Regulators have expressed concern in recent years that decentralized finance (DeFi) could pose risks to the traditional financial (TradFi) services sector. Those worries were magnified by events such as algorithmic stablecoin terraUST’s collapse and the failure of the FTX crypto exchange in 2022, which had relatively limited spillover effects on established financial institutions.

Cristiano Ventricelli is the associate vice president of DeFi and digital assets at Moody’s Investors Service.

But a new realization has emerged following the recent failures of Silicon Valley Bank and Signature Bank: distress from established financial institutions can spread to the DeFi sector, too.

That is, effectively, what happened this year when Circle’s USD coin (USDC) lost its peg to the dollar on March 10, the day U.S. banking authorities stepped in to take over Silicon Valley Bank (SVB). The fiat-backed stablecoin fell below $.90 following the announcement that Circle had up to $3.3 billion in exposure to SVB, which had suffered a deposit run.

Other, smaller-circulation stablecoins lost their pegs, too, including BUSD, issued by Paxos, and crypto-backed stablecoin DAI, issued by MakerDAO. Only USDT seemed to benefit from the turmoil, briefly exceeding $1, most likely because of investors shifting out of the depegged stablecoins.

The depeg event was relatively short-lived. After U.S. banking authorities announced that uninsured depositors at Silicon Valley Bank would be fully covered, the USDC price began rising toward $1, and USDC, DAI and BUSD remain at their $1 peg as of April 2, 2023.

But, in Moody’s view, the risks have now been laid bare. What the depeggings highlighted is that stablecoin issuers’ reliance on a relatively small set of off-chain financial institutions limits their stability. And broader awareness of these risks could actually make the situation worse for stablecoin issuers.

In the aftermath of the USDC depeg, Circle managed to onboard new banking partners, thereby reducing concentration risk. Nonetheless, TradFi financial institutions could decide to reconsider working with stablecoin operators, and the reduction in the available pool of financial institutions partners would make it even more difficult for fiat-backed stablecoins to maintain stable exchange rates.

In light of these recent events, regulators could increase their scrutiny of stablecoins. Last year, the Terra/LUNA collapse raised concerns about stablecoins' reserves, leading regulators to recommend additional liquidity and transparency requirements. Now, the depeg of USDC and other stablecoins is highlighting a different set of governance risks related to the custody of reserve assets. The EU cryptoasset regulation (MiCA) briefly touches on this, but leaves precise regulatory standards to be determined by European banking authorities.

Moody’s anticipates that the Silicon Valley Bank and Signature Bank failures could trigger additional regulatory requirements, notably on counterparty diversification. As TradFi and DeFi become more intertwined, notably through tokenization of real world assets, the risk of systemic failure increases, emphasizing the need for effective regulation, transparency and risk management.

There is also growing interest in exploring alternative solutions to address the shortcomings of stablecoins. One potential alternative is tokenized bank deposits, which allow users to hold digital tokens that represent ownership of underlying bank deposits. Tokenized bank deposits would be subject to the regulatory standards of banking, providing greater confidence in the underlying assets’ safety, although credit risks associated with traditional banking would of course remain.



By Cristiano Ventricelli | Original Link