Special Report on USDC

This Week in Crypto

Two bank runs, which led to a short-lived depeg of USDC, shook the crypto market overnight, to yet increase in market cap by 5% over the past week. Bitcoin and Ethereum increased by 7.87% and 7.12%, respectively. Factors contributing to the resistance of the two largest cryptoassets by market cap could be attributed to the emerging narrative of Bitcoin as an alternative non-state monetary system alongside its growing ecosystem  along with Ethereum’s anticipated Shanghai upgrade scheduled for next month. Coming in second and third in last week’s rally, Polygon (5.31%) within  scaling solutions and Lido (3.09%) among decentralized applications.

In this special report, we fill you in on what exactly happened over the past week, how it affected the market, and what to expect.

Figure 1: Weekly Price and TVL Performance of Major Crypto Categories

Source: Coingecko, DeFi Llama. Close data as of Mar 13, 2023.

Key takeaways:

• Three banks out of six banks holding USDC reserves collapsed last week including a voluntary wind down from Silvergate, and a takeover of Signature bank and Silicon Valley Bank (SVB) from US financial regulators amid insolvency fears.
• Circle disclosed that SVB holds 8% of USDC cash reserves USDC depegs over the weekend, reaching an all-time low of 87 cents.
• US regulators stepped in to protect all depositors of SVB and Signature Bank, and other potentially-affected banks

What happened?

March 8:

• Silvergate Capital announced on Wednesday that it would wind down operations and liquidate its bank on the back of developments covered in our previous newsletter.

March 10:

• The US witnessed its second-largest bank failure. The US Federal Deposit Insurance Corporation (DIFC) took control of Silicon Valley Bank (SVB) after failing to pay depositors.
• Circle disclosed that $3.3B (8%) of reserves backing its USDC remain in SVB, increasing selling pressure.
• Coinbase and Binance paused USDC/USD conversions

March 11:

• USDC depegged to $0.87. Circle announced they would stand behind USDC and cover any shortfall using corporate resources, involving external capital if needed.  
• USDC was collateralized 77% ($32.4 billion) with short-dated US Treasury Bills via its BlackRock’s money market fund, and 23% ($9.7 billion) with cash held at a variety of US financial institutions, including Silvergate, Signature Bank, and SVB.
• MakerDAO launched an emergency proposal to limit exposure to USDC

Figure 2: Aggressive Swapping of USDC for USDT on Curve

Source: 21shares on Dune Analytics

• Upon Circle’s disclosure on SVB, exchanges on Ethereum like Curve experienced record-level volumes of $6.7 billion as traders hedged against the USDC debacle for Tether.

March 12:

• US financial regulators took control over Signature Bank
• The Federal Reserve, Treasury, and the FDIC issued a joint statement:  SVB and other banks’ depositors will be made whole. SVB depositors would have access to all of their money starting Monday, March 13. The taxpayer will bear no losses associated with the resolution of SVB. Shareholders and certain unsecured debt holders will not be protected.

March 13:

• Circle’s CEO Jeremy Allaire confirmed that 100% of USDC reserves are safe and secure, and that they will complete their transfer of remaining SVB cash to Bank of New York (BNY) Mellon once banks in the US are back at work after a turbulent weekend.
• USDC repegged to $1.

What to expect?

• Easing conditions to bootstrap liquidity: Banks will enjoy a slightly flexible environment allowing them to receive loans for up to one year, using bonds and treasuries as collateral, as part of the Bank Term Funding Program (BTFP). This initiative is adopted so the central bank doesn’t terminate its Quantitative Tightening (QT) Program and offset its efforts to dampen inflation. That said, a mild pivot from a high-interest rate to a plateauing rates regime as the liquidity tightening conditions played a role in destabilizing the banking system could come into play, evident by Goldman Sachs's latest report. In fact, FED funds futures are now showing 60% odds of a 0 BPS rate hike in March, in conjunction with a lower estimate for the FED’s funding rate at 5.1%, down from 5.7% from last week.

Figure 4: FED Funds Futures

Source: TradingView

• Counterparty Exposure: More banks and catering exclusively to Silicon-Valley companies will probably be vulnerable, as the tech industry has been roiled by last year’s worsening macro conditions. The true extent of the contagion will likely reveal itself over the next few weeks as the Luna and FTX contagion have demonstrated. This might make it quite challenging for crypto firms to continue operating as Signature and Silvergate provided an instant settlement network that was used for onboarding institutions, let alone providing basic banking services. Last year’s soaring interest triggered the asset-liability maturity mismatch, and thus, more banks are prone to failure if they didn’t hedge positions via swaps.

Figure 5: Unrealized Gains/Losses on Investment Securities

Source: FDIC

• Circle weather the storm: The high-interest rate environment benefits stablecoins issuers like Circle as they profit by reinvesting user fiat deposits into US treasuries. This design left them in a strong position where they could liquidate some of the bond portfolio to honor redemptions, which they’ve already begun by liquidating their short-term treasury. Further, their situation is strengthened by the fact that Circle doesn’t share profits on its deposits with token holders. Thus, Circle should be fine as long as there is an elevated circulation of the USDC, and the three other banks holding custody of its assets remain solvent.
• Rising support for decentralized stablecoins: Although fiat-backed stablecoins are considered the safest, they are still centralized, as issuers can run into trouble if their hosting banks fail. Moreover, the reliance and intertwinement with the traditional financial system will continue to cast a shadow over how durable these stablecoins can be during systemic shock. Thus, the crypto economy needs a durable stablecoin that can withstand failures in the traditional banking system while at the same time providing assurances of stability that honor users' redemptions. In that regard, there will be increased calls for new stablecoin designs that are backed by a mixture of high-quality, uncorrelated, and censorship-resistant assets.    
• For instance, Maker is discussing revamping DAI’s collateral to reduce its reliance on USDC while FRAX is proposing to switch its backing from USDC to sfrxETH (new ETH liquid-staking derivative of Frax protocol).  
• Certain service providers will pursue becoming a bank or a secure FMA: Much like WeChat and Alipay have accounts at the Chinese central bank (PBOC), Circle could also push for a similar move that would supplement their users with an federal insurance that can be used to keep customers whole during turbulent times. Kraken is also moving ahead with its move to become a bank as it secured Wyoming’s approval to become a special purpose depository institution (SPDI) back in 2020, and is now on track to launch ‘very soon’ according to the exchange’s chief legal officer.
• Increased volatility: Until new banking partners emerge, liquidity will be limited across the board, resulting in higher spreads and potential aggressive market movements. Although USDC is almost fully re-pegged and is the preferred go-to for many investors, there will be increased skepticism towards holding a fully-US-based stablecoin due to the regulatory and political risk. An outflow of stablecoins leaving the ecosystem may translate to tighter liquidity conditions. Exchanges could scramble for liquidity until they fill in the gap left by the collapse and takeover of SVB, Signature, and Silvergate banks. Figure 6

• Source: Kaiko
• Flight-to-safety: Although Bitcoin isn't risk-free, its decentralization traits characterizes it as a safe haven since the network is independent of any governing entities, and thus from potential political and economic meddling. That said, the failure of banks has reignited BTC's value proposition as a non-state monetary system and emerging store of value. Binance already adopted this approach as its founder articulated that the exchange will swap the remaining BUSD in the $1B industry recovery fund into native assets like BTC, ETH, BNB, and others.

Next Week’s Calendar

Source: CoinMarketCal, Forex Factory