We won’t mince words: USDC is 100% centralized. Despite it living on a blockchain, being listed on “cryptocurrency” websites, and underpinning much of “DeFi,” it cannot be stressed enough that USDC is a centralized stablecoin run by a for-profit company that strives to adhere to all U.S. regulatory requirements. It can be argued that stablecoins exhibit varying degrees of centralization/decentralization. Given this mental model, USDC exists on the extreme end of centralization.
Fortunately for the space and potential users, Circle is upfront about USDC’s centralization and does not market itself in an untrue fashion like some other less-reputable stablecoins or cryptocurrencies. Therefore, with that understanding, users are free to make their own decisions around the tradeoffs associated with a centralized stablecoin.
USDC is essentially an IOU or debt. It is a representation of a dollar’s worth of Treasuries or cash held by Circle. Centralized custody of these U.S. dollar reserves exposes USDC to risks associated with the management and security of these funds. USDC relies on banking partners for the custody and transfer of funds. Any operational issues, insolvency, or misconduct by these partners could impact the stablecoin's operations and value.
Because of this, users of USDC are exposed to various compounding risks, such as:
- U.S. dollar risk/depreciation
- Treasury risk
- Bank runs
- Improper risk management by a bank/custodian (i.e., duration risk that brought SVB down)
- Improper management of the reserve portfolio or outright nefarious actions by Circle
USDC, a stablecoin issued by Circle, is essentially a transferrable claim on the issuer. Regardless of the issuer's creditworthiness, this model introduces a layer of uncertainty into the financial ecosystem, specifically in the form of counterparty risk.
According to Circle's own previous reports, out of the $10 billion held in cash in regulated financial institutions in 2021, only ~$1.75 million was covered by the Federal Deposit Insurance Corporation (FDIC) deposit insurance ("Circle Internet Financial Limited").
The limitations of the FDIC insurance become apparent in light of the considerable volumes intermediated by Circle. If a bank were to fail, the holders of USDC would find themselves in line with other creditors for the cash portion of the stablecoin backing. In essence, a significant portion of the cash backing USDC is/was at risk due to being held at banks over the $250,000 FDIC-insured threshold.
The crypto markets got a taste of these risks in March 2023, when USDC de-pegged due to a failed banking partner.
March 2023/SVB De-pegging Event
Following instability in the banking system in Q1 2023, stablecoins experienced considerable volatility themselves. During SVB’s collapse, Circle announced that they had ~$3.3 billion with the troubled bank (out of its ~$40 billion in total). Because ~8% of USDC's collateral was tied up in the failing SVB, traders started selling the coin, causing its value to drop below $0.90. Eventually, news broke that SVB depositors were going to be made whole/have access to their funds, and USDC returned to its $1 peg.
This situation highlights the interconnectedness of traditional banking with the crypto world and how instability in one can cause ripple effects in the other. It also underlines the importance of stablecoin reserves being kept in secure and stable financial institutions to maintain their pegged value.
The demand for a secure and reliable form of digital currency has never been more pronounced. Following the SVB/Signature incident, there has been a surge of proposals aimed at enhancing individuals' access to high-moneyness forms of currency. Suggestions range from unlimited deposit insurance to Central Bank Digital Currencies (CBDCs).
Censorship
Because Cirlce and USDC strive to remain compliant with the rules set by the US and other government agencies, it has the power to “freeze” addresses it deems necessary. Freezing an address stops the end user from being able to access or move the funds. Addresses that are frozen are said to be “blacklisted.” Circle regularly uses this feature, and an automated Twitter bot actually tracks the latest addresses each time one is frozen, with the most recent address added in April 2023. Make no mistake, this is financial censorship in its truest form but is openly communicated by Circle and USDC representatives. This is a known and accepted feature that users choose to opt into when holding USDC.
Regulatory Risks
As an asset-backed stablecoin, USDC is subject to regulatory scrutiny. Changes in regulations or enforcement actions could affect the stablecoin's operations or its value. In fact, this is expected and seen as a foregone conclusion considering the current talks among regulators in the U.S.
This is an opportune time to contrast USDC with a “true cryptocurrency” like Bitcoin. One of the pillars of the cryptocurrency/cypherpunk movement is the emphasis on separating money from governments. USDC strives to comply with government regulations, while bitcoin (BTC) exists independently of any government, law, or nation state. Circle serves as the single point of failure for USDC. Should any government choose to outlaw or ban USDC, they can go directly to Circle and force them to comply under the threat of jail time and/or violence.
While this may sound extreme, it is by no means hypothetical. Prior to Bitcoin, several attempts were made to create a digital currency outside the normal government-issued money (fiat) system. Previous examples include David Chaum’s DigiCash (1989), Jackson and Downey’s (1996), Wei Dai’s (1998), Nick Szabo’s Bit Gold (1998), and Arthur Budovsky’s Liberty Reserve (2006). In the specific case of Liberty Reserve, the government banned it and threatened the creator with jail time, forcing it to close down. The creator was the central point of failure.
“A lot of people automatically dismiss e-currency as a lost cause because of all the companies that failed since the 1990's. I hope it's obvious it was only the centrally controlled nature of those systems that doomed them. I think this is the first time we're trying a decentralized, non-trust-based system.”
Satoshi Nakamoto
This is what makes Bitcoin so special. There is no CEO, no headquarters, and no central server room in which to shut it off. It is critically important to understand and fully appreciate this distinction when navigating the cryptocurrency space and/or choosing to store funds in a centralized entity.
Smart Contract Risk
USDC operates on various blockchains, including Ethereum, Algorand, and Solana. The associated smart contracts may be subject to vulnerabilities, which could lead to the loss or theft of USDC tokens.
Auditing and Transparency
Regular auditing of the US dollar reserves is crucial for maintaining trust in USDC's value. Inadequate transparency or issues with auditing processes could undermine confidence in the stablecoin.
