Recent concerns have been raised by regulators regarding potential risks posed to traditional financial services (TradFi) by decentralized finance (DeFi). Such apprehensions have been amplified by events like the collapse of algorithmic stablecoin terraUST and the failure of FTX crypto exchange in 2022. Though the spillover effects on established financial institutions were limited, they have intensified the worries surrounding DeFi.
Regulators have been concerned about the potential risks decentralized finance (DeFi) poses to traditional financial services (TradFi) for years. These concerns were amplified by events like the collapse of algorithmic stablecoin terraUST and the failure of FTX crypto exchange in 2022. However, recent failures of established financial institutions like Silicon Valley Bank and Signature Bank have shown that distress in traditional finance can also impact DeFi.
This was evident when Circle’s USD coin lost its peg to the dollar on March 10, following U.S. banking authorities’ takeover of Silicon Valley Bank. Other stablecoins, including BUSD and DAI, also lost their pegs, while USDT benefited from the turmoil. Cristiano Ventricelli, the Associate Vice President of DeFi and Digital Assets at Moody’s Investors Service, warns of the potential risks for the DeFi sector.
According to Moody’s, the depegging incident was brief, and after the announcement that uninsured depositors at Silicon Valley Bank would be fully covered, the USD Coin (USDC) price started to rise towards $1. As of April 2, 2023, USDC, DAI, and BUSD have remained pegged to $1. However, Moody’s has warned that the depegging events have revealed the risks associated with stablecoin issuers relying on a small set of off-chain financial institutions, limiting their stability. In fact, the heightened awareness of these risks could exacerbate the situation for stablecoin issuers.
The potential risks posed by decentralized finance (DeFi) to traditional financial services have been a concern for regulators, especially following events like the collapse of algorithmic stablecoin terraUST and the failure of FTX crypto exchange in 2022. However, the recent failures of Silicon Valley Bank and Signature Bank have shown that distress from established financial institutions can also spread to the DeFi sector.
Circle’s USD coin (USDC) lost its peg to the dollar on March 10, 2023, following the announcement that Circle had up to $3.3 billion in exposure to Silicon Valley Bank, which had suffered a deposit run. Other stablecoins, including BUSD issued by Paxos and crypto-backed stablecoin DAI issued by MakerDAO, also lost their pegs. Only USDT saw a temporary rise above $1 as investors shifted out of depegged stablecoins.
The depeg event was short-lived, and the USDC, DAI, and BUSD stablecoins remained at their $1 peg as of April 2, 2023, after uninsured depositors at Silicon Valley Bank were fully covered by U.S. banking authorities. However, Moody’s warns that the risks of stablecoin issuers’ reliance on a small set of off-chain financial institutions have been laid bare, which could limit their stability. Broader awareness of these risks could also worsen the situation for stablecoin issuers.
Circle managed to onboard new banking partners after the USDC depeg, but traditional financial institutions may reconsider working with stablecoin operators, making it more challenging for fiat-backed stablecoins to maintain stable exchange rates.
In response, regulators may increase their scrutiny of stablecoins, as seen after the Terra/LUNA collapse, which raised concerns about stablecoin reserves. Additionally, the depeg of USDC and other stablecoins highlights governance risks related to the custody of reserve assets. The EU cryptoasset regulation (MiCA) touches on this, but European banking authorities will determine precise regulatory standards.
