(Bloomberg) —
For months, a visitor to the website of Coinbase Global Inc., the largest U.S. cryptocurrency exchange, would see that the company offered a stablecoin called USD Coin with a simple premise: For every dollar offered to investors, there was $1 “in a bank account” to back it.
That promise was important for the stablecoin, which unlike Bitcoin has a set price and can be redeemed by users for regular currency. It helped USD Coin grow to be the world’s second-largest stablecoin, with $28 billion in assets.
But when Circle Internet Financial Inc., Coinbase’s partner in offering the coin, disclosed USD Coin’s assets for the first time last month, it turns out the promise wasn’t true.
According to a disclosure in July, the assets actually include commercial paper, corporate bonds and other assets that could experience losses and are less liquid if customers ever tried to redeem the stablecoin en masse.
That is likely to catch the eyes of U.S. regulators and enforcers who have recently homed in on stablecoins as a potential risk to the economy, experts say.
“You can’t market a product with falsities,” said Columbia Law School lecturer Lev Menand, adding that the failure to disclose the truth could be considered a consumer protection violation. “There’s a material difference and a huge amount of evidence that something backed by dollars held in a bank account is different than something backed by things like U.S. Treasuries or corporate paper.”
That’s something that the Federal Trade Commission could investigate under its mandate to enforce against “unfair or deceptive acts or practices.”
Stablecoins have come under increasing scrutiny from the government in the past few months as U.S. investors pour money into the market. As of last week, such coins held $117 billion. Already, the largest stablecoin, Tether, settled with the New York attorney general after she said Tether lied about the reserves backing its coin.
A Circle executive said in a statement that his company’s own disclosures and marketing materials provide accurate information. Centre, a consortium founded by Circle and Coinbase to govern USD Coin’s protocols, didn’t respond to requests for comment.
A Coinbase spokesman pointed to a blog post from earlier this month that said USD Coin’s reserves comply with regulatory requirements. On the day Bloomberg News contacted the company, some of the language describing USD Coin’s assets on its website changed.
“Each USDC is backed by one dollar or asset with equivalent fair value, which is held in accounts with U.S.-regulated financial institutions,” the spokesman, Andrew Schmitt, added in a statement Tuesday. “Users can always redeem 1 USD Coin for US$1.00. We have added additional detail to our website for customers to understand more about USDC reserves.”
From December 2018, the earliest saved page available from the Internet Archive, to Monday when Bloomberg called, Coinbase on its website described USD Coin as backed by dollars “held in a bank account.” A more in-depth help page about the coin said it was “100% collateralized by a corresponding USD held in bank accounts of the issuer.”
The Centre consortium publishes reports from an auditor that attest to the level of reserves. As late as March 2020, those reports said the coin’s reserves were held at federally insured U.S. depository institutions. But starting in April 2020, the attestations said the reserves could also be held in “approved investments,” without describing what those are.
Centre revealed in July of this year that 61% of the reserves were in risk-free assets like cash and its equivalents, but that some of the reserves were in assets that contain some risk of default, such as corporate debt and certificates of deposit with foreign banks. An additional 12% of the funds were in U.S. Treasury bonds, which aren’t considered a default risk but also aren’t as liquid as cash.
Stablecoin issuers “say trust us and that’s all well and good until there’s a problem,” said Adam Levitin, a professor specializing in financial regulation at Georgetown Law. “They can’t turn to the Fed for liquidity, there’s no deposit insurance — it’s an investment gamble.”
Cryptocurrency investors typically use stablecoins as a place to park cash when they want less exposure to more volatile currencies such as Bitcoin or to move money in and out of the crypto market more quickly than they can with banks. Stablecoins also allow users to easily move money between different crypto exchanges almost instantaneously, a process that can take days if done through a bank. Key to stablecoins’ promise is that investors at any time can redeem $1 of a stablecoin for $1 in real money that can be deposited at a bank.
In a blog post explaining the more detailed disclosure, Circle Chief Executive Officer Jeremy Allaire said the company wanted to “continue leading the sector with greater transparency” as stablecoins become more important to the broader financial system and Circle moves toward becoming a public company.
Circle announced on Monday that it intended to apply to become a full-service U.S. federally chartered crypto bank, a move that could give regulators more insight into its practices.
Policy makers are expressing mounting concern that consumers don’t know what risks they’re taking when they purchase a stablecoin. That concern is fueled by a lack of disclosure among some coins about what, exactly, is contained in their reserves.
In July, Treasury Secretary Janet Yellen convened U.S. officials to discuss whether the snowballing stablecoin market could be a risk to financial stability. Soon after, Securities and Exchange Commission Chairman Gary Gensler suggested some stablecoins should probably be regulated as securities and subject to more investor protection.
An investigation by New York Attorney General Letitia James found that Tether, the largest stablecoin, hadn’t always backed up its coins. Tether settled the case earlier this year and now says it doesn’t operate in the U.S.
USD Coin, which was founded in September 2018, took advantage of doubts about Tether’s backing to enter the fast-growing market. From the beginning the companies and Centre said USD Coin would be transparent about its assets and comply with U.S. regulations.
Gensler and other regulators have said the reserves backing stablecoins look more similar to those of money-market mutual funds than cash deposits. Such funds also try to maintain a value of $1 and can invest in Treasury bills as well as in corporate debt or other securities that have some chance of default. The funds charge a management fee and pay a yield to investors. Although they’re generally considered safe, such funds have “broken the buck” in the past, meaning their value fell below $1. That happened in 2008 when the Reserve Primary Fund couldn’t withstand rapid withdrawals by its investors after the failure of Lehman Brothers Holdings Inc.
Some policy makers have said stablecoins could face a similar risk if investors panicked.
The move into noncash assets has allowed Circle to build up its profits ahead of its planned market listing this year. Unlike money market funds, USD Coin doesn’t pay its holders a yield. Instead, Circle keeps whatever profits it earns for its own shareholders. In an investor presentation, Circle described returns earned on investing its reserves as one of the “fundamentals of our financial model.”
In a filing with the SEC last week, Circle said the company earned about $3.2 million in the first quarter on interest income from USD Coin’s reserves, which at the end of March stood at about $11 billion. That’s more than the company could have made investing solely in cash equivalents.
The filing, made in connection with Circle’s bid to become a public company, said a portion of that income was shared with Coinbase per a contractual agreement. The company in the same period made about $14.1 million in revenue from other business lines, like managing business accounts and payments systems.
Circle has yet to disclose exactly what investments comprise USD Coin’s reserves.
“It’s like Schrodinger’s stable coin,” said Rohan Grey, a professor at Willamette University, referring to the famous thought experiment used to explain quantum theory. “You don’t know if the cat is dead or alive until you open the box,” said Grey, who has been a critic of stablecoins and advised lawmakers on legislation to increase their regulation.
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