Reserve practices for major stablecoins have become more conservative, but stablecoin holders continue to face other sources of risk, some of which have been spotlighted in the failure of major cryptocurrency entities, says Fitch Ratings. These include incomplete attestations, weaknesses in the legal rights of stablecoin holders, and contagion risks linked to the cryptocurrency ecosystem.
 
The overall capitalisation of the stablecoin sector has shrunk significantly since the collapse of Terra in May 2022, falling from around USD189 billion at end-April to around USD144 billion at end-December. The bankruptcy of the second-largest crypto exchange, FTX, amid a fraud scandal in November, followed by Binance’s pause in withdrawals in December, led to heightened stablecoin redemption activity and episodic unmooring of Tether’s USDT and Binance’s BUSD stablecoins from par. Both tokens were only unmoored by slight amounts and stablecoin trading velocity has recovered somewhat, but these events have negatively affected sentiment towards stablecoins.
 
 
 
 The three main stablecoin issuers, Tether (USDT), Circle (USDC), and Binance (BUSD) remain significant, with a combined circulating supply of over USD127 billion as of end-2022, constituting almost 90% of the stablecoin sector.

We believe market concerns and pressure from regulators have driven a trend towards more conservative reserving and some improvement in transparency, although significant variation between stablecoins remains. Reserves for the dominant stablecoins increasingly comprise short-term US Treasuries and cash. For example, Tether has said it reduced its commercial paper exposure by USD24 billion in 2022.
 
 Nonetheless, the price volatility of USDT and BUSD is still high compared with money market funds. This reflects lingering risks around reserving practices and transparency, as well as other factors such as contagion risk, counterparty risk, the legal rights of stablecoin holders (notably around redemption rights) and operational risks, including cyber risks.
 
 
 
 Potential contagion risks were highlighted by auditing firm Mazars' pause in work for crypto clients including Binance in December, which led to outflows for BUSD. Counterparty risks were flagged when Silvergate Bank, a key custodian for crypto entities, reported an almost 70% drop in deposits over 4Q22.
 
 Meanwhile, the bankruptcies of FTX and Celsius have heightened questions regarding the legal rights of digital token holders. Among other things, it is still not common practice for major stablecoins to provide guaranteed timelines for redemption into fiat currency or alternative assets. This may become a focus for regulators - Singapore’s proposed regulation of stablecoin issuers, for example, would toughen requirements on this front.
 
 We expect the close linkages between major stablecoins and the broader crypto sector to remain a focus for regulators. US banking regulators said in a joint statement on 3 January they had significant safety and soundness concerns over business models that were concentrated in crypto-asset-related activities or have concentrated exposure to the crypto-asset sector. This may encourage US-based banks to limit their engagement with stablecoins, which could make it more difficult for crypto-focused stablecoins to find reliable US custodian partners. Such challenges are unlikely to affect bank-issued stablecoins with use cases focused on non-crypto payments.
 
It remains unclear whether regulators in other key financial markets will have similar concerns. The Basel Committee on Banking Supervision’s new global standard for the prudential treatment of crypto assets allows banks to treat stablecoins that have ultra-safe reserve practices based on looking through to the underlying assets, with an infrastructure risk capital add-on that individual regulators can determine.