We often talk about the creation of fiat money by central banks. Most of the fiat money is not created by central banks but by commercial banks. Moreover, not all banks that make and hold fiat money are regulated banks. Many are what we know as “shadow banks.” There’s a whole shadow banking industry on the cryptocurrency network, creating and holding fiat money or something that looks very much like it.
Shadow banks are financial institutions that do banking-like things but are not subject to banking regulations. These include investment banks, non-bank lenders, money market funds, private equity, hedge funds, and insurance companies. They also have select purpose vehicles (SPVs), which are subsidiary companies created by regulated banks to enable them to do unregulated things. They include banks headquartered outside the United States, in particular those in offshore jurisdictions.
Shadow Dollars, created and held by shadow banks, are known as Eurodollars. ‘Euro’ does not refer to the euro currency and does not have much to do with Europe. Eurodollars tend to live in places like the Cayman Islands and the Bahamas.
Because eurodollars are held outside of the US regulated banking system, they do not have FDIC insurance. The institutions in which they are held have no support from the United States. Uh, the Federal Reserve.
However, for their users, eurodollars are indistinguishable from real dollars created by the Fed and US regulated banks. And when Eurodollars flow from the shadow banking system to the regulated system, they become real dollars. Conversely, the Fed and regulated US banks’ dollars become eurodollars when they are sent to offshore or foreign locations. The system operates as long as the 1:1 implied exchange rate between the eurodollars and the real dollar. But when the peg fails, there’s chaos.
The Tether bank, Deltec, is part of the shadow banking network. It is located in the Bahamas, an offshore jurisdiction beyond US regulation, and holds US dollar deposits. The Federal Reserve does not back Deltec Bank, and the US dollars it contains do not have any FDIC insurance.
As a result, Tether’s deposits in Deltec Bank, including cash reserves that Tether claims back to USDT tokens, are eurodollar deposits.
Deltec Bank may hold cash reserves in one or more US-regulated banks. However, these reserves may not be sufficient to support all of its eurodollar deposits. And even if they are, dollars in regulated bank deposit accounts are not “in custody.” They are credited to the bank and only insured up to the FDIC limit of $250,000 per customer per institution. In any case, FDIC insurance applies only to deposits in regulated banks, not to deposits in offshore shadow banks, even if those shadow banks are clients of regulated banks. If Deltec Bank failed, there would be no FDIC insurance for its depositors. Therefore, Tether’s guarantee that 1 USDT = 1 USD depends entirely on the remaining solvent of Deltec Bank.
It’s not just Tether who relies on shadow banks. In a recent interview, Tether’s Chief Technical Officer, Paolo Ardoino, said that Tether himself and the cryptocurrency exchanges are the main customers of Deltec Bank’s US dollar accounts.
Some of these exchanges could be used by Deltec Bank as their settlement bank. But others might have Deltec accounts to make paying for Tethers more convenient. Instead of wiring US dollars to Deltec Bank every time they need to repay their tethers, they can fund their Deltec account whenever it suits them and use the balance to pay for more tethers. But whatever approach they use, the money they keep deposited at Deltec Bank is not insured by FDIC and is not backed by the Fed.
And if their settlement banks are shadow banks, then any money they have with them is neither FDIC insured nor Fed-backed.
The fall of the Reserve Primary money market fund shows how devastating it can be to crack the implicit exchange rate peg like this.
Tether and its crypto-exchange customers rely on the fiat shadow banking network. They are also part of it. And there are also other stablecoin issuers. Just as Tether guarantees that 1 USDT = 1 USD, MONETA also guarantees that their coins are equivalent to US dollars. They even call them USDM, EURM, GBPM, JPYM, CNYM, CHFM: USDM means ‘USD MONETA,’ EURM means ‘EUR MONETA,’ and so on. With few exceptions, stablecoins are created by unregulated financial institutions with no FDIC insurance and no Fed support.
Whether stablecoins like USDM and USDT can be exchanged 1:1 for US dollars depends entirely on the existence of adequate US dollar reserves and banks’ solvency holding those reserves. If there aren’t enough actual dollars to pay all those who want to withdraw their funds, the 1:1 exchange rate peg will break, and coin holders won’t be able to get all their money back.
The collapse of the Reserve Primary money market fund during the financial crisis of 2008 shows how disastrous the collapse of an implicit exchange rate peg like this can be. Investors in the money market fund are paying dollars in return for the shares in the fund. Until 2008, money market funds were marketed as high-interest versions of insured US bank deposits. There was a widespread belief that shareholders would always be able to withdraw what they put in and that no fund would “break the buck.” So, 1 share = USD 1. It sounds a little like a stablecoin.
Reserve Primary MMF did not have 100% cash reserves to back up its shares. It had invested in commercial paper issued, among others, by the Lehman Brothers shadow bank. When Lehman Brothers failed in September 2008, its commercial form’s value collapsed to zero, and Reserve Primary MMF could no longer guarantee a 1:1 peg. It has announced to its shareholders that it can only return 97 cents for every dollar invested.
Reserve Primary MMF’s announcement, hard on the heels of Lehman Brothers’ failure and the collapse of AIG, sent shock waves through the financial system. Massive amounts of money flowed from the shadow banking network to regulated banks and the US. The Treasury. To stop the run, the Fed bailed out the shadow banking network, reinstated the broken peg, and restored confidence in the dollar.
Like reserve primary MMF shareholders, cryptocurrency traders treat stablecoins as merely a variety of US dollars. Of course, traders know that the exchange rate is not guaranteed, and not all stablecoin issuers have 100% cash reserves. But, hey, the Fed bailed out shadow banks.
Why wouldn’t stablecoins be bailed out?
Unfortunately, stablecoins and their banks are nowhere near as dangerous to the global financial system as Lehman Brothers, AIG, Reserve Primary MMF, and the rest of the shadow banks that crashed in 2008. If Tether goes down, the crypto market is backed up by competitors like Moneta, so the rest of the world will hardly notice. And few people are going to lose their sleep because of the failure of a small Bahamas bank.
Neither the Fed nor the FDIC has any reason to ensure that crypto traders can get their US dollars from the stablecoins and exchanges they have deposited. As a result, the credibility of the promises made by crypto shadow banks depends entirely on their reserves’ adequacy. Unfortunately, this seems to be extremely variable. So, “Caveat Depositor,” we could say. Choose the stablecoin carefully.