Key Takeaways
- A stablecoin that “fully backs” its reserves are always able to fulfill conversions to the original asset
- Fully backed, however, does not necessarily mean that assets are held one to one. That claim refers to the idea that if you, say, give me a dollar, I’ll hold that dollar as a dollar and won’t turn it into something else. Lots of stablecoins that claim to be fully backed, like U.S. dollar stablecoin are not backed one to one.
Most banks don't actually hold 100% of your money. They lend out most of your deposits in an attempt to generate returns from financial markets. Theoretically it is safe to do because the bank insures their customers deposits with the federal government and because the bank widely diversifies its exposure to risk to ensure that it won’t be caught short in the event of a financial crash.
There are times when this non fully backed reserves strategy failed (i.e. Lehman) but this failure is more shown frequently in crypto (i.e. FTX, Terra LUNA, BlockFi). Currently, government does not insure deposits to crypto platforms and the platforms often do not manage their risk particularly well, making high-risk bets that end in catastrophe during black swan event.
After so many platforms squandered customer funds, crypto traders are thinking twice about depositing funds to crypto exchanges and lending institutions that due to the fear of uninsured deposits – which means they repurpose customer money and lend the funds out in the markets, or worse, taking a trade position using customer funds (i.e. Alameda Research using FTX customer funds). A safer bet looks like trading on platforms that “fully back” their reserves. But what does this really mean, and should such claims be taken with a pinch of salt?
Fully Backed, Explained
When a financial institution claims to “fully back” its reserves, it means that it has stored enough money behind the platform to support its worth.
So, a crypto exchange that “fully backs” its reserves should always be able to pay out customer withdrawals at any time no matter the state of the market. One such example is, which does not lend out its customers’ funds without their permission, meaning it should always have enough money on hand to prevent a bank run - a large number of customers of a bank or other financial institution withdraw their deposits simultaneously.
A stablecoin that “fully backs” its reserves are always able to fulfill conversions to the original asset, no matter what.
Example of Fully Backed Reserves
One example is wBTC (wrapped bitcoin), which holds real bitcoin (BTC) in a, then issues an equal amount of an Ethereum-based version of the coin that trades as an ERC-20 tokens.
Fully backed, however, does not necessarily mean that assets are held one to one. That claim refers to the idea that if you, say, give me a dollar, I’ll hold that dollar as a dollar and won’t turn it into something else. Lots of stablecoins that claim to be fully backed, like U.S. dollar stablecoin are not backed one to one.
This is because the companies that issue USDC hold the deposits of real U.S. dollars in “cash and cash equivalents.” Cash equivalents refer to U.S. Treasury bonds, which is debt issued by the U.S. Treasury Department. These bonds, which pay small returns to holders over time, are close enough to the worth of actual U.S. dollars that the market accepts bonds being essentially worth the same.
But “fully backed” does not always mean that the backing can withstand financial shocks. U.S. dollar stablecoin also claims that its reserves are fully backed, but this backing is secured by “other assets and receivables from loans made by Tether [the issuing company] to third parties.” So, USDT may be fully backed, but it is partially backed by loans to other crypto companies.
Until October 2022, USDT was also backed by commercial paper – short-term commercial debt to other companies – and moved those funds to U.S. Treasures. The concern about the commercial paper was that nobody knew which companies Tether was using to back USDT, so it was impossible to determine the worth of that backing. What’s more, its “fully backed” claim has historically turned out not to be true after it emerged in 2019 that USDT was, at one point. As wrote the Commodity Futures Trading Commission's Dawn D. Stump, the claim that it was backed to the U.S. dollar was “not 100% true, 100% of the time.”
Some stablecoins do not fully back their reserves, which has led to catastrophic results in some cases. The popular UST, wiping billions from the market.
On the opposite end of the spectrum, U.S. dollar stablecoin over collateralizes its reserves with crypto, meaning it has more than enough crypto on hand to back its coin. DAI has survived several market crashes.
