Introduction The Decentralized Finance (DeFi) Revolution is taking over traditional finance (TradFi) and centralized exchanges (CEX), with billions in...
With the collapse of Nobel Bank, and with growing concern that Tether may be one of the biggest frauds in history, people are rightly asking “are stablecoins safe
This is a critical question as more stablecoins are popping up to serve a wide variety of purposes, from facilitating e-commerce to video game rewards to in-app purchases to international settlements to being a digital store of wealth.
Is it safe? That’s a question that can be answered using four tests:
1. Are funds held by a qualified trustee?
By “qualified” I mean an entity that is regulated and overseen by financial authorities. I mean a bank or a trust company. By “trustee” I mean a bank or trust company that hasn’t just simply agreed to hold funds, but to hold them in a fiduciary capacity exclusively for the benefit of token-holders.
I’m sure that stablecoins who don’t use a qualified trustee likely didn’t start out with fraudulent intentions. But the ability to use funds in accounts as a piggy-bank is almost always too great to resist. Perhaps it starts out with well-meaning intentions, such as having to pay rent or make payroll and intending to put the money back into the account soon. Then feeling that the token issuers deserve a new home or a luxury car, and maybe rationalizing it with thinking that they consider those to be assets of the stablecoin. Eventually morphing into a private island in a non-extradition country.
The point is this: without a qualified custodian there’s nothing to prevent theft of the assets by the issuer. (this is true for all assets being tokenized, not just USD but also including gold, diamonds, real estate, stocks, bonds, etc)
2. Are tokens backed by ‘fully reserved’ assets?
I’ve heard some people say that they intend to issue a ‘fractionally reserved’ stablecoin and that they will use math to ensure a stable value on the exchanges.
I have a word for that: FRAUD.
People have argued with me that it’s okay because they are disclosing it. And that they are really good at math. Really? That doesn’t change the fact that if I give you $100 in USD and you issue me $100 in tokens, then you pocket $25 of my $100 to go towards that Ferrari or private island you’ve been dreaming about, even if you disclosed that you were going to steal my money, it doesn’t give you a get-out-of-jail-free pass. A crime is still a crime. And promising to manipulate the market as a way to give me stable value is also nothing more than just another crime.
Stablecoins must be 100% backed by the assets that they represent. Period.
3. Are funds 100% insured?
People make a big deal about FDIC insurance, and rightly so. It’s terrific. But it’s limited to $250,000 per bank. Banks, of course, are not motivated to do anything when customers exceed this limit…quite the opposite in fact, because they want the deposits so they can make loans and juice their profits, and also because FDIC insurance is expensive (25bps on insured funds). So they love it when people have uninsured deposits.
Well aren’t banks like State Street, Citi, Chase, BofA, and others “too big to fail?” Maybe, maybe not. The government bailed many (but not all) of them out in the last crisis. Maybe they’d do it again. Maybe not. It wasn’t that many years ago when we saw the failure of Washington Mutual ($307B in assets) and depositors lost everything above the FDIC limits. The same with Continental Illinois ($40B assets), First Republic Bank ($32B assets) and many others. Do you really want to bet your hard-earned money on this? Especially when it’s very easy to insure the assets? Laziness is rarely rewarded.
How? Easy. First, the trustee should create a syndicate of banks. They should then monitor their customers’ accounts (per tax ID) and as soon as any customer exceeds $250,000 in cash, then the excess is placed in another bank. Thus, $1M in cash would be in 4 different banks. Etc, etc.
4. Is the stablecoin audited by a reputable CPA?
When done properly, this isn’t hard. The CPA firm checks the blockchain to see how many tokens are outstanding, then they work with the qualified trustee to verify assets backing the tokens. Some terrific firms like Cohen & Company, and others, are stepping up to provide this service.
Look for something like this in the auditor’s letter: “XYZ stablecoin is US dollar denominated and all principal funds are 100% insured by a combination of FDIC-insurance and short-term US Treasury notes. We have reviewed the token balances on the blockchain and compared that to the balances held in trust by Prime Trust and hereby confirm that there is $1 USD backing every token issued and that the funds are fully insured by the US government and its agencies.”
Stablecoins are, I believe, the future of commerce. They represent a new form of electronic money that is more convenient than debit cards and far more flexible for use in everything from super-micro purposes (e.g. in-app or video game purchases) to massive transactions (e.g. replacing letters of credit in international settlements). A huge variety of applications are in the works that will revolutionize how people use and think about money.
But as this evolves, there is the risk of fraud (e.g. Tether), the risk of theft (e.g. fractionally reserved coins), and the risk of loss (uninsured deposits). So when picking the coin you want to use, be aware of these four tests. At some point, they will likely be codified in regulation, but at the moment it’s still a bit of a wild west out there.
Written by: Scott Purcell, CEO and Chief Trust Officer of Prime Trust. His firm provides custody, escrow, AML, KYC, & payment processing for the new digital economy.
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