Stablecoins: What Could Go Wrong?

What’s going on in crypto-currency land and how does it impact legitimate investors in stocks, bonds and commodities?

We’re assuming by now most readers are at least somewhat acquainted with Bitcoin (BTC) and the other leading cryptocurrencies including Ether (ETH), Ripple (XRP) and Tether (USDT). The combined market capitalization of those four coins is $2.6 trillion, with over $2.0 trillion of that represented by Bitcoin alone.

In fact, $2.6 trillion is a relatively small market cap in the world of investible assets. The market cap of U.S. stocks is over $60 trillion. The market cap of the U.S. Treasury securities market is over $36 trillion (not including government-guaranteed debt such as mortgage-backed securities and student loans). The daily trading volume in foreign exchange markets is $7.5 trillion with a far higher market cap if you combine the values of all global currencies.

The Bitcoin Casino

Still, a $2.6 trillion market cap for the major cryptos is a material amount. When Bitcoin goes from $1.00 per coin to over $100,000 per coin in a matter of years, it’s impossible to ignore. My view of Bitcoin hasn’t changed, which is to say that it has no powerful use case. It is helpful for criminals seeking to avoid money-laundering rules. It’s helpful for individuals in chaotic societies facing war or social breakdown who are trying to move money out of the jurisdiction.

Other than that, it’s just a casino chip that you buy with good money. You can make or lose money in casino gambling but it’s still gambling. If you want to spend or invest outside the casino, you have to visit the cashier, convert to dollars and then leave the casino. In the crypto world, the cashier is a bank. The crypto world is a closed system with little connection to the much larger world of securities markets and banking except through the banking system itself.

I realize Bitcoin maximalists disagree. It’s interesting to watch the Bitcoin crowd act like the new establishment while dismissing new cryptos as “just gambling.” Perhaps they should look in a mirror when they say that.

Meme Coins vs. Stablecoins

That said, our focus is on two aspects of the crypto market that are dominating the news today. The first is the meme coin. The second is the stablecoin. The impact of these tokens on coin investors is of little interest. The impact on broader financial markets should be of far greater interest to investors.

A meme coin is a crypto coin with little to offer except an association with a celebrity, politician or a popular cultural icon. If not frauds, most of them are failures. A typical meme coin starts out with a low valuation, skyrockets to some inflated value pumped up by fans of the meme sponsor and then crashes back to earth. The meme coin sponsor makes money by keeping the dollars paid for the new issue and on transaction fees on the blockchain ledger entries between buyers and sellers in the secondary market.

Early investors can make money by dumping the coin on latecomers just in time for the crash. It’s the crypto version of what Wall Street calls a pump-and-dump scheme also known in the UK as a ramp. Meme coins are new but pump-and-dump is not.

Enormous attention has been drawn to the Trump family efforts in meme coins. The $Melania coin opened at $13.00 per coin and now sells for about $0.32. The more recent $Trump coin rallied from $1.00 to $70.00. Since this market is almost completely unregulated, it’s important to consider that these gains may have been realized on small volume with a boost from wash trades where two parties sell the same coins back and forth at progressively higher valuations to attract the suckers. We’ll see where it goes from here.

Meme coins are a sideshow in the world of crypto. They may or may not prove profitable for buyers, but they will not change the world or disturb financial markets. Of far more importance are stablecoins.

A stablecoin sponsor issues a stablecoin in exchange for U.S. dollars. The ratio is usually 1:1 but it could be a different ratio. The main point is that the ratio is fixed, like a fixed exchange rate. The idea is that if you want to redeem the stablecoin for dollars, you will get back exactly the amount you put in. No gain or loss. It's a crypto token but the value does not fluctuate.

This begs the question, why would you buy a token that will always be worth what you paid for it with no gain or loss? Some holders like the fact that the coin is digital and cannot easily be traced or seized by government authorities. That’s an attraction but it’s false comfort. I’ve worked with U.S. Special Operations Command to track and trace Bitcoin used by ISIS and Al Qaeda. It’s a challenge but not that difficult in the end. The U.S. leaves most cryptos (including stablecoins) alone because there’s no compelling reason to go after them. But if the government wants to seize or shut down your crypto accounts, they know how.

The bigger reason for buying stablecoins is that they are a transaction currency in the crypto world. Once you have Tether, you can use it to buy Bitcoin or any other crypto. In fact, most Bitcoin purchases are made with Tether. The Tether stablecoin ecosystem acts as a kind of crypto bank account while you’re waiting to buy or sell other cryptos. It’s a par value parking place in crypto world.

What does the sponsor do with the dollars received for issuing the token? Since the sponsor promises that the token value will not fluctuate, they have to invest in something highly liquid that will not fluctuate either. The obvious choices are short-term Treasury bills and high-quality bank deposits. Highly rated commercial paper (unsecured IOUs with a maturity of less than 365-days) is another possibility but that market is not highly liquid. These instruments are referred to as "cash or cash equivalents" on a corporate balance sheet.

The point is that when you give dollars for the stablecoin, the token sponsor turns around and invests in dollar instruments, primarily short-term Treasury bills. Some crypto cultists claim stablecoins will eventually displace the dollar. That’s nonsense. Far from undermining the dollar, the stablecoin sponsor is actually supporting the dollar by buying Treasury debt. This is the kind of real-world dynamic that the hysterical screamers about a "dollar reset" or "dollar collapse" simply do not understand.

If the sponsor takes dollars in and then reinvests them in dollar assets, how does the sponsor make money? The answer is the spread. The sponsor pays zero interest on the stablecoin but earns approximately 3% interest on the Treasury bills and bank deposits. Operating costs are quite low because the entire operation is digital. You just need some servers, tech support and a digital ledger. That's about it.

So, this is an extremely profitable business for the sponsor. Howard Lutnick, the U.S. Secretary of Commerce, is a 5% investor in the sponsor of Tether through his company Cantor Fitzgerald. It's practically free money for the stablecoin sponsor.

What Could Go Wrong?

Two things. The first is fraud. The stablecoin sponsor could just steal the money. There's no transparency, regulation or auditing in this market. It's all set up for a Bernie Madoff type Ponzi or worse. That's probably just a matter of time.

A stablecoin fraud will not automatically cause a dollar panic. It would cause a crypto panic, although there could be spillovers into the banking system in the manner of Silicon Valley Bank.

The second disaster-in-waiting is that the stablecoin operation is legitimate but the commercial paper or bank deposit market seizes up. This happened in October 2008 and the Fed had to guarantee the entire commercial paper market (remember General Electric?). It also happened in 2023 with Silicon Valley Bank when the Fed and FDIC had to guarantee every bank deposit in the country regardless of deposit insurance limits.

If the panic to sell liquid assets get bad enough, even the Treasury bill market could face distress. In this scenario, the stablecoin sponsor could not get the cash to meet the redemption requests and the stablecoin would "break the buck" (meaning it could not satisfy the fixed exchange ratio). This may not be a fraud but it is a good old-fashioned bank run in the crypto market, which would spillover into the banks and Treasury markets.

We've lived through these panics before (1873, 1898, 1907, 1929, 1998, 2008). That's why we have regulation. Stablecoins are popular because they're unregulated, but they're just as vulnerable to run-on-the-bank style panics. I view the entire stablecoin market as an accident waiting to happen. Greed triumphs over the lessons of history. None of this means the end of the dollar. It may mean the end of cryptos and the end of some banks. It will be at least a Madoff-type disaster for investors.