First presented on June 22, 2021 at SORA Economic Forum. Discusses collateral-backed "stablecoins" that rely on the U.S. financial system. See also Daistats.com for up-to-date charts.

1. DeFi's dependency on the
U.S. banking system
E.g., collateral custodied at U.S. commercial banks
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2. Disclaimer
The views expressed in this presentation do not necessarily represent the views of
my employer or any project that I advise. I am not a lawyer.
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3. Narrative violation
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4. Hyperdollarization
Over the past decade, several vocal coin promoters have claimed a
“hyperbitcoinization” event will occur soon.
But the cryptocurrency ecosystem as a whole has seen the opposite take place:
rapid dollarization due to the growth of commercial bank-backed stablecoins.
● Nearly 10% of the aggregate cryptocurrency “marketcap” is comprised of stablecoins.
This is the central conceit for much of the coin world today: promoters and meme
artisans often claim they are about to launch off from planet Earth all while drilling
ever deeper foundations into the Earth’s crust.
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6. Definition of a “stablecoin”
Hundreds of papers and articles have been published on this topic. Often the
author(s) conflate collateral-backed tokens held at commercial banks, with central
banks (this is not accurate).
For the purposes of this presentation, we want to stress that the term “coin” is
misleading because nearly all of these are un(der)regulated bank deposits.
Compared with bank deposits, stablecoins do what a bank checking account is not
allowed to do due to regulatory arbitrage.
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7. Taking a step back
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8. PFMIs
The Principles for Financial Market Infrastructures (PFMIs): is an evolving set of principles and
guidelines for financial market infrastructures (such as CSDs, CCPs, payment systems) that are
maintained and updated based on research and collaboration between two international regulatory
bodies: BIS and IOSCO.
Following the Great Financial Crisis (GFC), their joint 2012 paper is considered the gold standard
and is frequently cited in the press, academia, and regulatory bodies.
For the purposes of this presentation we will look at just once slice of the 2012 document. Principle
9 of the PFMIs states:
An FMI should conduct its money settlements in central bank money where
practical and available. If central bank money is not used, an FMI should
minimise and strictly control the credit and liquidity risk arising from the
use of commercial bank money.
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9. Fragility built on fragility?
Without going into weeds, the PFMIs and the committees involved in drafting them, state and
then re-state the importance of reducing credit risk exposure to commercial banks.
Yet in all instances today, almost every collateral-backed stablecoin that has thus far been
issued does so through tokenizing deposits custodied at commercial banks which likely
amplifies credit risk.
This is arguably improper for a variety of reasons and there are proposed remedies in addition
to enacting new legislation.
For instance, while we await liberalized access to central bank digital accounts (CBDAs) or
currencies (CBDCs), setting up “narrow banks” or FedAccounts have been highlighted as
complimentary solutions in the United States.
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10. Lack of on-chain per transaction AML and CFT screening
As an aggregate, in 2020, on-chain volume alone from these stablecoins reached more than $1
trillion and that trend accelerated in the first half of 2021.
That does not count the exchange-based (off-chain) transactions that also use these collateral-
backed coins.
And problematic for policy makers: the on-chain volume was exchanged with limited oversight or
surveillance sharing, which is part of the reason why various major governments are moving
quickly to pass laws to deanonymize self-hosted wallets that are exchanging this parasitic “e-
banknote” or “shadow deposit.”
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11. What is a “shadow bank”?
The term itself is just over a decade old but these entities existed prior to 2007.
In general they are “non-bank financial intermediaries that provide services similar to traditional
commercial banks but outside normal banking regulations.”
Viewers can imagine that this type of activity is what organizations such as the Financial Stability
Board (FSB), which monitors potential systemic risks, would like to keep track of.
In China, “shadow banking” is thought to have topped out at around $13 trillion two years ago (that is
about 86% of GDP). De-risking campaigns have attempted to dismantle hundreds of schemes, like
the P2P lending ecosystem, wherein victims had no recourse beyond storming corporate offices.
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13. The Federal Reserve and the FSB
The screenshot in the previous slide is a relevant portion of their mandate and why the Federal
Reserve could – in theory – be interested in obtaining information of off-shore entities that are
attempting to (anonymously) use U.S. linked e-banknotes.
“Shadow banking” is occurring off-shore through intermediaries (e.g., coin exchanges and lending
protocols) that use USDT or USDC without needing to connect to a local bank who would require
some semblance of surveillance such as AML or CFT compliance.
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14. Is it really bankless if you are ultimately dependent on
depository accounts in U.S. based commercial banks?
Based on their external messaging, multiple centralized exchanges (CEXes) claim to operate
banklessly but this is a superficial: they each maintain an umbilical cord to the U.S. dollar via USDT or
USDC.
Similarly, decentralized lending protocols such as Compound or Aave accept commercial bank-
backed stablecoins as collateral and allow rehypothecation of these same tokens (or others).
Putting aside new proposed legislation for the moment: stablecoin issuers (administrators) have
fought feverishly to categorize themselves under a “lighter” more lenient regulatory regime (money
service business) despite more stringent laws covering deposit-taking activities that are not enforced,
such as 12 USC 378 (a)(2) being on the books.
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15. Shadow banking versus shadow money
Related to the concept of shadow banking is shadow money, and clearly stablecoins fit the bill.
When he was a Governor at the Federal Reserve, Dan Tarullo gave a speech, stating:
“Shadow banking also refers to the creation of assets that are thought to be
safe, short-term, and liquid, and as such, “cash equivalents” similar to insured
deposits in the commercial banking system. Of course, as many financial
market actors learned to their dismay, in periods of stress these assets are not
the same as insured deposits.”
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16. Money market funds got bailed out, will stablecoins?
The classic example of shadow money is money market funds which were deemed to be “money
good” pre-2008 crisis.
Reforms were implemented post-crisis, such as redemption gates and floating NAVs for certain
money funds, but in March 2020 the Federal Reserve still had to backstop money funds via the
money market mutual fund liquidity facility (MMLF).
In December 2020, the President’s Working Group on Financial Markets released a report highlighting
the need for further reforms to money market funds.
If consumers and investors think stablecoins are the same as insured deposits because they are
“backed” by insured deposits at a commercial bank, they are clearly not.
Does this mean that if stablecoins become big enough, the U.S. government would bail the sector out
just like they have bailed out other shadow money investors? This is an open question but the answer
should arguably be no. 16

17. What does this have to do with parasitic stablecoins?
Transactional users and speculators of commercial bank-backed stablecoins are faced with at least
two potential credit risks:
● the credit risk of the stablecoin issuer
● the credit risk of the commercial bank that the stablecoin issuer uses as a custodian
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19. Credit risk
A conventional bank account exposes to the account holder to a single level of credit risk, the risk that
the bank becomes bankrupt and is unable to meet its liabilities to account holders.
In most developed countries and many developing countries, deposits are protected by a national
deposit insurance scheme ranging between tens and hundreds of thousands of dollars.
Even if Signature Bank or Silvergate Bank have impeccable credit quality, they are not the lender of
last resort. They rely on the implicit and explicit backing of the FDIC and the Federal Reserve.
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20. Double or even triple layers of credit risk
As a result, stablecoins present at least double layers of credit risk. There is the risk that the issuer of the
coins fails and the risk that the party holding the reserves (e.g. a bank, fails).
● Generally stablecoins would not benefit from the deposit insurance provided for bank accounts.
Where the issuer invests in a more complex range of assets to act as reserves, such as debt instruments,
it also exposes the stablecoin holder to the risk that assets fall in value, which can be an issue, even for
relatively short-dated assets, where reserves have to be liquidated.
This raises a major question: who bears losses, the issuer or the holder of coins? An issue banks deal
with (to a certain extent) by having to set aside regulatory capital.
In other words: a stable coin backed by commercial bank deposits has worse credit risk than simply
having money in the bank because it would not benefit from any deposit insurance scheme.
● Note: does not account for the possibility of an intentional or unintentional chain fork and/or death of a chain 20

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22. Growth due solely to reg arbitrage?
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25. And stablecoins represent the lionshare of TVL
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28. Aave and Compound
In terms of deposits:
Five out of the top six assets on Aave are some type of USD-denominated
stablecoin. Together they consist of more than ~$7.2 billion assets, or about 60%
of all deposits on Aave.
Three out of the top five assets on Compound are some type of USD-
denominated stablecoin. Together they consist of more than ~$6.2 billion assets
or about 60% of all deposits on Compound. (Coincidence)
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29. Quickly drilling down into DAI
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31. Multicollateral backing a single asset
As of today about 59% of the collateral backing DAI is USDC, whose tokenized
deposits are custodied in U.S. commercial banks.
● About $3 billion, or more than 12% of all USDC issued is currently locked in DAI
Worth pointing out: in terms of collateral, part of the reason for why USDC has “grown”
over the past several months is because other collateral -- namely ETH and BTC --
have dropped in USD-denominated value by more than 50% (since mid-April).
Note: also when exogenous coin values drop there is demand for DAI to close out
vaults, which means if it breaks above $1 thus creating an opportunity to create DAI
with USDC and sell which is relatively inexpensive.
● Vault owners needed to put up more collateral as ETH fell in value, or close their vaults. Closing
vaults meant repurchasing Dai in the market. And this demand would have pushed Dai to a premium
above $1. And the easiest way to arbitrage this premium was by using the PSM to deposit USDC,
withdraw Dai.
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33. Aggregates
Of the ~$51 billion in TVL - as tracked by DeFi Pulse - at least ⅓ is stablecoins in lending
protocols. Another ~$340 million is in the top 10 Uniswap pairs.
And of the stablecoins, about two-thirds of the value is either USDC itself or DAI (which
again, whose collateral is largely comprised of USDC).
Note: other chains such as BSC have lending protocols. For instance, Venus has about
$500 million in stablecoins including DAI and USDC.
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34. So if DeFi is trending towards greater dependency on U.S.
banking access why is it not front and center for
coinfluencers?
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35. Currently the shilling is about NGU and growth at any cost
If the goal of DeFi and the larger “cryptocurrency” zeitgeist is to create a new,
more orderly, more transparent, more robust and resilient financial system, then
by most marks it has failed thus far. In some ways it is actually worse than the
current financial system.
How is that?
The current financial system, as bad as it is, has consumer protection and
restitution, agencies, some forms of accountability, and entire efforts of deposit
insurance.
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36. Feels like 2015-2017 all over again
The discussions around enforcing on-the-books regulations for stablecoins today involves a lot of
déjà vu.
Why?
Because the various blockchain consortia of that era included dozens of commercial banks, nearly
all of which experimented with some kind of proto-stablecoin.
They eschewed that model for multiple reasons including:
(1) it reintroduces / amplifies systemic risks (reliance on TBTF commercial banks and SIFIs)
(2) it fails to provide required surveillance on all legs of the transaction for AML / CFT purposes
(3) is not aligned with the PFMIs
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37. Why has it grown to be this size?
Globally financial regulators are often underfunded, understaffed, underresourced.
Daily they are faced with a very vocal - and very wealthy - group of coin promoters
and coin lobbyists who are using every tool at their disposal to prevent stablecoin
issuers from being regulated as banks.
In one scenario, barring G20 coordination, it is likely that these issuers - and the
parties that rely on them - will grow to become “too big to fail” TBTF status and
when a crisis occurs, will demand a bailout. We see this narrative already being
pushed around by coin promoters.
See Appendix for examples.
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38. Concluding remarks
● Proposed technical solutions: Rai, UST (from Terra), Frax-like models
● No external bailouts: financial regulators explicitly, publicly tell market participants that they
will not provide bailouts to stablecoin issuers and/or shadow money instruments. This could
help reduce the moral hazard problem.
● DeFi currently resides in a contradictory world: reliance on centralized collateral and
traditional intermediaries… it is not decentralized as people claim
● For legal / regulatory reasons, should not peg to exogenous unit-of-account… to be taken
seriously, DeFi world should find or create its own native U-o-A and decouple from USD
● In previous administration, OCC could, but did not opine on credit risks or types of reg capital
- will this change with Michael Hsu’s team?
● Stablecoins are really shadow banks, but with a key characteristic is they are not subjected to
AML/KYC and bank-like risk oversight.
● Stablecoins pose risk via facilitating illegal activity & potential unregulated credit and market
risk.
● Stablecoin collapse may ripple through (coin) markets due to direct and indirect exposure.
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39. Contact
e: tim.swanson@clearmatics.com
t: @ofnumbers
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40. Appendix
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41. SIFIs and TBTF
As mentioned above, the credit risk (solvency) of commercial banks is worse than central banks.
During the 2007-2009 financial crisis, while a number of commercial banks received direct taxpayer-
funded bailouts that immediately underwent public scrutiny, the entire financial industry was
effectively propped up through the coordinated actions of central banks and finance ministries around
the world.
We could always argue about which policies should or should not have been implemented during that
time. The Dodd-Frank Act was just one set of legislation that was passed in an attempt to prevent
another, similar systemic crisis from happening again.
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42. What headline was encoded in the
original Genesis block in 2009?
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44. Twelve years later...
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48. Too big to fail is bad, let us count the ways
If the takeaway by some coin promoters of the 2007-2009 GFC is that instead of
trying to build an orderly, more resilient financial system, we simply allow
unaccountable actors to do whatever… this creates a lot of moral hazard and
likely will end with privatizing gains and socializing losses once more.
By requiring shadow banks and shadow payment providers register or become
regulated like their peers, this will clearly reduce the type of growth that stablecoin
issuers have hoped to achieve. That is not a desirable outcome by issuers.
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49. “Even Stephen”
Either laws around bank-related activities are abolished and removed from the books...
or shadowbanks are roped in and required to follow the same frameworks that banks
do.
Commercial bank operators could save a lot of money not complying with AML / CFT
requirements. Or FDIC mandates. Or safety and soundness regulations. If you
thought laundering money for ransomware was bad now, imagine if all commercial
banks removed the frictions in the rails and infrastructure; allowing anyone to move
funds anywhere via a KYC’less deposit account.
What most stablecoin issuers are saying is: treat us differently even though we are
providing some of the same services and products that banks do.
● E.g., as one reviewer asked: What’s the point of having a Financial Stability Board if it doesn’t
identify and act on something - a trend - before it becomes systemically important?
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50. Parasitic stablecoin
Cryptocurrency traders - especially in the DeFi world - are trying to have their cake
and eat it too.
On the one hand many promoters demonize the Fed and independent industry
oversight. Yet nearly all of their commercial activities - especially trading - relies
on:
- Stable unit-of-account
- Deposit insurance
- Safe and sound commercial banking system
- Clearing provided by the New York Federal Reserve
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54. Curiously the same coin investors who depend on a stable
exogenous rule-of-law and a stable unit of account, are
actively trying to undermine it as well.
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58. Important caveats
● Commercial banks existentially rely on central banks as lender of last resort (e.g., provide liquidity
when all others cannot)
● Collateral backed stablecoins get access to the RTGS payments system (Fedwire) via their
commercial banking partners.
● If you claim to be building a more decentralized and disintermediated world, the opposite is
occurring through hyperdollarization of DeFi.
● Currently it’s a one way relationship: all traders want and depend on a stable U.S. banking system.
If that stability went away, if a systemic crisis once again took place, they would likely need a bail out
- just like Money Market Funds. In fact, stablecoin issuers indirectly received one in March 2020
when the Fed stepped in to once again help MMFs.
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