even more welcome that critical attention is being paid to companies such as Tether. Yes, crypto fans might howl. But, without some accidents and controversies to keep investors on their toes, there could be a bigger disaster. Perhaps a gentle wake-up call is due.