Fully backed reserves, the latest thing that people are calling for crypto companies to have, prove that these companies have enough funds to pay out to their customers.
This may or may not come as a shocker to you, but all banks don’t actually hold all of your money. What you deposit in a bank can end up being lent out by the bank, in order to compensate for returns from the markets.
Fundamentally speaking, banks lending out deposited funds has been working quite well, since banks typically insure these deposits with a central figure – typically a federal government – while diversifying its risk exposure so that they can find a way out once a financial crisis happens.
From time to time, we’ve seen it fail in TradFi. But this very deposit system fails way much more often in crypto.
As of the moment, most governments around the world do not insure deposits to crypto platforms. As there’s no insurance, bad risk management can often result in gambles that can endanger the very existence of a crypto platform. We’ve seen this happen with Celcius, Voyager, and most recently, FTX.
With many instances of corruption, where crypto firms have misused funds that their users have deposited (and trusted) into their platform, many traders are eager to switch to platforms that “fully back” their reserves.
But what does this ‘full backing’ thing entail, and does it guarantee the safety of everyone’s funds?
Fully backed reserves in a nutshell
A financial product claiming to “fully back” its reserves means that it already has enough money stored in order to support what it’s worth, especially for times of crisis. This money can take the form of a stablecoin, or a user’s trading account on a crypto trading platform.
As for stablecoins that claim to be “fully backed”, it doesn’t mean that they’re backed one-to-one. It doesn’t guarantee that the dollar that you give to a stablecoin issuer will get you back that very dollar’s amount. It also doesn’t 100% guarantee that it can survive major financial meltdowns.
Fully backed reserves, in fuller detail
How does fully backing work?
Crypto exchanges claiming to have “fully backed” reserves means that they’ll always be able to pay out customer withdrawals, even if everything is falling apart.
One of the more famous examples is Coinbase, which won’t lend out a customer’s deposited funds without their permission. As such, Coinbase should have enough funds on hand to not experience a bank run.
More on fully backed stablecoins
Goin back to fully backed stablecoins, their reserves can always be converted to the original asset that it is pegged to, no matter what.
One example of a fully-backed stablecoin is wBTC (wrapped bitcoin), where real bitcoin (BTC) is held in a ‘cold wallet’ in order to issue the same amount of money for use on the Ethereum network.
In this case, the ‘converted’ bitcoin is now available for trade on the Ethereum network, in the form of an ERC-20 token. Any user’s remaining wBTC can be converted back to BTC, at the rates given at any moment.
As such, any fully backed financial product doesn’t always mean that assets will always remain a 1:1 trading ratio. Stablecoins that claim to be fully backed such as USDC (US dollar stablecoin), are not traded 1:1 to the fiat US dollar.
When crypto companies issue USDC, they hold user-deposited fiat US dollars in “cash and cash equivalents.” The cash equivalents in question refer to US Treasury bonds, also known as debt issued by the US Treasury Department.
These bonds soon come back to holders of USDC over time, which eventually pay small returns over time. The values of these bonds are typically close to value of the fiat US dollar, and the market also typically accepts that these bonds are essentially worth the same.
Some stablecoin issuers however stretch the definition being “fully backed”. For example, USDT, or Tether, claims that it has fully backed reserves secured by “other assets and receivables from loans made by Tether [the issuing company] to third parties.”
Essentially, USDT is fully backed in name, and is also partially backed by loans to other crypto companies.
Another USD stablecoin issuer DAI also stretches their scope of being “fully backed”, where it overcollateralises its reserves in the form of crypto.
This means that DAI has a stash of other crypto assets ready to be paid to back its coin, and gave DAI the luxury of surviving a few crypto market crashes.
But what happens if a stablecoin hasn’t fully backed their reserves? Back in May, the infamous algorithmic stablecoin UST crashed, and in turn wreaked havoc, with billions disappearing from the market, and firms left insolvent.