1) What Happened? | The Empire Strikes Back
The USDC Depeg, Bailout of Banks & Operation Chokepoint 2.0
The Blockchain Sector provides information relating to emerging financial technologies. It should not be considered financial advice. Disclaimer below.
The value of USDC hit an all-time low ($0.82) on Saturday after Circle, the US firm behind the coin, revealed that $3.3bn of the reserves backing it were held at Silicon Valley Bank, which collapsed on Friday.
What Happened?
Silvergate Capital
It all started at Silvergate Capital, a crypto-fiat gateway network for financial institutions and a significant on-ramp for cryptocurrencies in the United States. They have been on the brink for some time and shut down operations due to liquidity problems.
Silvergate announced that it planned to voluntarily wind down operations and liquidate. This announcement caused the bank's stock to drop by 37% between Tuesday and Thursday, but the shares had already tumbled 90% since early November due to the bankruptcy of crypto exchange FTX. The collapse of Silvergate was gradual, then sudden, leading to huge profits for short sellers who had bet against the bank's stock.
Senator Elizabeth Warren rejoiced
Silicon Valley Bank
Shortly following this rumours started circling among VC’s and start-ups that Silicon Valley Bank was illiquid and that depositors should withdraw their funds.
This led to a bank run of epic proportions as panic set in and the withdrawals amounted to $42 billion on Thursday alone.
Silicon Valley Bank had invested customer deposits in 10 year mortgage backed securities. These had declined in resale value due to the rise in interest rates making the yield uncompetitive. Their $91 billion portfolio of “held-to-maturity” securities was worth just $76 billion creating a deficit which meant they couldn’t meet withdrawals.
Circle the issuer of USDC had in excess of three billion dollars held at SVB which was part of their short-term liquidity provisions.
Signature Bank
Signature Bank, a New York-based financial institution with $110.4 billion in assets became the second bank to collapse in this ongoing banking crisis. Regulators declared that the bank posed a systemic risk and could threaten the wider US banking system.
Signature Bank's sudden closure will cause technical challenges for the crypto industry, as it operated Signet, a payments system used by Circle, Coinbase, OKX and others.
This was seen as many as an outright attack on crypto-fiat infrastructure by regulators.
“I think part of what happened was that regulators wanted to send a very strong anti-crypto message. We became the poster boy because there was no insolvency based on the fundamentals”
Signature Bank Board Member Barney Frank
The Bailout
In a joint statement by @federalreserve @USTreasury @FDICgov it was announced that Silicon Valley Bank and Signature Bank will be taken over to protect depositors and provide confidence in the banking system.
Shareholders and some unsecured debtholders of these banks will face losses, but depositors will be protected.
The US government is taking actions to ensure that the US banking system continues to function properly and provide access to credit to households and businesses in a manner that promotes strong and sustainable economic growth.
The Federal Reserve Board will make additional funding ($25B?) available to eligible depository institutions to help assure that banks have the ability to meet the needs of their depositors. The aim of these actions is to prevent further contagion and bank runs and make the banking system more resilient.
Full statement: https://www.federalreserve.gov/newsevents/pressreleases/monetary20230312b.htm
In essence they are closing the banks, making depositors whole and providing a resale venue of last resort for banks to liquidate or take loans against assets that have lost value due to interest rate rises.
Bitcoin and Ethereum along with many risk assets have rallied due to the increasing probability of a FED reversal or slowdown in interest rate hikes and quantitative tightening.
The agencies involved were keen to point out that no tax payers funds will be used and this certainly is not a bailout. This is not surprising as such a thing would be fiscally irresponsible given the current economic conditions and levels of inflation.
USDC
USDC had exposure to SVB and short sellers piled in creating a depeg event as liquidity dried up.
USDC is one of the most transparent and largest centralized stablecoins. At time of writing there is around $40B USDC in circulation and these funds are backed by Circle who custody the assets.
75% of the assets were held in short term treasuries (less than 3 months) which are highly liquid and don’t depreciate in the same way that 10 year bonds do. The remaining 25% was split between six banks including SVB which held over $3B of Circles assets. These funds were used for day to day liquidity and withdrawals as SVB was considered a crypto friendly bank.
The deposits are secured under the FED “bailout (not a bailout)” discussed above but this created short-term liquidity problems for circle who could not cover withdrawals quick enough over a weekend where banks were closed and the entire banking sector was in chaos.
Since then USDC has almost reclaimed peg and the drama seems to be residing. However this does highlight a new and emerging scenario.
TradFi A Systemic Risk To DeFi?
Is it possible that in the future traditional finance incorporating human error and greed could become a systematic risk to DeFi?
We have heard a lot from regulators about how crypto is a risk to tradfi but in this situation failures and human greed led to the depegging of a collateral asset used widely throughout the DeFi ecosystem.
The increase in regulatory litigation and the recent events with banks looks like offensive action against the blockchain sector in the US. Some are branding the latest wave of actions “Operation Chokepoint 2.0”.
As developers can we do more to work with decentralized protocols and trust in immutable code to reduce the exposure to centralized single points of failure?
Regulators haven't been able to remove greed and human error from the financial markets over the last hundred years and I don't expect them to be able to over the next 100 years either
Is the token or protocol you are building on top of at risk of regulatory attack, corporate failure, mismanaged funds?
Long term I expect there will be a Darwinian effect where robust decentralized systems create the next generation of financial technology and the strongest will go on to become long-term financial primitives.
Throughout this drama Bitcoin and Ethereum continued producing blocks on the brink of another bailout for banks 14 years after this was etched in Bitcoin’s genesis block
“The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”
Thanks for reading, if you enjoyed this you might enjoy the other content I create around blockchain development and decentralized finance
This week I wrote up some research I’ve been doing on zkEVM based Ethereum rollups: https://jamesbachini.com/zkevm/
If you would like to stay up to date with the latest developments in the blockchain sector then subscribe to the newsletter and check out my other social channels
Disclaimer: Not a financial advisor, not financial advice. The content I create is to document my journey and for educational and entertainment purposes only. It is not under any circumstances investment advice. I am not an investment or trading professional and am learning myself while still making plenty of mistakes along the way. Any code published is experimental and not production ready to be used for financial transactions. Do your own research and do not play with funds you do not want to lose.