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Unstable Bonds And Stable Coins

mano@immin.io
April 14, 2025

Stable coins issuers, like the banks they aspire to disrupt, have about 70-90% of client deposits invested in a portfolio of fixed income instruments such as government treasuries, repurchase agreements, highest quality bonds and money market funds.

Therefore, similar to banks such the failed Silicon Valley Bank (2023), their portfolios are also sensitive to changes in interest rates/inflation, foreign investors sentiment and reduction in assets-under-management (AUM) due to withdrawals far exceeding new deposits.

These sensitivities caused the 1933 banking crisis that saw the need to insure deposits against bank failures to restore trust in the banking system, through the creation of the Federal Deposit Insurance Corporation (FDIC).  However, for the initiative to be sustainable, banks had to de-risk significantly by segregating deposit taking operations that prioritize client interests over investment management that prioritizes returns.  This was the purpose of the Glass–Steagall Banking Act of 1933.

However, stable coin issuers like broker/dealer fintechs are not subject to these regulations and thus also not viable for any deposit insurance.  Stable coin issuers are at the full mercy of their AUMs and bond markets with no safety nets.  The latter is currently in turmoil as the 10-Year Treasury bonds saw the largest single week spike in yields from 3.99% to 4.5% for week ending 11th April 2025 since Covid

Bonds are not always safe havens.

The most common misconception is that buying highest grade bonds at issuance and holding them to maturity will always result in a positive return.  However, this ignores default risks and assumes there will be no adverse changes to the issuer's credit rating.  Even the largest economy in the world, had its longer-term treasuries downgraded from AAA to AA+ by Fitch in August 2023 that briefly saw a significant increase in credit default swap spreads, an insurance against defaults. As such, the default-risk-adjusted returns of a bond might not always be positive.

A volatile interest rate environment can also adversely affect bond prices and make them risky.  There are a number of reasons that can cause volatility in interest rates starting with the central bank surprising markets by raising rates too aggressively to combat inflation like the US Fed did that triggered to the Global Bond Massacre of 1994.  

Decline in demand for treasuries due to poor or fickle economic policies that rattle financial markets such as the recent sweeping tariffs imposed by President Trump that not only threatens to increase prices/inflation but also to upend supply chains essential for inshoring or American-made products.

In all, default risk, economic policies and investor sentiments drive bond markets and volatility is the antithesis of a fixed income instrument that could break its safe haven status.

Bank runs can easily happen to stable coin issuers too.

If withdrawals outstrip new deposits by more than readily available cash then bonds will be sold off on short notice in secondary markets, crystalizing the losses.  If these sell-offs reduce the AUM below the required minimum for the company to generate sufficient returns to cover expenses then the bank is no longer of going concern.  

Such instances have caused the failures of several banks such as Silicon Valley Bank, Signature Bank and First Republic Bank and the failure of the broker/dealer, Synapse, that in-turn took down a number of fintechs that used its Banking-as-Service offerings.  Stable coin issuers have also failed in similar ways with most notable being BitUSD in 2019 and Terra/Luna in 2022.

The FDIC works better than rudimentary trust/custodian accounts.

In 2023, there were 5 banks with a total of USD 548B in assets that failed and all deposits were fully reimbursed within a few days. Even accounts with balances exceeding the USD 250,000 limit were made whole. On the other side, Synapse's Trustee is still unable to account for about $85 million in client deposits and around $40 billion evaporated in the Terra/Luna crash when UST de-pegged from the dollar.

Summary

Stable coins are only as stable as the weakest bonds in their portfolio and their AUM.  Being deployed in a public blockchain, does not preclude them from the same risks such as changing interest rates and bank runs that conventional banks face because they follow a similar investment playbook to that of the banks.

While a few of the larger stable coin issuers are printing record revenue numbers, it is mainly due to the current high-interest rate environment and high demand from investors for treasuries.  If interest rates increase too much, governments might default and the bond markets could crash taking stable coin issuers with it. 

Conversely, if interest rates were lowered, stable coin issuers might either take a hit with an unsustainable lower return on their investments or change their investment strategies to invest in riskier longer-term T-bonds just like Silicon Valley Bank did before its collapse.

Either way, caveat emptor!

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