Over the weekend, USDC depegged after a $3.3b shortfall in the USDC reserve account appeared due to funds stuck in SVB. USDC subsequently regained its peg following the fed decision to cover depositor losses at SVB. In a press release issued before the fed decision was announced, Circle stated it would “stand behind USDC and cover any shortfall using corporate resources, involving external capital if necessary.”
When people think of USDC, they don’t think of a stablecoin backed by the balance sheet of a company called Circle. USDC is meant to be fully-backed by dollar-denominated collateral in the USDC reserve account – a series of segregated positions held for the benefit of USDC holders and ringfenced from the other assets on Circle’s balance sheet.
The recent USDC depeg, together with Circle’s commitment to top up the reserve account, raises a critical question: what would happen to USDC holders if Circle the company were to go under?
I think most USDC holders assume that, even if Circle were to fail, the collateral in the USDC reserve account would still be used to back USDC 1:1 and allow redemptions to occur 1:1.
But is this true? I briefly looked into this question and below is what I found. In the past, I worked with weird structured finance deals and large, messy bankruptcies. It’s been a minute, so I also reached out to legal experts and will update this post as I dig deeper and learn more. For now, take this analysis with a grain of salt. If there are others familiar with bankruptcies of money transmitters, I’d appreciate your comments / corrections.
Circle isn’t a bank backed by the feds; it’s licensed as a money transmitter. Circle tells us that “USDC is backed by the equivalent value of US dollar denominated assets held as reserves for the benefit of USDC holders,” and provides detailed breakdowns of the these assets as well as monthly third-party attestations of their value. The market cap of USDC is currently about $40 billion, and there was an equivalent amount of assets the reserve account as of the end of January (and presumably now, following the SVB depositor bailout).
The $40 billion dollar question is this: if a money transmitter keeps assets in segregated accounts “for the benefit” of holders, does this prevent the company’s other creditors from making claims on those assets if the company fails?
First off, it’s important to recognize the general premise that, in a bankruptcy, a failed company’s assets are distributed to all its creditors on an equal basis, except where some group of creditors has a legal priority (e.g., if the company pledged a specific asset to a specific group of creditors, then those creditors get to recover the value of that asset first). A company can segregate its funds into many different bank accounts that are earmarked for different purposes, but unless an account is pledged to a specific group of creditors, the accounts on the balance sheet of the company are lumped together in its bankruptcy estate.
Is there something special about a money transmitter that overrides this general rule? It doesn’t seem so.
In a consumer protection analysis comparing the safety of traditional bank accounts with that of prepaid debit cards issued by money transmitters, Pew points out that “[w]hile a money transmitter may have to hold investments meant to provide security to its customers, if the business fails and the investments that are held against debts are insufficient, the surety bond might be the only source of funds that customers can rely on to have their money returned.” (Note: a “surety bond” is, in essence, some value posted by the money transmitter with a state for benefit of its customers. These values are typically small.)
The Pew analysis was focused on consumers who deposit their salaries or other funds into accounts with money transmitters to prepay debit cards the money transmitter issues, instead of using traditional bank accounts. It found that, even if a money transmitter holds those funds in a separate account for the benefit of a particular customer, that customer still doesn’t have a special claim on the funds it deposited if the money transmitter fails (beyond any nominal value posted in advance by the money transmitter with a state in its licensing process). The money transmitter’s other creditors would have an equal claim on deposits. In practice, this means that everyone – including depositors – would take a haircut.
Because US money transmitters are licensed on a state-by-state basis, there’s some nuance here and I’m looking into the question whether certain states create additional protection for segregated accounts held by money transmitters. I haven’t yet seen anything suggesting that is the case.
If Circle were to fail in the future, it seems obvious that its creditors would try their hardest to recover their losses by claiming a right to receive some of the proceeds from the USDC reserve account. If I were a Circle creditor, I know I would. If there are no special protections for segregated accounts held by money transmitters, we have a problem.
Consider the following hypothetical:
- Circle has $4 billion in USDC reserves deposited at a bank that fails.
- The feds decide not to bail out the failed bank’s depositors. USDC depegs.
- Circle incurs $4 billion of unsecured corporate debt to top up the reserve account and regain the peg, so it can continue to honor 1:1 redemptions.
- Circle funds the growth of its other business units, including Circle Ventures, Circle Impact and Cybavo (custody a service, programmable wallets, web3 integrations, etc.) by raising another $3 billion in unsecured debt.
- Circle is adversely affected by market conditions, makes bad business decisions, and goes bankrupt.
- At the moment of Circle’s bankruptcy, USDC’s market cap is $20 billion. There is $20 billion in the USDC reserve account, no other significant assets and a $7 billion hole in Circle’s balance sheet.
In this hypothetical, in addition to $20 billion in USDC holders, there will be an additional $7 billion of creditors looking to recover what they can from Circle’s bankruptcy estate. If all creditors are treated equally, then everyone – including the USDC reserves – will take a 35% haircut. USDC would most likely depeg to $.65, with no clear mechanism available to recover the peg.
Circle’s multitude of business units that are at best ancillary to operating USDC, like “Circle Ventures” (remember FTX ventures?) and “Cybavo” – as well as its recent failed attempt to go public via SPAC – suggest it views itself as a growth company. There is an incentive mismatch here: USDC holders don’t care about Circle’s corporate growth; they care about USDC’s stability. Circle, on the other hand, is willing to risk the long-term stability of USDC so it can consolidate the reserve account into its corporate balance sheet and sell a growth story.
This is not to say that Circle is at risk of imminent failure. But in the longer term, as we have seen time after time, companies that sell growth stories are subject to elevated business risk. Their managers make big bets and sometimes fuck up. In the long run, they often fail.
USDC is today a critically important piece of crypto infrastructure. It is important to know whether it’s backed by a truly ringfenced collateral pool or if it’s backed by the corporate balance sheet of a growth company. The information available suggests the latter. In that case, any eventual failure of Circle the company would very likely lead to a depeg of USDC – perhaps a substantial depeg – that would be difficult to reverse. This would have catastrophic consequences for crypto.
I don’t see why USDC holders should take this risk.
The easiest way to solve this problem is for Circle to stay in its lane. If Circle wants to keep doing growth things, it should spin them off into a separate entity with a separate capital structure that has no claims on the entity holding the USDC reserve account.
Otherwise, Circle should take USD deposits, invest them in liquid assets like treasuries, issue USDC (paying no interest to holders), use the $1.8 billion in investment income on $40b of 4.5% treasuries to overcollateralize the reserve account with a capital buffer to compensate for black swan events like those of recent days, skim profits off the top, and count its blessings for earning such easy money. It should not have other business units.
In any case, the corporate structure holding the USDC reserve account should have no ability to take on creditors other than USDC holders.
The king himself put it best in his Silvergate post-mortem:
Circle should learn from the muppets’ mistake.
JR crypto research 
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