Dear Prudential: Where are all the stable(-ish)coins?

Is there an alternative model for people interested in stablecoins as a means of yield generation, instead of a means of exchange?

Greetings, denizens of the crypto-verse! Here’s the first in a series pondering the application of prudential principles to crypto and digital assets.

Prudential regulation is coming. As more people come to rely on DeFi as a means of managing financial risk, the social imperative to ensure protocols and dApps operate smoothly will only build. Prudential principles will enable DeFi to work at scale, and may even have the useful side-effect of getting regulators on side. How, you ask? Let me show you.

What’s in a prudential promise?

Promises lie at the heart of all financial transactions: money paid now in exchange for something gained later. The most important of those promises, by dint of their criticality and scale, tend to be subject to prudential regulation to safeguard their performance in a well-functioning economy. Prudential regulations most commonly come in the form of a balance sheet control, regulating the type and amount of assets and liabilities an entity is able to hold. Whatever their form, entities are trusted to pay out insurance policies, pensions and banks deposits at the promised rate of interest in no small part because of the limits prudential regulation places upon institutional risk-taking behavior.

Prudential regulation implicitly distinguishes between promises that are fundamental to the integrity of the financial markets, versus those that are nice to have. Not all financial activities are prudentially regulated, and the limits of the prudential framework usually taper off as transactions vary into riskier territory. But the boundary between prudential and non-prudential activities is a blur, not a bright-line.

Is stable(ish) good enough for you?

Let’s then consider the role of stablecoins in DeFi. The promise embodied by a stablecoin is the ability to transact value through DeFi at a constant rate. And yet, the dominant motivation for many holding stablecoins is yield generation, rather than the ability to exchange value.

The pursuit for higher yields in nearly all cases necessitates a move up the risk/reward ladder into riskier assets. At the same time, the prudential imperative for stablecoins to restrict their holdings to the most conservative instruments makes them an ill-fitting investment for yield-hungry investors.

For these kind of people, what’s needed isn’t a stablecoin, but rather a stable(ish)coin.

Money market funds avoid coming under prudential regulation, Down Under

Over in Tradfi, money market funds have long been the go-to option for investors looking for marginally higher yields while still maintaining a strong focus on capital preservation. Money market funds achieve this mandate by constructing a portfolio out of high-quality debt instruments: think treasuries/government bonds, highly-rated commercial debt. While the superior yields on offer make money market funds a common alternative to bank deposits, that comparison frequently invites the question as to whether money market funds should be prudentially regulated.

In the aftermath of the GFC – where runs on money market funds exacerbated the meltdown of the short-term lending market relied upon by big retail banks – that question was often answered in the affirmative. In the US and EU, money market funds were hit with heavier regulations of a prudential flavor, restricting the assets funds could invest in according to their maturity terms and credit rating.

By contrast, regulators in Australia decided against regulatory intervention. In explaining why, ASIC homed in on the following:

• The dominant use of variable NAVs in contrast to constant NAVs;
• The ability to suspend redemption requests during times of volatility/illiquidity;
• The relative insignificance of money market funds to the domestic short-term lending market;
• A lack of mismatch between the branding/promotion and product characteristics, with some exceptions;
• A prevailing market practice for funds to only invest in ‘A’ rated instruments; and
• Limited exposure to lending out fund assets via repurchase agreements (‘repos’).

Money Market Funds: blueprint for stable(ish)coins?

ASIC’s analysis holds some interesting insights for people aspiring to develop a stable(ish)coin:

• Abandon the peg: if your aim is become a medium of exchange, a constant peg is a prerequisite. If however, your intent is to construct a stable(ish)coin, conceding a hard peg in favour of a narrow range the token’s value can vacillate between is a compromise that should be made in the pursuit of greater yield.

A variable NAV would imbue the stable(ish)coin with the commercial discretion required to  hold riskier assets to generate higher yields, while signalling to the market that downswings would be socialised between all its holders by revaluing its reserve assets on a mark to market basis;

• Suspending redemptions should be on the table: Asset-backed stablecoins need to offer at-will redemption with their reserve assets to establish their credibility with holders. At the same time, a completely unfettered ability to redeem exacerbates a stablecoin’s potential run-risk, incentivising holders to cash in early to avoid being stuck with worthless tokens in case reserves are depleted. An ability to suspend redemptions according to a set of pre-determined criteria could anchor a stable(ish)coin during market volatility;

• Are you small enough to fail? Perhaps surprisingly, ASIC also pointed towards the relative insignificance money market funds played as a source of funding for the Australian short term lending market as reason not to intervene. While it’s anyone’s guess as to what the exact level at which a non-prudentially regulated stable(ish)coin should sit under, my bet would be at a figure significantly south of the $60 billion Terra/Luna was allowed to reach before it imploded. At the time of the report, money market funds constituted less than 2% of the overall Australian short term lending market.

• True to label: Lastly, perceptions matter: people – even degens – are entitled to expect stability and consistency from something which includes ‘stable’ in its name. At a bare minimum a stablecoin’s price should exhibit minimal volatility, but I’d argue that the fidelity to stability should carry through to the stablecoin’s construction. Anything else that pushes the envelope of sound prudential practice in the name of higher yields or crypto-innovation should be placed into the stable(ish)coin bucket.

Stable(ish)coins: keys to the institutional kingdom

A proliferation of stable(ish)coin projects will be a critical milestone in convincing institutional capital to get off the sidelines and into DeFi. For fund managers with an insatiable appetite for yield-bearing instruments, the stable(ish)coin concept represents an enticing alternative for satisfying short-term liabilities and collateral requirements. For this to happen however, prospective stable(ish)coins must get serious about embedding prudential principles into the heart of their design. For the projects that succeed, rivers of gold await.

Odds and sods

• Unchained episode #403 with Sam Bankman-FriedI’m not the only one saying it, SBF has a long spiel on the dangers of describing novel innovations as a stablecoin.
• ASIC Report 324: Money Market Funds (Dec 2012)
• RAI/Reflexer: for those of you who wanted to see how a stablecoin could operate without a peg
• Fringe Finance: turns out you don’t need to look too hard to find a money market fund in DeFi, after all.