A Word of Caution on Stablecoins
With savings account interest rates stuck near zero, investors are earnestly seeking alternative ways to earn a higher yield on their cash. A nascent, but increasingly popular method is to lend cryptocurrencies that are pegged to the U.S. Dollar. These so-called “stablecoins” inherit some of cryptocurrencies’ benefits, like nearly instant transaction settlement, while attempting to mitigate one of their main drawbacks—high volatility. In addition, they can be lent at an attractive yield. For these and other reasons, stablecoins have gained rapid adoption and now have an aggregate market value exceeding $120 billion.1 Unbeknownst to some investors, though, crypto “savings” accounts and other stablecoin income strategies carry significant risk, unlike traditional savings products.
The first main source of risk is related to the cryptocurrency itself. Traditional currency pegs have a long history of breaking. Stablecoins carry the same risk. To maintain their peg, stablecoins are typically backed by collateral—ranging from cash to other cryptocurrencies. Ultimately, the peg depends on investors’ trust in that collateral. In the case of stablecoins issued by traditional companies, the issuer can disclose their collateral to build trust. Sometimes audit reports are published on a regular basis as well. Even then, the collateral can carry risks of its own (e.g., credit risk) and be subject to other creditor claims if the stablecoin issuer defaults. Some issuers attempt to alleviate these concerns by opting to be regulated by one or more government entities who supervise the collateral. Clearly, not all stablecoins are created equally.
The other source of risk is related to the act of lending these stablecoins. To generate income, investors can lend their stablecoins to a company, such as Gemini or BlockFi, or through decentralized platforms, such as Aave and Compound. Lending stablecoins to a company involves several risks, including the possibility that the custodian is hacked or that borrowers default on their loans. Lent funds are not insured and due to the nature of cryptocurrencies, stablecoin owners can suffer irreversible fraud and errors. Decentralized platforms involve similar risks.
Additionally, regulators are still grappling with how to supervise stablecoins and crypto lending. Earlier this month, Coinbase cancelled the launch of their stablecoin lending product after the SEC threatened to sue. A couple months ago, BlockFi’s lending product was issued a cease-and-desist order by the state of New Jersey. Decentralized platforms and even some stablecoins themselves might also be deemed unlawful. At this point, it’s unclear how the U.S. government will regulate the quickly evolving world of crypto and what consequences investors will face.
Traditional savings accounts, with all their investor protections, are not an appropriate comparison for stablecoin lending. It’s possible that as the crypto industry grows and matures and as regulation evolves, stablecoin lending could become more mainstream, possibly even appropriate for most investors to consider. Although, at that point it would likely offer lower yields. In the meantime, we would caution investors against using stablecoin products for a meaningful portion of their wealth.
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1Source: CoinMarketCap.com, as of 9/20/21.
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