The biggest crises in financial markets happen when an asset previously assumed to be safe turns out not to be.
Investors rush to sell it, they find they can’t get all their money back, prices plummet and market confidence collapses. Credit disappears and the financial shock quickly spreads to the real economy.
After Lehman, when the real panic set in
In popular memory, the 2008 financial crisis was triggered by the failure on September 15 of investment bank Lehman—a bankruptcy that US policymakers let happen.
But it was a day later that the real panic set in and the US government was forced to reverse course, launching the biggest bailout in history.
On September 16, an investment treated by markets for decades as the equivalent of cash turned out to have ‘broken the buck’. In other words, it started changing hands for less than its assumed $1 face value.
Shares in the Reserve Primary Fund fell to $0.97 cents, triggering chaos
The drop in shares of the Reserve Primary Fund to 97 cents triggered chaos throughout the financial system.
The Reserve Primary Fund was a Money Market Fund (MMF), a type of mutual fund designed to mimic cash deposits. And MMFs, for decades, had been treated by investors as the same as dollars held in a bank.
But there was a catch, which turned out to have put the whole financial system at risk. MMFs weren’t subject to the same regulation as banks, and during the boom of the 2000s some of them had been taking liberties with the extra freedoms.
The repo market, which underpins credit to the wider economy, seized up
Reserve Primary Fund, for example, had invested heavily in asset-backed commercial paper, a type of debt instrument. Its value was now highly exposed to the US property market, which was in free fall.
The MMF failure threatened to drag other investment banks and insurance companies into a Lehman-like spiral. The repo market, which underpins credit to the wider economy, seized up.
Soon, more than a dozen other fund companies were forced to step in to prevent their own MMFs breaking the buck.
On September 19, the US authorities decided to direct a stream of taxpayer money at the problem. Under the Temporary Guarantee Program for money market funds, the US Treasury guaranteed investors that, henceforth, MMFs’ values would remain at $1 per share.
The MMF bailout was the first of many. On October 3, the Emergency Economic Stabilization Act, also called the Troubled Asset Relief Program (TARP), was signed into law, helping relieve banks of the bad loans on their books.
The interventions calmed the US money markets and helped prevent the financial crash causing wider, more catastrophic damage.
A 2020 repeat
2008 was supposed to be the financial sector bailout to end all bailouts. Except it wasn’t.
Early last year MMFs were under pressure again during the market slump that followed the coronavirus outbreak.
Early last year MMFs were under pressure again
On March 18 2020 the US Federal Reserve established the Money Market Mutual Fund Liquidity Facility, or MMLF, saying it was acting to ‘support the flow of credit to households and businesses’.
Paul Tucker, director of markets at the Bank of England during the 2008 crisis and now chair of the Systemic Risk Council (SRC), a think tank focusing on financial sector systemic risk, was sharply critical of regulators’ failure to prevent another taxpayer-funded bailout.
“A decade ago, after the federal government had rescued the money-fund industry, the SRC strongly urged the Securities and Exchange Commission (SEC) to act to ensure money funds did not again jeopardize financial stability,” Tucker wrote earlier this month in an open letter to the SEC.
The SEC is the regulator of the US MMF sector.
“Some measures were taken,” Tucker went on, referring to reforms introduced in 2010 by the SEC to help head off a repeat of the 2008 MMF collapse.
MMFs are risky in a way that other types of mutual fund—like those investing in shares—are not
The new MMF rules required a floating net asset value (NAV) for institutional prime money market funds. The floating NAV meant that the daily share prices of MMFs would fluctuate along with changes in the market-based value of fund assets, helping prevent a sudden shock to investor confidence.
In addition, new tools such as liquidity fees and redemption gates could also address potential ‘runs’ on MMFs—investors all heading for the exit door at once.
But, said the SRC’s Tucker, these reforms didn’t go far enough.
In their capacity as ‘shadow banks’, he argued, MMFs are risky in a way that other types of mutual fund—like those investing in shares—are not.
And, as a result, MMFs merit much closer scrutiny than insured deposits held in a bank, he said. Otherwise, Tucker warned, we risk an endless cycle of central bank interventions in the money markets.
“It turns out that taxpayer bailouts were not a once in a lifetime event but, rather, twice in a generation, so far,” Tucker said.
“This is not a sensible course if financial services are to find a sustainable, legitimate place in the market economy,” the SRC chair wrote in his open letter.
Stablecoins—the crypto MMFs
But far from learning from the difficulties that MMFs created in the traditional financial system, those building a parallel system based on cryptocurrencies appear to be repeating the same mistakes.
Worse, they may be amplifying them.
Those building a parallel system based on cryptocurrencies appear to be repeating the same mistakes
In the crypto markets there are no MMFs. But they have a close equivalent—private sector stablecoins.
For cryptocurrency investors, traders and financiers, digital asset tokens like Tether (USDT) and Circle (USDC) perform the same function as dollar-pegged money market funds in the legacy system.
These stablecoins act as quasi-fiat currencies, performing the role of the dollar within a system that—despite the presence of cryptocurrencies like bitcoin—still needs dollar-based liquidity and dollar-denominated collateral.
Against the backdrop of another cryptocurrency boom, it’s hard to overstate just how quickly stablecoins are growing. Tether’s assets have soared from $3bn to over $50bn in little more than a year.
The stablecoin now reportedly represents the sixth largest corporate cash pile in the world, after those of Apple, Google, Microsoft, Amazon and Facebook.
Circle’s assets have jumped from $0.7bn to $14bn over the same period—a twenty-fold increase.
Stablecoins act as quasi-fiat currencies
It’s not as if central banks are unaware of the trend. Last year, the Bank for International Settlements (BIS), the main think tank of the legacy financial system, said that stablecoin assets could grow exponentially in the future.
But they are growing in an effective regulatory void. While US MMFs operate according to a framework called Rule 2a-7, first set out in the 1940 Investment Company Act, stablecoins like Tether and Circle operate on a ‘trust me’ basis, with no limits on holdings by asset type, nor any formal disclosure regime.
Prompted by press scrutiny and clients’ demands, stablecoin issuers have taken some steps towards transparency.
Since October 2018, Circle has published monthly attestations of its reserve backing, given by auditing firm Grant Thornton, although the reports for end-February and end-March are still not available.
Circle did not respond to a question from New Money Review about why its end-February attestation is now nearly two months late.
In its reports, Grant Thornton attests that Circle’s reserves are ‘US Dollars held in custody accounts at federally insured US depository institutions’ and ‘approved investments [held] on behalf of USDC holders’ at each month-end report date.
Stablecoins like Tether and Circle operate on a ‘trust me’ basis
Circle says its stablecoin’s reserves ‘are bound by permissible investment rules under US state banking supervision and regulation of money transmission companies’, but offers no further information.
Permissible investment rules vary state by state but typically allow US state banks to hold corporate bonds, currency, foreign government debt, asset-backed and mortgage-backed securities.
Tether, the largest stablecoin, has a highly controversial history. Its operators have a record of lying about its reserves and deflecting questions about its asset backing. Tether released its first attestation by a third-party auditor at the end of March.
The report, published by Cayman Islands-based Moore Cayman, said that Tether’s assets exceeded its liabilities—then $35bn, compared to the current $50bn—at the end of February 2021, but did not disclose the make-up of those assets.
However, this is due to change. Under a February legal settlement with the New York Attorney General, which had accused Tether of lying in the past about its reserves, Tether committed to increasing its levels of transparency.
It said it would publish the categories of assets backing its stablecoin, and whether any category constitutes a loan to an affiliated entity, by May 20 and for a period of two years.
For former banker Frances Coppola, these disclosures by stablecoin issuers go nowhere near far enough to address the underlying risks of operating a cash substitute.
In an article published in Coindesk, Coppola drew an explicit link between the past problems with MMFs and potential future ones in private-sector stablecoins.
“The collapse of the Reserve Primary fund during the 2008 financial crisis shows how disastrous the breaking of an implied exchange rate peg can be,” Coppola wrote.
And, she went on, those holding USDT and USDC face disproportionate risks compared to investors in MMFs in the legacy system.
In particular, stablecoin investors could not expect taxpayers to come to their rescue if their tokens broke the buck—like the Reserve Primary Fund had done in 2008—Coppola warned.
“Neither the Fed nor the FDIC has any reason to ensure crypto traders can get their US dollars out of the stablecoins and exchanges in which they have deposited them,” she said.
The Federal Deposit Insurance Corporation (FDIC) insures US dollar bank deposits up to $250,000 per depositor per insured bank.
“The credibility of the promises made by crypto shadow banks thus depends entirely on the adequacy of their reserves. Sadly, this seems to be enormously variable. So ‘caveat depositor’, we might say,” Coppola went on.
“It is time to confront the difficult and costly problem of shadow banking”
According to John Kiff, a former International Monetary Fund expert and an April interviewee on the New Money Review podcast, regulators may have been distracted from monitoring the risks in stablecoins like Tether by tech giant Facebook’s ambitions, announced in 2019, to launch its own digital dollar.
“Facebook’s proposed stablecoin—Diem—would be orders of magnitude bigger than Tether,” Kiff said during the podcast.
“That’s why [regulators’] focus has been so far mainly on Diem. Overnight, it would be on people’s iPhones and Android phones. That’s what scares the authorities,” he said.
But with Tether now growing like crazy and Circle’s USDC being integrated by the leading payment card networks as a settlement currency, stablecoins appear to be the latest ‘shadow banks’, potentially rivalling or even displacing MMFs in this role in future.
According to the SRC’s Tucker, getting dollar shadow bank regulation wrong could have broader, geopolitical consequences.
“It is time to confront the difficult and costly problem of shadow banking,” Tucker said earlier this month.
“Failure to do so would jeopardise not only the stability of the financial system, but the role of the dollar in global finance.”
***Correction: in an earlier version of this article we gave Paul Tucker’s title in 2008 as deputy governor of the Bank of England. He was director of markets at the time, becoming deputy governor in 2009***
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