Stablecoins Add ‘Novel Vulnerabilities’ to Crypto, Financial Stability: NY Fed

The rapid growth of the decentralized finance (DeFi) sector is fraught with several challenges, including run risks among major stablecoins, according to a new report by the Federal Reserve Bank of New York.

Titled “The Financial Stability Implications of Digital Assets,” the report provides an overview of stablecoins as part of the broader crypto ecosystem, pointing, among other things, to several features that “introduce novel vulnerabilities” to both crypto and traditional finance’s stability.

These include run risks arising from Circle’s USDC stablecoin, which, based on self-disclosures, is collateralized by higher-grade assets than, for example, Tether (USDT), the industry’s largest stablecoin by market capitalization. Though this collateral may be more stable than, say, crypto-native backing, the Bank of New York argues that these traditional assets are still susceptible to volatility.

Researchers highlighted “significant financial stability implications” that liquidations and fire sales of even these traditional assets would have for fast-growing stablecoins. Examples of these assets include cash, commercial paper, U.S. treasuries, and corporate bonds.

Pointing to the events surrounding the TerraUSD collapse in May this year, when USDT lost over $7 billion in market cap as opposed to USDC, which saw over $4 billion of new inflows over the same period of time, the paper says, “this substitution from Tether into USDC illustrates a bigger concern—namely, that resilient stablecoins can amplify run risks from more fragile ones, as they provide a convenient instrument to run to.”

Essentially, researchers are arguing that as stablecoins grow, any risk to their underlying collateral becomes even more important to monitor. The current macro environment has also highlighted how even the safest of assets, like bonds, are still subject to big market moves.

The report concluded that a run on a stablecoin “can create negative feedback loops” via its relationships with DeFi applications and prices of crypto assets. USDC and USDT are, for example, heavily integrated throughout the leading decentralized exchanges, lending platforms, and derivative protocols.

“Because stablecoins are supposed to be the safest asset in the crypto ecosystem, problems with them pose the greatest systemic risk within crypto,” said the paper.

More stablecoin interoperability needed

To mitigate those risks and address additional concerns about systemic risk, regulators “should have authority to implement standards to promote interoperability among stablecoins,” argued the Bank of New York.

One potential way to achieve greater interoperability, per the report, is the use of the so-called “bridges,” which allow tokens designed to be used on one blockchain to be deployed on another, expanding access to new protocols and assets.

Bridges, however, come with certain trade-offs as they can also “become a transmission channel for stress,” warn researchers.

“For example, users might address a loss of liquidity on one blockchain by transferring funds from another, leading to cascading contagion over multiple networks,” reads the paper. “Bridges have also proved a key source of technical weakness as the targets of many successful cyberattacks.”

Several cross-chain bridges fell victim to attacks this year, including the $100 million hack of the Horizon Bridge in June. Roughly 69% of all stolen crypto funds this year—amounting to as much as $2 billion—came from hacking protocols that bridge different blockchains, according to a recent Chainalisys report.

Other ways to mitigate the above risks, according to the Bank of New York, include legislation that “should require stablecoin issuers to comply with activity restrictions that limit affiliation with commercial entities.”

“In addition, Congress may wish to consider other standards for custodial wallet providers, such as limits on affiliations with commercial entities or on use of users’ transaction data,” according to the report.

The bank’s paper came out almost simultaneously with the “Report on Digital Asset Financial Stability Risks and Regulation” published by the Financial Stability Oversight Council, the federal government organization charged with identifying risks to the financial stability of the U.S.

In the 124-page paper, government regulators and advisors warned of the risk digital assets can pose if their scale or interconnections with the traditional financial system were to grow without adherence to “appropriate regulation.”