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Fed Sounds Alarm on "Recent Strains" in Stablecoin Market

U.S. government agencies are taking a close look at the stablecoin market following Terra’s dramatic meltdown.

Fed Sounds Alarm on "Recent Strains" in Stablecoin Market
Shutterstock cover by MDart10

Key Takeaways

  • A new report from the Federal Reserve mentions stablecoins and the risks they pose to the stability of the financial system.
  • The report said that "recent strains" in the stablecoin market highlight the fragility of the ecosystem.
  • The report comes as government officials are looking to implement a broad regulatory framework for crypto.

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Stablecoins pose a risk to the financial system due to their lack of transparency and often lack of “safe” reserves, according to a new Federal Reserve report.

Federal Reserve Highlights Stablecoin Risks 

Stablecoins could endanger the financial system, the Federal Reserve has reiterated. 

In the Monetary Policy Report submitted today to Congress, the U.S. central bank claimed that “the collapse in the value of certain stablecoins and recent strains experienced in markets for other digital assets demonstrate the fragility of such structures.”

The report further stated that “stablecoins that are not backed by safe and sufficiently liquid assets and are not subject to appropriate regulatory standards create risks to investors and potentially to the financial system, including susceptibility to potentially destabilizing runs.”

Stablecoins are a type of cryptocurrency that aims to retain a 1:1 ratio with an underlying asset such as the U.S. dollar. Some issuers achieve this by backing their coin with reserves; others rely on complex algorithms. Stablecoins have increasingly caught the attention of government officials and regulators in recent weeks thanks to the spectacular collapse of UST, an algorithmic stablecoin that was pegged to the Terra blockchain. 

While the Federal Reserve’s report stopped short of mentioning Terra by name, it seemed to allude to the protocol as an example of the type of damage stablecoins are capable of inflicting on markets. 

The report furthermore criticized the lack of transparency among stablecoin issuers concerning risk and reserve liquidity. It also warned that stablecoins are popularly used as collateral for leverage trading, which could potentially “amplify [market] volatility” and heighten risks of non-redemption by issuers.

The Treasury Secretary Janet Yellen is one of several officials to have echoed the Federal Reserve’s sentiments in recent weeks, and she had made it clear that she wanted to establish a regulatory framework for stablecoins even before Terra collapsed. 

A bipartisan crypto bill introduced in the Senate this month has also called for “a strong, tailored regulatory framework for stablecoins”; if passed, it will require centralized stablecoin issuers to guarantee 100% reserve backing for their products.

Disclosure: At the time of writing, the author of this piece owned ETH and several other cryptocurrencies.

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